Here Comes the Weatherman II

The discussion of the likely impact of the adverse weather has intensified following some unexpectedly weak economic numbers such as US housing starts, consumer confidence or the German Ifo index. The ifo institute stated that the drop in the business climate has been on the back of worsening sentiment in the retail sales sector as well as a weather-related weakening in construction activity. At the start of the year when I suggested a tactical long position in government bonds (see: Rates Strategy: Here comes the weatherman dated) I referred to the unusually cold winter as one factor which would be likely to drag yields lower. Unfortunately, my proposition to move to a tactical short last week seems a bit ill-time now. Still for the time being I maintain this view.

The loss of economic momentum in several sectors during winter is a regular phenomenon and statistical techniques are employed to adjust economic data for this loss in momentum (and also for the gain in momentum that follows during spring). However, if the loss in economic momentum is more pronounced than usual due to a stronger-than-usual winter, then the seasonally adjusted economic data should turn out weaker than expected. This is confirmed by a study on the impact of the mild winter 2001-02 on the US economy (Lessons from the unusual impacts of an abnormal winter in the USA. Changnon & Changnon. Meteorological Applications 12, 187-191 2005. The abstract can be found here). More specifically, the study found that the mild winter reduced costs of heating, led to reductions in transportation problems, lower road/highway maintenance costs, increased construction activity, reduced insurance losses, greater retails sales and increased home buying.

On the other side, if we have a cold winter and especially if there are severe snowstorms such as happened in the US and continental Europe since the start of the year, then one should expect retails sales to be weaker than usual (people will stay at home more often), higher insurance losses, less home buying, weaker construction activity, more frequent transportation problems (which also means that people will get to work later, hurting output). On a brighter note, utility output should have profited. The impact of these effects should not be underestimated. I already presented at the start of the year a small model which enters a receiver or payer position in the 10y USD swap rate depending on whether a certain month was colder or warmer than usual. The model enters a receiver position if a winter month is colder-than-usual or a summer month warmer-than-usual (and a payer position if it is the opposite). The position is entered at the start of the following month and held for one month. I used the population weighted heating degree days and cooling degree days vs. the norm for that particular month to determine the positioning (the actual HDD/CDD as well as the normal HDD/CDD can be found here on the website of the CFTC. Additionally, the website provides a description of the methodology used to calculate the degree days). Over the past 11 years this would have resulted in a profit of 1130bp (excluding transaction costs) with gains in both bearish as well as bullish market environments.

Profitable trading rule suggests that the weather has indeed a significant impact on short-term market behaviour

Source: Research Ahead

This profitable simple model should highlight that indeed the weather has an impact on the economy and therefore financial markets which should not be underestimated. Winter in the US and continental Europe has been colder-than-usual with more snowstorms since early December. Also January has been colder (albeit not that much) as have the first weeks in February. In turn, near-term economic data is likely to continue painting a weak growh environment. However, most of this weather related economic loss should not be a permament one. It is much more likely that once the weather improves, there will not only be the usual seasonal strength of spring but rather also some catch-up in the form of improved retails sales etc. Again, this is confirming my neutral strategic outlook for government bond markets (with a horizon of approx. 3 month). However, my bearish tactical call seems to be a bit premature.

