Thursday, February 28, 2013

What claims say about investment strategy

First-time claims for unemployment remain in a downtrend, a clear sign that the fundamentals of the labor market continue to improve. This is the natural progression of any economic recovery, and strongly suggests that the economy remains in recovery mode, however weak it might be. 


The chart above shows the long-term trend of non-seasonally adjusted claims (white) and the 52-week moving average (purple). The pattern is clearly down, although the rate of decline appears to be slowing—which is natural, since claims are unlikely to ever fall much below 250K per week. At this time of the year, claims haven't been this low since 2007, a year before the recession began.


This next chart shows the non-seasonally adjusted number of people receiving unemployment insurance. Over the past year this number has declined by 1.24 million, or 18%. That is a very impressive change, and arguably one of the most impressive changes on the margin in today's economy, because it means that there are more people with a greater incentive to seek out and accept a new job. Changing incentives typically have very important impacts on the economy, and this is one good reason why the economy is likely to continue to improve, however slowly.

From the perspective of the market, which is still braced for economic deterioration, the most important thing is not the speed at which claims are falling, but the fact that they aren't rising. There is no sign here that the economy is losing vitality or at risk of slipping into another recession. Therefore, there is little justification for holding substantial assets in cash and cash-equivalent investments that pay virtually nothing, when there is a panoply of alternative investments that yield substantially more.


This is one message that the Federal Reserve is trying very hard to beat into the heads of the world's investors. It's a risky gambit, to be sure, because if substantial numbers of economic actors start getting the message, then the demand for cash and cash-equivalents will decline. This would be manifested chiefly in an increased velocity of money (money would circulate faster as people attempted to reduce their holdings of money relative to other things), which in turn would cause nominal GDP to accelerate.   Much of this acceleration in nominal GDP could come from a rising price level (i.e., inflation), and too much of this would present a real challenge to the Fed, since they would have to take measures to keep money demand from declining too much. This would entail hiking the interest rate it pays on reserves, ceasing its purchases of Treasuries and MBS, reducing (selling) its holdings of Treasuries and MBS, and/or not reinvesting principal repayments. Treasury yields could rise meaningfully.

For the past four years I've been worried about the Fed not being able to respond in a timely fashion to a declining demand for money, and thus allowing inflation to rise. Obviously, those concerns were premature, since inflation has been relatively subdued. But anyone concerned about an acceleration in nominal GDP, whether or not that meant an acceleration in inflation, would have taken the same steps that would have been appropriate had he or she merely anticipated an economic recovery, no matter how tepid. Since the market has been braced for deterioration for years now, those who have bet on recovery have been rewarded: virtually all risk asset prices are higher, and holders of non-Treasury bonds have been rewarded with substantial interest income in addition to higher prices.

I sense that we are now more rapidly approaching the point at which market psychology shifts from being passive/defensive to being more aggressive: from waiting for the train to slow down to get on board, to running to catch the train before it leaves the station. The bond market still expects the Fed to keep short-term interest rates near zero for a very long time, but those expectations could change dramatically, and the Fed's timetable for exiting QE3 could accelerate significantly. Lots of things could change, and in a big way. I'm not sure when, but more and more I think that it pays to be on the side of optimism than on the side of pessimism.

At the same time, it makes sense to retain a healthy fear of an unexpected rise in inflation, and that argues for investments in real (tangible) assets that could benefit from faster nominal growth and higher inflation. Real estate and commodity prices top the list of potential beneficiaries. Gold not so much, since I believe it has already risen by enough to anticipate a significant rise in inflation. Gold is very vulnerable to any sign of "good news," which in this case would take the form of an acceleration of the Fed's tightening timetable. That's how I read the latest decline in gold prices, as an early warning indicator of a shift in the Fed's strategy in response to improving economic fundamentals. TIPS, normally considered to be the classic inflation hedge, are also vulnerable, since real yields are very low and negative, and would likely rise if the Fed started raising rates sooner than is currently expected. TIPS investors would benefit from rising coupon payments if inflation exceeds expectations, but they would suffer from declining TIPS prices. In short, TIPS today are very expensive inflation hedges.

11 comments:

Gloeschi said...

So much wrong with this post. Let's start:
1) claims do not say anything about investment strategy. It's backward looking. Claims do not contain any information regarding the future.

