By any measure, the death spiral in house price is over and the recovery is now setting in motion powerful forces of growth across the economy. The S&P Case Shiller House Price Index was up 1.4% in March – the most recent data available – and 10.9% from a year ago, the strongest pace in years. While other indexes are still in the single digits, all are well off the bottom and solidly trending up. The recovery has been so robust that some analysts are already calling a new bubble. That’s a bit premature. The house price recovery only has one year under its belt, and we think it is just getting started.
Nationally, house prices peaked in 2006, plunged sharply through 2009, drifted sideways to down through 2011, and really only began to recovery in early 2012. Altogether, house prices declined 35.1% from peak to trough. Since the bottom, prices are up an impressive 10.9% (the dark orange bar in the chart) but are only about a fifth of the way to the prior peak (the light orange bar), well removed from bubble territory.
Regionally, San Francisco has posted the strongest recovery from the trough (the dark blue bar at the top) but is only about a third of the way to the prior peak. A few cities had less of a boom/bust, such as Denver and Dallas, and could post new all-time highs before the year is out. Other cities like Las Vegas are up smartly from the trough but are in such deep holes that they might not see new highs until a future business cycle altogether.
In the meantime, homeowners across the country are seeing higher house prices and feeling wealthier, more and more underwater mortgages are getting back above water, and mortgage assets that banks and others wrote down during the bust are now being written back up. It surely is no happenstance that the two sectors with the most exposure to the housing recovery – Consumer Discretionary and Financials – have been consistent leaders in the equity market since house prices turned up decisively a year ago … and they are still leading. The house price recovery is well underway but the positive feedback effects on the economy are just getting started.
The third leg of the Abe Trade is finally kicking in: Japanese government bonds have begun to sell off. Last fall, ahead of Japan’s elections, Shinzo Abe began to emerge as the likely winner with a radical agenda for change. McAlinden Research mapped out how Abe’s strategy, if successful, would lift stocks but undermine bonds and the yen. Since Abe’s victory, stocks have surged and the yen has plunged. But government bonds had been holding up despite the massive shifts in fiscal and monetary policy.
Last month, JGB yields hit an all-time low of 0.4% and have been grinding up ever since. The market is recognizing that the new government’s reforms are credible and mark an inflection point for the economy. Japanese investors are already reallocating overseas. Although the coincident economic data remains mixed – industrial production is still weak while retail sales are improving – the OECD’s leading indicators are turning up and the latest purchasing manager survey is back in expansion. After years of sluggish growth and persistent deflation, stronger growth and rising inflation will push nominal yields higher.
The government’s stimulus policies have been helped by the rally in stocks and the sell-off of the yen (just ask the exporters), but policymakers won’t want to see rates rise too high or too quickly. If that happens, the Bank of Japan might intervene and buy even more bonds to slow the rise in yields. Whether slow or fast, however, yields are going up and bond prices are going down. The Abe Trade is now firing on all pistons with quite a long way yet to go.
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Warren Hatch, PhD, CFA
Chief Investment Strategist
McAlinden Research - a division of Catalpa Capital Advisors, LLC
Global financial conditions are about as good as they can get. Stock markets are hitting new highs. May has been the busiest month for IPOs in a decade. Lending conditions are easing. Many central banks are again cutting rates while others are still buying up assets as part of their massive quantitative easing programs. Although yields on US government debt have edged up, yields on corporate debt have kept coming down, leaving credit spreads as tight as they have been since before Lehman’s collapse. US high yield debt is now below 5% for the first time ever. The global stretch for yield has brought emerging market yields down to levels usually associated with developed markets – and in some cases lower.
For borrowers, the drop in interest rates is great news. With mortgage rates so low, housing affordability remains at all-time highs. Corporate issuance has been booming, and even cash-rich companies like Apple are borrowing with rates this low. And Brazil’s Petrobras is about to offer the biggest emerging market bond issue ever.
For central bankers, while low rates can be good for growth and asset prices, some policymakers are starting to voice some concerns about the risk of a new credit bubble forming – but not enough to signal that they intend to reverse course any time soon. The most Ben Bernanke has said is that the Fed is “watching particularly closely” for signs of excessive risk taking. Meanwhile, the flood of liquidity is set to get even higher, thanks to the latest rounds of easing led by Japan. In this environment, all asset prices could go higher. According to Lipper, US fund flows are still strong for both stocks and bonds.