Random Thoughts November 5

a) Fitch downgrades Ireland: Yesterday Fitch downgraded the sovereign credit rating of Ireland by 2 notches to AA-. The downgrade reflect "the severity of the decline in nominal GDP and the exceptional rise in government liabilities" However, the agency also notes the vigour of the government's fiscal consolidation response to date and the expectation of further aggressive budget tightening which helped stabilise the outlook for Ireland's creditworthiness. Fitch expects a cumulative fall in the nominal GDP of 14% in between 2007 and 2010! The downgrade and the rationale fit perfectly with my view on the Eurozone peripherals laid down in detail on October 30 in No easy way out for Eurozone peripherals. It also shows that while for example France and Germany are contemplating further fiscal easing measures, Eurozone peripherals' ability to even maintain the current level of fiscal accommodation is severely constrained. Rather the need to tighten fiscal policy is growing sharply which will result in a prolonged recessionary environment, a higher output gap and with that lower inflation pressures and therefore higher realised real yields than in the core of the Eurozone. Again, it will take several years to rebalance the economies and restore competitiveness, not only for Ireland but also for countries such as Spain and Greece. I continue to suggest an underweight stance in these countries for any fixed income investments.
b) US employment report: Expectations for tomorrow's US October employment report are for a loss in nonfarm payrolls of 175k. What is more, the growth in average hourly earnings is forecasted to fall further to 2.2% from 2.5%. It is this combination of falling employment and falling wage growth (amid the rising unemployment rate) which will hold back consumption growth if fiscal support is not increased further. Wage income growth (i.e. essentially hours worked times hourly earnings) grew at a yearly rate of 4.9% at the end of 2007 but has since collapsed to -5.6% yoy according to the Q3 GDP report. Personal income (where wages constitute a bit more than half) itself has dropped by -2.8% yoy with the fall in the sum of wage income accounting for the largest part of this drop. With personal income continuing to fall, it will be difficult to see a significant growth in personal consumption, not even taking into account a likely rise in the savings ratio. As the chart below shows, personal consumption growth and personal income growth are closely related with both having grown by approx. 5.5% yoy in between the start of the 90s and the end of 2007. While employment growth is usually being seen as a lagging indicator, I think that as long as the sum of wages earned (i.e. hourly earnings times worked hours) continues to drop, the underlying dynamic in the US economy will almost excclusively be dependent on the accommodation provided by monetary and even more so fiscal policy. And as long as personal income continues to fall, we need ever increasing fiscal support just to maintain the level of consumption! Therefore, what I will be focusing on in tomorrow's employment report will be the development of nominal hourly earnings and the so-called index of aggregate weekly hours. This is not the same as the data on average weekly hours (which indicates how much an employee has worked on average) as it measures the total of hours worked in the private economy (i.e. it is dependent on the average workweek as well as on the number of people in employment).

The drop in personal income growth bodes ill for consumption growth

Source: Bloomberg

Baltic Dry Index as a leading indicator for stocks?

Trader Narrative in Baltic Dry Index continues leading the stock market has this interesting chart below. It states that 'While the Baltic Dry Index is a leading economic indicator, lately, it has been also behaving as a leading indicator of the stock market.' It adds: 'In fact, if you compare the S&P 500 index for the past few years with the Baltic Dry Index (BDI), it would seem that shipping rates have lead the equities from 1 to 3 months in both rallies and tops.'

Baltic Dry Index vs. S&P500

Source: Trader's Narrative

However, while the chart at first sight looks good, it does not provide a convincing story. Rather, the Baltic Dry Index seems to be more closely correlated to commodities:

Baltic Dry Index vs. CRB Index

Source: Bloomberg

As I suggested in Commodities and related markets to fall first?, commodities seem to be falling as the Chinese re-stocking cycle has ended (and with that shipping rates which rose during the re-stocking have eased again). If it is indeed due to less demand amid an ending of re-stocking (or due to increased supply) as opposed to lower end demand amid weak growth, then lower commodity prices as well as the drop in the CRB index are a positive for equities (as they increase the purchasing power of households and reduce costs for corporates in net-commodity consuming economies) while they are also rather positive for government bonds amid lower inflation pressures. In turn, the drop in the Baltic Dry Index would also explain the diverging performance of bond yields/commmodities on the one side and equities on the other and does not necessarily need to be associated with lower equity prices. Therefore, we can not yet tell whether indeed the significant drop in the Baltic Dry Index is a warning signal that stocks are about to fall or whether this is yet another positive (amid lower costs for shipping and for commodities) for the economy and therefore stock markets.

Random Thoughts July 27

a) This is my last post before going on vacation. I will resume blogging in mid August.
b) Swine Flu: at the beginning of last week, new Swine Flu infections have started to increase at a significantly faster rate in Germany. This is probably due to Germans returning from their summer vacations. As written in Deflation due to swine flu?, the swine flu might start to hit especially hard in September when most of the tourists are back from vacation and kids are back to school. Developments so far seem to underpin this scenario. Just to repeat: So far the mortatility rate has been low. Nevertheless, if indeed infections should affect roughly 25% of the population, it will have a significant impact on the economy. Both demand and supply will be negatively affected and therefore the impact on GDP growth is clearly negative.
On a different note, the Warwick Business School has developed an Influenza Pandemic Risk Index, which shows '...the UK most at risk to the spread of an influenza pandemic, ranking number 1 out of 213 countries. The Netherlands, Germany, Italy, Russia, Canada and Japan are also categorised as extreme risk because of their high population density, urbanisation and busy airports.' (for further details see here)
c) Markets: My assessment from last week (Market Update: Near-term risk-recovery not over yet) remains fully valid: it seems that the near-term risk-recovery can run further as Q3 growth is likely to surprise positively. However, growth in final demand promises to be much more subdued and risks moving lower again into autumn/winter. Therefore, the recovery remains a temporary one. While I previously expected the recovery across risky assets to be over by the end of this month, I now think it will likely extend well into August.

