Holiday Thoughts

Silent Night

I recently remembered an NFL game quite a few years ago between the New York Jets and Miami Dolphins.  (Note:  I had to look up the date, and was surprised to find out it was Dec. 20, 1980-by pure coincidence, this marks the 30th anniversary…)  Normally, this wouldn’t have stood out in memory, but this particular game was a little bit different.  It was called the “silent game,” because NBC had decided on an experiment of using no announcers through the entire broadcast.  All you got were the sounds of plays, the crowd, referee’s whistles, tackling, etc.  No commentary on the action.  You were left to make your own interpretations and it forced a focus on some of the more subtle (or just appreciate the more obvious) aspects of the game, since so much of that was usually intertwined with audio commentary.  It ended up being much like attending a game in person, but without a stadium announcer and only occasional flashes of data and scores on the screen.  I remember thinking that, in a way, it was kind of refreshing… but, obviously, the idea never took hold.  It’s hard to imagine that happening today, with so much riding on the personalities and “expert” analysis of the action, during the game itself and in the accompanying coverage.

Imagine a television scene like that in today’s financial markets.  Turning off the “coaches’ corner” on certain news channels, ignoring the constant internet stock ticker or muting the minute-to-minute commentary of the day.  If you like, take it a bit further back and imagine waiting for closing prices in the next morning’s paper or thumbing through stock charts in hardbound books published only a handful of times per year.  It would give you a completely different perspective, similar to the days before play-by-play, and making each investor a bit more responsible for their own analysis of the current happenings.  With no “experts” leading the way, and reducing the entertainment component of minute-to-minute financial coverage, would investors trade as often, blindly taking the advice of others, or would they spend a little more time thinking before they reacted?

Recovery Thoughts

Amidst all the continued cautiousness in the investment environment, we have started to see several of the more bearish economists and forecasters come around.  Goldman Sachs, for instance, raised their 2011 GDP forecast from 2.0% to 2.7% (still moderate, but quite a change in relative terms) and offered a tentative 2012 estimate of 3.6%-also up from prior forecasts.  Consumer “saving” has begun to taper off and bank lending has begun to grow-two of the missing elements up until now.

What tends to be forgotten in periods where things look their worst (considering sentiment levels, this accurately reflects the last several years), is that economic effects are cumulative.  It’s not realistic for a switch to be flipped one day which causes the environment to move from dire to euphoric.  But, small changes made during the process of financial repair eventually begin to work-much like a snowball effect-and success seems to breed more success.  As growth builds, it creates an environment for further growth.

Over the course of the last two years, the fears of many investors have moved from  double-dip recession or outright second depression scenario toward hyperinflation and complete debasing of several developed nation currencies.  However, the level of popularity of an idea at a given moment can tend to be a contrary indicator for us.  When it comes down to it, investing is the quest for finding growth or a search for the cheapest assets, or both.  Over the long haul, investment success has been achieved by correctly indentifying where those areas and drivers of growth are, while similarly avoiding areas of risk disproportionate to the potential growth.  This is the essence of “top-down” investing and explains to a large degree our interest in the foreign, particularly emerging, markets.  It should be a somewhat liberating feeling for clients when they understand that portfolios are not dependent solely on the growth of certain segments of the U.S. to fuel returns.  A larger toolbox gives us more options to choose from and implement.

Role of the Fed

One could argue that it is difficult to combine politics and economics.  The differences are sometimes not obvious in normal times, but tend to become more apparent during times of crisis and subsequent recoveries.

While central banks have existed for several centuries, in 1900, there were only 18 of them.  When the U.S. Federal Reserve System was created by an act of Congress in 1913, the primary objective was as a stabilizer of the banking “panics” that tended to occur on a fairly regular basis.  J.P. Morgan (the man, rather than the bank) personally took control of the 1907 episode, but it was thought that a more structured and permanent solution was needed-similar to what the Europeans had done.  So, in keeping with central bank theory and tradition, the initial Fed was tasked with the job of maintaining price/monetary stability (a.k.a. keeping inflation under control), in addition to regulatory and liquidity responsibilities.

Over the last century, the number of world central banks grew to 173 in 2000 (the most recent of which are overwhelmingly in the developing world).  While stated objectives differ a bit (often dependent on the use of currency pegs or not in some nations), most banks utilize a straightforward monetary stability-based mandate.  The act of creating a central bank has been helpful in improving credibility for many emerging market nations, especially to those chronically prone to long bouts of hyperinflation, crises of confidence and currency volatility.  While a central bank cannot solve every problem, having one in place is certainly a first step in enhancing a smaller nation’s legitimacy.