2) S&P earnings yield, bond yield chart: so you have fixed-income (paper assets) and stocks (real assets) on the same chart. You take the cash flow (interest payments) for one investment, but not for the other (EPS is not paid out). You compare an asset where, at least in nominal terms, your income stream is exactly predictable, with an asset where most of the income stream is completely unpredictable. You seem to suggest there is no equity risk premium.

3) Demand for cash: you keep claiming demand for cash is so terribly high. Why, then, have declined from almost $4 trn to 2.6 trn?

4) You believe the velocity of money is driven by financial assets. That would be the tail wagging with the dog.

5) You correctly state that most of a nominal GDP growth would come from inflation. Why would that be positive for stocks? Input price increases can only be passed on to consumers if there is growth in real incomes (which is not the case since 12 years). You could see margin pressure instead. See periods of stagflation in the second half of the 1970's and beginning of 80's. In periods of rising inflation, stocks did badly in both real and nominal terms.

"Catching the train before it leaves the station": The S&P has gained over 100% since the lows, and is a few % off its all-time-high. This train has long left the station.

Gold is highly correlated to real interest rates. With the Fed squatting on short rates while inflation rises you will see more negative real yields = positive for gold.

Pragmatic Investor said...

Mind explaining why you keep claiming the market braces for recessions? Please don't tell me it's because 10 year treasuries yield only 2%. That's manipulated. You make a bunch of claims that can't be backed up by solid evidence.

Unknown said...
This comment has been removed by the author.
db said...

Thanks as always for your insightful analysis Scott. Have been following you for 3 years now and enjoy your viewpoints. Have even benefited from some of your investment themes! Please keep up the good work. Thanks again.

William said...

Scott wrote: "Real estate and commodity prices top the list of potential beneficiaries."

With regard to commodities, do you favor investing in commodity futures or ETFs.

I am happy to own equity shares in a oil produces in the US, Canada, Brazil and Australia and in global miners since they pay decent dividends while I wait on the potential rise in commodity prices. I also prefer major oil service companies involved in drilling in general but deep water and fracking in particular.

The question is how do you prefer to take advantage of a possible rise in commodity prices?

marcusbalbus said...

i think it is time to call BS on your claim that stocks are priced for disappointment. they are price for perfection. stop retailing a hack line.

Scott Grannis said...

Re: commodities. I can't claim to have great insights into commodity investing. I'm aware of the difficulties posed by using commodity futures. If I were to seek commodity investments I would probably stick with the stocks of commodity producers. In any event, commodities are a riskier investment than equities in my book (they can be much more volatile), so approach them with a healthy degree of caution.

Benjamin said...

I may disagree with Scott Grannis from time to time, but so what? It is great to read his blog. Lots of info and insights.

I would like to see a chart on the economy and stocks since QE3 kicked in. The Fed started QE 3 on Sept. 12, 2012. The Dow is up about 5 percent since then, and that was one of the highest closes in a while.

Meanwhile, as Scott has pointed out, housing has come back.

Why is QE 3 important? For the first time in Fed history, the Fed said it would undertake an action---in this case, buying bonds---until certain economic results were obtained.

The ongoing mystery in all of this is why we are now in minor deflation. Seven of the last nine CPI readings have been flat to down.

Back when I took econ 101 (the gas lamps were being phased out, but Fortran was in) they told us if you printed a lot of money you got growth and then inflation.

So far, the Fed has printed money but we are getting record low inflation and even now deflation.

I will let Scott Grannis explain that one.

Unknown said...

@Benjamin,
Look at the value of the euro against the US dollar for the past 10 years. You will see a peak in 2008, and since then a series of lower highs. There is long-term support at around 1.20, which I have a feeling will be broken in the next year or two. Also check the overall US dollar index, which has broken out on the upside. Much of that has been against the falling yen, but more recently it's even been rising against the euro.

Essentially, we seem to be transitioning to a high-dollar economy. Scott's other post on rising US oil production likely takes at least some credit for that, as reduced need for imports raises the dollar's value. Note also that the US trade deficit has been flat for some 2 years. Normally in a growing economy the deficit would be rising.

Thus, you are seeing zero inflation due to a rising dollar.

Unknown said...

^
Oh yeah, forgot to mention ...

The tax raises and the sequester will have the effect of reducing the budget deficit, which will also help support the dollar. At this point I think there are too many forces working against the Fed for them to produce much in the way of inflation. If you're an inflation fan, your best hope is for the economy to super-heat up.

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