Random Thoughts July 22

A) Growth: Martin Feldstein thinks 'the economy could “flatten out” or “even be positive” in the third quarter, and then it’s likely to contract again in the last three months of the year as the effects of the federal stimulus program wear off and companies finish rebuilding inventories'. My own view about near-term growth prospects is similar (see here) as I think Q3 could even surprise positively in terms of GDP growth amid an end of the inventory correction, less negative contribution from residential investment, strenghtening effects from the fiscal stimulus and a less pronounced than usual seasonal drop in auto manufacturing. However, final demand should remain weak and with that GDP growth should move lower again into autumn/winter (further aggravated by the threat of the swine flu).
Regarding the longer term outlook, I argued frequently that nominal growth should stay low for an extended period of time amid weakness in consumption and investment as households and corporates restore their balance sheets resulting in limited inflation pressures. Richard Bernstein in an FT article - America is for now still blowing bubbles - comes to a similar conclusion but from a different angle (I totally agree with this view). He suggests that 'Financial history shows that bubbles create capacity, which is no longer needed once they deflate. An inevitable and intense period of consolidation follows....History would suggest, therefore, that there should now be massive overcapacity in the global economy. That is indeed the case. Global capacity utilisation was recently at generational lows. Ignoring this history, the goal of Washington’s policies has been to stymie the inevitable consolidation, keeping companies operating – and employing voters – rather than managing the consolidation to maximise the economic benefit. History says that Washington’s is an unwise and ultimately fruitless strategy. Certainly, there may be short-term gains in an economy by keeping a bubble’s unnecessary capacity alive (this may explain the recent improvement in economic statistics), but the continued misallocation of capital significantly hinders longer-term growth....Many observers claim that comparisons between the US and Japanese economies are inaccurate because the US economy is more “dynamic” and less “rigid”. There are, of course, differences between the two economies, but it seems increasingly clear that both the US public sector and, with CIT, now the private sector too are working against post-bubble consolidation, slowing the economy’s dynamism and increasing rigidity.'
In light of my expectations for growth and inflation, FOMC Chairman Bernanke's testimony stated rather the obvious: the Fed has several tools to withdraw the policy accommodation but they wont be used for an extended period of time...

b) Demographics: This UK Telegraph article (World's elderly to overtake number of infants) reports that each month the number of people aged 65+ grows by 870,000. The main conclusion of the article is that 'this will reduce the size of the working population and impose huge new pension costs, threatening to reduce the overall growth of the world economy.'
An ageing society is nothing new amid the drop in fertility rates and the rise in life expectancy especially during the past century and has not threatened economic prosperity, rather to the contrary. What is new is that now more people get older than 65 which is close to the statutory age of retirement in a host of countries. As I suggested in Demographics, the savings ratio and interest rates, that retirement age is not set in stone. It might be difficult to change the retirement age but the pressure to do so will increase in the years ahead given the rising expenses for social security and amid the huge fiscal deficits. George Magnus in this FT article (Older societies have to retire later) makes the same point.

Random Thoughts July 9

a) The ECB has published a document called 'The international role of the Euro'. One article focuses on the private use of the euro as a parallel currency in non-Eurozone countries. It finds that during 2008 especially in Central Eastern Europe as well as in Southern Europe holdings of Euro banknotes increased. "Evidence from a number of sources suggest that euro banknotes are increasingly used in countries east of the EU, mainly as a store of value and for large transactions." Furthermore: "Around EUR95 billion worth of euro banknotes were estimated to be in circulation outside the euro area at the end of Deccember 2008, around 13% of the euro banknotes in circulation for that reference month." This is up from 71.1 billion at the end of 2007.
To me one sign of a potential upcoming currency crisis is that domestics lose faith in their own currency and divert their assets into another currency while starting to use foreign currency for daily transactions. This leads to a lower demand for the home currency with likely inflationary consequences. On the other side, it increases demand for the foreign currency (in this case the Euro) which might well add to already existing disinflationary consequences.

b) Risky assets have moved signficantly lower since the start of the month and the larger equity indices have lost approx. 10% from their late May highs. However, commodities - especially energy - has been hit even harder. The chart below shows the CRB-Index since the start of the year. Between late February and mid June, the CRB gained 33% but is now up only 15.5% (so it lost half its previous gains). Equities on the other side, have gained more during their spring rally and lost less so far in the current correction.
To me this confirms that the end demand for commodities is weak (as it should be given the world-wide recession) and that a lot of the run-up in prices has been down to stockpiling and speuclation. However, especially stockpiling can not go on forever as it is costly to hold physical commodities and the capacity to do so are limited. Furthermore, the recent sell-off in broader commodity indices confirms also that inflation is not around the corner and a 'flight' into real assets amid inflation and sovereign default worries carries substantial risks as well. However, this should not be so surprising given that we have a destruction of real demand and an oversupply in several real assets (most notably housing): Too little money chasing too many goods!