For investors, the asset allocation environment is shifting. With bond yields already pancake flat, bond prices are close to being capped out: there is not much more yield to reach for, at least for fixed income. The Barclay’s Aggregate Bond Index has already been lagging the S&P 500 since last November. As the global economy regains momentum and inflation begins to turn up, investors should consider shifting into assets with better total-return prospects like stocks, commodities, and real estate.
Payrolls were doubly strong in the US last month. April’s payrolls gained a solid 165 thousand. But the real story was in the upward revisions to March and February by a combined 114 thousand. That adds up to 635 thousand jobs over the last three months, nearly 25% more than the consensus had been expecting. And that’s before the benchmark revisions.
In the initial release, the government relies heavily on assumptions and estimates about business hiring trends. The statisticians then update the data as they are able to collect more information. Typically, each month’s release will include revisions to the prior two months and each year there will be benchmark revisions to the prior five years or so.
Since the current economic expansion began in July 2009, payrolls as originally reported have averaged just 75,000 each month (the light blue bar on the left). After the initial monthly revisions are included, the average monthly gain improves to 105 thousand, much better but still sub-par historically. Including all the benchmark revisions, payrolls during expansions since 1950 have added 175 thousand jobs each month. As it happens, April’s performance was just under the historical average … and that’s before any revisions at all.
Even after all the revisions are made, the labor market in this cycle was slow to get traction, partly a reflection of how much damage was done during the recession. While there’s a long way to go, the pace of recovery in the labor market is finally closer to the norm as the data picks up steam, including the revisions. So the first release of the payroll data should always be taken with a grain of salt: payrolls can often have the appearance of slowing because the initial release is typically revised up when the economy is growing. So it’s often better to ignore the latest release and focus on the direction of the revisions.
The US economy is now 15 quarters in to the expansion, and government has subtracted from growth in 11 of them, or two thirds of the time. Even with the headwinds, the economy posted a respectable 2.5% pace of growth in the first quarter of 2013, an improvement over the last quarter of 2012 (when the government was an even bigger drag), but somewhat below expectations of 3.0% and well below the typical pace of post-war expansions. In the 10 prior business cycles since 1950, the US economy grew an average of 4.2% during expansions (ie, excluding recessions), exactly double the average 2.1% so far in this cycle (the white dots in the bar charts).
The government also reports the GDP data in four principal accounts, which can help show how the current expansion stacks up. On average, investment contributes 1.3 percentage points to GDP growth (the blue bars), close to the current cycle’s average 1.1 percentage points. The US typically runs a trade deficit during expansions and the quarterly hit from net exports is also close to the norm (the brown bars), averaging -0.1 percentage points historically compared to -0.2 at the current pace.
The two other categories account for current cycle’s subpar performance. In past expansions, personal consumption alone added 2.5 percentage points to growth (green bars), a full percentage point higher than the 1.5 contribution in the current cycle. And then there’s government (orange bars), which flipped the sign from a typical contribution of 0.6 percentage points to a loss of -0.3, a difference of nearly another full percentage point.
Going forward, we expect the contribution from personal consumption to improve as the labor market improves, wages pick up, and household net worth recovers to new highs. We also anticipate continued strength from investment, both business and especially residential. Assuming net exports to be a modest drag, the big wild card is the government. With the recent tax changes still reverberating and the full effects of the sequester yet to hit, the government is likely to be a drag for at least a few more quarters and represents a complicating factor in assessing the economy’s fundamentals
So we’d be concerned if consumer spending really faltered, business investment ground to a halt, or the housing recovery suddenly rolled over. When GDP for the first quarter came in below expectations, however, all of those private-sector pistons were firing just fine. Instead, blame the government.
With all the cross currents, GDP alone can be a misleading indicator of the underlying trends, which brings us back to what we believe to be a better metric: “final sales to private domestic purchasers,” which strips out the government as well as the swings from inventories and net exports (the yellow diamonds). Over time, its average is close to headline GDP but tends to be more stable from quarter to quarter. Without all the noise, the pace of “core” GDP was up a respectable 3.3% in the first quarter.
What started out as cracks in the edifice is starting to reach the foundations. While the European Union is highly unlikely to fail altogether, the post-war consensus for ever-deeper integration might have peaked. Meanwhile, stress points seem to multiply faster than the EU is able to solve them. For the markets, the stress points are emerging in three critical areas.