The U.S. Fed’s single mandate was kept in place for several decades until the difficult economic environment of the 1970’s, when, in 1977, it was expanded to a include an additional objective of promoting “maximum employment.”  This was supported mainly by politicians concerned with possible side-effects of high interest rates at the time.  (Note that the Fed’s statement of objectives officially lists three mandates:  “maximum employment, stable prices and moderate long-term interest rates.”)

Of course, many Americans, including workers, business people and policymakers, would probably argue that stable prices and high employment are desirable outcomes.  Fed Governor Frederic Miskin, in 2007, commented that the multi-mandate was consistent with the Fed’s purpose in “fostering economic prosperity and social welfare.”  Unfortunately, multiple goals can be vague and difficult to implement if/when defined differently by respective parties involved in the economic and political discussion.  For example, how do we determine when each is satisfactorily achieved?  In the case of Fed’s multiple mandates, what if we embark on too much intervention in one (such as monetary stimulus) in order to close the gap in the other (employment)?  Would we have seen a QE2 under the Fed’s original, single mandate?

In the past few months, several member of Congress, including Reps. Mike Pence and Paul Ryan and Sen. Bob Corker, along with some economists, such as John Taylor at Stanford (founder of the “Taylor Rule”), have been questioning the effectiveness of this current multi-faceted mandate (the employment part, in particular) in favor of a return to a simpler, rules-based or more quantitatively-driven version focused solely on monetary policy-specifically “price stability” and “protecting the dollar.”  Pence has introduced legislation to re-narrow the Fed mandate, which could be a policy debate worth watching.  Even though such a change would be a return to simplicity and better theoretical “purity” from an economic standpoint, it is hard to imagine this being an easy battle in an environment of currently high unemployment.

Economic News

As noted in an earlier note, the Fed left their target rate unchanged at 0.00-0.25%.  However, the language regarding economic activity was moved a notch higher from “slow,” to reflect its improvement, while weakness in employment was acknowledged and language regarding the housing situation was broadened to reflect widespread negativity beyond just housing starts.

Retail sales were very strong in Nov. (up +0.8%) and were revised upward for Sept. and Oct. on both the “core” and “headline” levels (the former does not include vehicles, building materials and gas, while the latter does).

The seasonally-adjusted headline CPI-U increased +0.1% for November (+1.1% on a year-over-year basis) following an increase of +0.2% in Oct.  The “core” index (which excludes food and energy) rose an identical +0.1% last month.  Producer prices were up a bit more (+0.8% for the month, +3.5% year-to-date), particularly in food, so up significantly less when food and energy were excluded.

November industrial output was broadly in line with expectations, although a drop occurred in autos and auto parts.  Capacity utilization was up to 75.2%, which was a few tenths of a percent better than expected.

Housing starts were slightly better than expected for Nov., to 555,000 homes, and the Oct. number was revised upward a bit.  However, permits for new construction fell 4%; permits for multi-family houses dropped by 23%.

The four-week moving average of initial jobless claims continued to improve downward, and remains at post-recession lows (lowest level of claims since August 2008).  This is positive news from the employment front-one of the laggards in the recovery.

Market Highlights

All-in-all, an uneventful pre-Christmas week.

The S&P 500 and Russell 2000 ended the week slightly higher last week.  From a sector standpoint, healthcare was the best performing index, up 1.2%, while consumer staples and materials also beat the overall market.  Financials lagged-roughly down 1.2%.  As measured by the EAFE, developed market stocks in Europe lost about a percent, while Japan and the U.K. gained about the same amount in the opposite direction.  Emerging markets traded fairly flat for the week on average.

Rates on the bellwether 10-year Treasury rose a few basis points in keeping with their recent trend.  Net performance in fixed income was fairly flat, with the exception of TIPs, which gained ground on better economic growth prospects.  Municipal bonds have suffered as of late due to increased issuance at year-end, which has loaded the market with additional supply.  While foreign bonds performed similarly in local terms, a stronger dollar (which gained roughly a third of a percent last week) acted as a negative on returns.  Sovereign debt concerns remain an overlay onto the environment here.

Real estate in the U.S. was down roughly a percent, while foreign REITs lost slightly more-in keeping with the stronger U.S. dollar.  In the commodities world, crude oil was virtually unchanged last week, while gold lost value in light of positive U.S. economic data as of late and a stronger USD.  Agricultural commodities, such as sugar, coffee and corn were the best performing assets of any last week.

Until Next Time

I would like to wish you and your families a Season’s Greetings, and I look forward to working with you over the coming New Year.

Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.