Market Update: Consolidation or Correction?

While risky asset markets are rather in a consolidation than correction mode, government bond yields have dropped markedly. Looking ahead, I maintain the government bond-bullish outlook which I adopted early June (see here: Have we seen the highs in UST and Bund yields?) as well as my defensive asset allocation (Asset allocation: defensive stance).
The underlying economic situation is improving only slowly and the output gap is increasing further, leading to an ongoing easing in inflationary pressures. Today's employment report confirmed this. While unemployment tends to lag the recovery, there are some forward looking elements within the report, such as temporary work and hours worked. Temporary workers are usually the first to be let go and the first to be hired. However, the number of temporary workers is still declining (-38k vs. May09) while average weekly hours declined slightly. I also look at what I call the index of aggregate weekly earnings. This is constructed by multiplying average weekly earnings with the index of aggregate weekly hours for the private sector (for more details see here: Consumer deleveraging spiral still getting worse). The chart shows the yoy change in this index. The sum of wages paid to private sector workers is declining at an unprecedented rate of 4.4% (after 3.8% in May) amid easing wage growth and sharply dropping aggregate hours worked.
Combined with the destruction in households' net worth, this is a strongly disinflationary development. Employment benefits and active fiscal easing by the federal government cushion the negative impact on households' income. However, the fiscal easing would need to increase further given the ongoing drop in income. Therefore, the outlook for consumption remains very bleak!
In the Eurozone, the situation remains even more fragile amid a less aggressive ECB than its US counterpart but a more substantial drop in growth across a host of Eurozone countries. Today's acknowledgement by the ECB that there might be more rate cuts if necessary is at least a positive sign and accepting the reality of falling inflation (and therefore potentially higher real yields) and further falls in domestic and external demand.
Overall, the outlook for nominal growth remains very subdued amid low/negative real growth and lower inflation. This will seriously constrain the ability of real assets to show positive returns! The risk remains that the current consolidation in commodities and equity markets (<=10% price fall) turns into a correction (>10% fall in prices). Government bonds on the other side should remain underpinned. Stay defensive in equities/commodities but stick to long duration positions in Bunds and USTs.

Random Thoughts 02 July 2009

Random Thoughts is a regular column with the aim of providing some interesting bits and pieces but does not give a holistic picture/view/outlook.

a) Restrictive fiscal policy: the budget woes in California highlight that fiscal policy is not universally accommodative in the US. For a short overview of Furlough Fridays back - now three days a month. Amongst others, "The executive order signed by Schwarzenegger will reinstate 'Furlough Fridays', requiring more than 200,000 state workers to take unpaid leaves on the first three Fridays of each month. The move amounts to an additional 4.62 percent pay cut for state workers, bringing their total reduction in 2009 to about 14 percent because of two furlough days imposed previously. " Clearly that is a disinflationary development. The problem is not confined to California. In fact a lot of US states have to cut spending/increase taxes and thereby run a pro-cyclical fiscal policy. Discussion about further necessary support for the states by the federal government is ongoing and is likely to intesify. What is more, problems are not confined to states only as also cities face severe budgetary issues, see for example here: El Monte avoids bankruptcy after police union agrees to cuts.

b) US Monetary policy: two interesting articles by inflation doves. San Francisco Fed president Yellen remains more worried about a sluggish recovery and easing inflation pressures (see here). More interesting is one comment about future Fed tightening: 'the Fed can push up the federal funds rate by raising the rate of interest that we pay to banks on the reserve balances they have on deposit with us—authority that was granted to us by Congress last year. An increase in the interest rate on reserves will induce banks to lend money to us rather than to other banks and borrowers, thereby pushing up the federal funds rate and other rates charged to private borrowers throughout the economy. The ability to pay interest on reserves is an important tool because, as I mentioned, it’s conceivable that, even if the economy rebounds nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. This tool will enable us to tighten credit conditions even though our balance sheet wouldn’t shrink.'
This is interesting in the sense that it generally is seen that the Fed would first shrink its balance sheet and then hike rates. But clearly they have the option to go down a different route.