Economically, the outlook is grim. Unemployment just hit a record high. Industrial production continues to contract. Purchasing manager surveys remain weak. Retail sales are sluggish. And sentiment is uneven at best. When the financial crisis first hit, policymakers responded with fiscal stimulus. When that failed to turn things around, they tried austerity. Now the pendulum is starting to swing back the other way. Meanwhile, the divide between north and south is getting blurry: Greece and Spain are still struggling but now France and the UK have been getting weaker. Even Germany is beginning to sputter. There are a few bright spots, such as low inflation and a trade surplus, but they are getting hard to find.
Politically, the governing elites are embattled. France had a presidential election last year and the winner is already less popular than his predecessor. Italy had parliamentary elections earlier this year but has yet to form a government. Germany will have elections later this year; right now the chancellor is leading the polls but her coalition partners are not. The UK will vote in two years and the future for its current coalition is not bright. Historically, the leading parties across Europe had a shared vision of a united continent; where they have differed was in how united it should be and the best way to go about it. As the elites lose their edge from Finland to Greece and from France to Germany, smaller parties are rising in prominence with more radical agendas. And those agendas are going mainstream. The UK’s government has promised a referendum on whether to leave the EU altogether. Such talk has always been on the political fringes; the difference now is that it is respectable.
Internationally, the third critical area, the European Union is now punching well below its weight. Even with its current ills, Europe is a leading global market with a highly educated and dynamic population. But in international affairs the EU is losing influence. The euro was intended to be a global reserve currency, but lately China has had better traction with its yuan. Carbon trading was to be Europe’s signature policy contribution to curb global greenhouse emissions, but that initiative now lies in tatters. Vestigial over-representation in international bodies like the United Nations Security Council and the International Monetary Fund is not only anachronistic, it risks bringing those institutions into irrelevance as well. It is probably not a coincidence that trade talks at the World Trade Organization are paralyzed while regional trade agreements are blossoming across the globe.
Europe’s markets have been doing reasonably well despite the headwinds, with some caveats. Borrowing costs for most of the continent remain low, partly thanks to the ECB’s bond purchases. Credit default swaps show little risk of sovereign default, in part because regulators recently banned speculators from trading CDS. Equities have been rallying, even if they lag the US and Japan. The euro itself has strengthened against its trade partners, although that might be a reflection of relatively restrained policy at the ECB. The Fed’s quantitative easing policies have been far more aggressive all along. And the yen’s recent plunge shows what can happen to a currency when a central bank abruptly shifts policy. The ECB is expected to cut rates a modest twenty-five basis points at their next meeting. If EU policymakers change course to take bolder action and adopt their own version of Japan’s Abenomics, the “Draghi Trade” might see stronger stocks and weaker bonds combined with a sharp drop in the euro.
The bottom line is that for over fifty years the European Union had the luxury of evolving in an environment of relative prosperity, with strong elites, and a sense of common purpose and destiny as new institutions were created and its membership expanded. The results are now being stress tested. If Europe is able to negotiate its way through these stresses, as eventually seems likely, it will undoubtedly be stronger with a renewed sense of unity. If. As Roman emperors found centuries ago, an empire is built in pieces but must be held together as one.
Much ado has been made about the decline in the participation rate as evidence of a weak cyclical recovery in the US labor market. It means nothing of the sort.
The participation rate measures the share of Americans who currently have jobs as a percent of the civilian non-institutional (ie, not in jail) population. In the 1950s, the rate was around 59%, started increasing in the mid-1960s, peaked at 67% in 2000, and has been on a downward slope ever since. The participation rate is now 63%, a multi-decade low. Analyzing the participation rate by gender provides a clearer picture of what’s really going on.
For men, the participation rate started out at 87% back in the 1950s but has been steadily declining ever since and now stands at 70%. There are many factors at work, but the simple truth is that Americans are getting older: while many senior citizens choose to keep working, those who retire drop out of the ranks of the employed but remain part of the civilian population, thereby dampening the participation rate.
For women, there is more to the story. Back in the 1950s, their participation rate was just 35% but rose for the next several decades and eventually reached 60% in 2000. After the surge of women into the labor force peaked, the women’s participation rate began to decline as they too got older and is now 57%.
The point becomes crystal clear when focusing on Americans in their prime working years. The participation rate for people between 25 and 54, is currently 81%, down about two percentage points from five years ago but exactly where it was five months ago. The delayed entry of younger workers into the labor force and the steady increase of older Americans both present policy challenges, but the overall participation rate is not sounding alarm bells for the economic recovery.
The bottom line is that the labor market might be weak or strong (and we think it’s stronger than the recent data suggests), but the participation rate is a poor guide to those cyclical changes. It’s been mainly demographics all along. The participation rate surged because women came into the labor force. It is now declining because all Americans – men and women – are getting older. There is no real cyclical story here.
Warren Hatch, PhD, CFA
Chief Investment Strategist
McAlinden Research - a division of Catalpa Capital Advisors, LLC.
Last week, US initial jobless claims hit a new low for the cycle, confirming a healthier labor market and signaling stronger economic growth ahead. Claims came in at just 332,000, which is consistent with monthly payroll growth of around 200,000 jobs; the 3-month moving average for payrolls is currently pretty close at 190,000. As impressive as the low level of jobless claims already is, the change in the level itself is pointing to stronger growth ahead.
While far from perfect, the change in jobless claims can be a real-time, rough-and-ready indicator of GDP trends. During the fourth quarter of 2012, for instance, claims were little changed from the preceding quarter; GDP growth registered just above zero. In the first quarter of 2013 to date, claims have declined by 35,000, which would be consistent with GDP growth of around 4%.
According to Bloomberg, economists currently expect just 2% growth for the first quarter, although the consensus has been moving up as stronger data comes in. In our view, housing, consumers, and capex taken together will be stronger than expectations, and the drop in jobless claims will prove to be a better predictor of 1Q GDP growth than the consensus.
Warren Hatch, PhD, CFA
Chief Investment Strategist
McAlinden Research - a division of Catalpa Capital Advisors, LLC
As the introductory Commodity Corner column of the magazine I found this to be a good opportunity to introduce commodities and futures.
One could argue commodities have been around since the beginning of civilization. People have produced, paid or bartered for commodities to use for either production or to consume. Some of the uses of commodities include food, energy, construction, manufacturing, and clothing.
According to the Merriam-Webster dictionary, commodities are defined as: 1) an economic good. 2) A product of mining or agriculture. 3) An article of commerce especially when delivered for shipment. 4) A mass produced un-specialized product. [i]
In today’s global markets both large and small firms will trade and hedge commodities as part of their daily business as either a producer or end-user of the commodity. For example a chocolate candy producing firm will need to purchase cocoa, sugar and of course energy to fuel their factories. If they do business in foreign countries they may need to buy and sell foreign currencies for hedging or delivery purposes. (See “Currencies in Your Future Portfolio?” of the Spring/Summer 2012 issue).
To manage their price risk, a commodity producer, such as a farmer may sell a futures contract to lock-in their selling price. An end-user, such as a coffee chain may buy a futures contract to lock-in their purchasing price. Keep in mind commodity markets tend to be mean-reverting markets as they spike or decline from an average price and then revert back towards that average price overtime. This is often due to shocks in the system such as increased demand, reduction of supply, weather concerns, disruption of distribution channels or possibly political or regional events. If a commodity becomes too expensive, the market participants’ behavioral mechanism will appear as they seek less expensive substitutes. This is known in economics as the substitution effect and one of the differences to note between commodity and equity trading.
Commodities are traded in two common locations: either the spot/cash market usually reserved for industry or sometimes known as “commercials” such as producers, distributors and end-users as the actual physical commodity is traded. Or the products trade on an exchange such as one of the futures exchanges found around the world. The futures exchanges are often utilized by both commercials and speculators. An exchange offers commercials the opportunity for immediate offset of their commodity risk by speculators offering liquidity to take on the risk. If a commercial has a loss from hedging, it often means they profited in the underlying cash market, because they are holding the opposite direction in the cash market. One can think of the loss on the hedge as a premium on an insurance policy.
Read more [i] Shore, M. (2011) DePaul University 798 Managed Futures Lecture notes
Mark Shore is also an Adjunct Professor at DePaul University’s Kellstadt Graduate School of Business in Chicago where he teaches a managed futures / global macro course and an Adjunct at the New York Institute of Finance. Mark is a contributing writer to Reuters HedgeWorld.
Past performance is not necessarily indicative of future results. Â There is risk of loss when investing in futures and options. Â Always review a complete CTA disclosure document before investing in any Managed Futures program. Â Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. Â The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.
Stanley Druckenmiller, Duquesne Capital Founder, explains what the Fed is doing wrong, the state of the economy and the number-one threat to young people’s financial futures. “The biggest unintended consequence of the Fed right now is Congress is not getting the market signal,” says Druckenmiller. He is joined by Geoffrey Canada, Harlem Children’s Zone CEO.
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