Alan Blinder - a former vice chairman of the Federal Reserve - states in Why inflation isnt the danger that banks hold excess reserves and therefore Fed's balance sheet lengthening is not inflationary. I fully agree with this. With respect to future tightening, Blinder makes one interesting point: 'The possibilities for error are two-sided. Yes, the Fed might err by withdrawing bank reserves too slowly, thereby leading to higher inflation. But it also might err by withdrawing reserves too quickly, thereby stunting the recovery and leading to deflation. I fail to see why advocates of price stability should worry about one sort of error but not the other.'

c) Too much hope in the Chinese growth saves the world story? There is a lot of talk about the strength of the Chinese economy. A shift away from the export driven GDP growth model towards a more consumption-driven model of growth would be welcome. This would add to global demand and at the same time would help to reduce global imbalances (via a reduction in the Chinese current account surplus). China has the means to promote growth via macro-economic stimulus and is doing so. Despite being the world's manufacturing powerhouse, the economy seems to be back on a good growth path (However, it remains questionable whether China can divert itself towards a sustainable growth path without relying on export growth). Still, while it certainly helps, I fail to see how that alone will take the global economy out of the dolldrums in the short term as nominal GDP is just not high enough compared to the ailing advanced economies (see chart, source: IMF). The nominal GDP of the US economy alone accounts for some 25% of world nominal GDP with Japan 9% and the Euro Area 21%. With the outlook being that Japan continues its weakish growth, Eurozone trend growth to be a bit weaker than since its inception (amid the substantial structural imbalances in the so-called periphery and Spain) while the US should see trend GDP growth significantly lower than during the last years, we will have 55% of current nominal world GDP failing to deliver a significant increase in demand. China itself accounts for 9% of world nominal GDP (so it is currently the size of Japan according to the IMF). This size of 9% is just not high enough to overcome the weakness in 55% of the world economy.

Random Thoughts

Random Thoughts is a regular column with the aim of providing some interesting bits and pieces but does not give a holistic picture/view/outlook.

a) US CPI (from macroblog): "The chart below (hat tip to Brent Meyer at the Cleveland Fed) shows another interesting feature of yesterday's CPI release. Notice the clear downward shift in the distribution of CPI component price changes. Over half of the prices within the CPI market basket posted declines at or below 1 percent last month, up from an average of 29 percent in 2008, with a whopping one-third of the price index posting declines in May."
To me this highlights that an incresingly large area of goods and services is affected from disinflationary forces and the low headline number is not only down due to energy.

b) Guarantees, loan facilities and costs: the sums involved in the bailout measures are huge and also the costs involved are huge. However, guarantees, loan facilities/credit and costs are NOT THE SAME THING. If my local tv station or newspaper states: "Germany has spent EUR430bn to bail out the banks", then that is just not true. In fact they have provided capital injections (which is a real cost), much more money via credit injections (which is a cash-outflow for the state but no cost and we will only see in the future how much that really costs in the end) and finally a lot of guarantees (which is no cash-outflow and we will see how much it costs in the end). You can forgive the public and journalists for not knowing what they say but increasingly in the professional sphere the same mistakes are made as well. For example for this chart (Bailout Costs vs Big Historical Events) provided by the Big Picture - an otherwise very insightful blog - it seems that the aim was more to show a dramatic picture than to compare apples with apples: The post states: "This early Bailout Nation graphic shows the the total costs to the taxpayer of all the monies spent, lent, consumed, borrowed, printed, guaranteed, assumed or otherwise committed."
Again: you do not need to be an accountant to know that a guarantee is not the same as a cash-outflow via a loan facility and a cash-outflow is not the same as a cost. Furthermore, just because a loan facility has been established it does not mean that it has been drawn upon (otherwise the Fed's balance sheet would be much larger than it currently is). We just do not yet know how much the enacted (and potentially future) bail-out measures will cost. I personally see that buying the crappy Bear-Stearns assets can amount in a 100% loss but I fail to see how extending the swap lines with other large central banks such as the ECB can be stated as a cost...
Bloomberg provides an internet-based tool to view various programs and how much money has been drawn in each (but I do not know how up-to-date it is). For example out of the committed USD540bn for the money-market investor funding facility exactly USD0 has been drawn.

c) Brad Setser is pretty sure that China did not sell USTs in April and May: "China shifted from bills to short-dated notes in April rather than actually reducing its overall Treasury portfolio. It just so happens that China buys all its short-term bills in ways that show up in the US TIC data, but only a fraction of its longer-term notes in ways that show up in the US TIC data. A shift from bills to notes then could register in the US data as a fall in China’s total Treasury holdings and a rise in the UK’s holdings."