If you’ve been thinking that stock markets have been pretty quiet this year, you are right. Through the first seven months of the year, none of three major stock market indexes has fallen by more than 5 percent. And one gauge of market movement, the CBOE Volatility Index (VIX), which measures investors’ expectation of the ups and downs of the S&P 500 Index over the next month, recently dropped to its lowest level in 24 years. Low readings have tended to be equated with low anxiety and high stock prices. Amid this environment, you might be wondering what could go wrong? There are a number of risks to the US and global markets that persist. Their existence does not mean that long-term investors should change their game plans, but they are a reminder to guard against complacency and to always approach investing with caution.
The US economy added a much stronger than expected 242,000 jobs in February and the two previous months were revised higher by 30,000, pushing up year-over-year job creation to a solid 2.67 million. The unemployment rate remained at 4.9 percent, the lowest level since February 2008. The report puts the Federal Reserve in a quandary for its upcoming policy meeting. With job creation averaging 228,000 over the past three months and the labor force increasing by 555,000 in February and by 1.5 million in the last three months, the participation rate rose to a 15-month high of 62.9 percent. According to Capital Economics, the report shows that “remaining labor market slack is getting eaten up very quickly.”
If the central bankers are in fact “data dependent,” then the strong jobs report, along with rising core inflation (the Fed’s favorite inflation measure, the core PCE price index, was up 1.7 percent in January from the prior year), would add to the rationale for increasing the fed funds rate by another quarter of a percent in March.
But by now we know that the Fed likes to err on the side of caution. Officials are likely to cite some negatives from the February jobs report as a rationale for doing nothing in March. Chief among the concerns would be the drop in average earnings in February, which translated into a 2.2 percent annualized increase—that’s down from 2.5 percent in the previous month — and average weekly hours worked, which fell sharply to 34.4, from 34.6.
Part of the issue on wages may be the quality of jobs created in February. Big gains in retail and food and drinking establishments contributed to the weakness. Additionally, although the broader unemployment rate (U-6), fell to 9.7 percent, that is still about 1.5 percent ABOVE the precession level.
Bond investors put the likelihood of a March rate hike at essentially zero, believing that the slowdown in global growth will prompt the central bank to do nothing in a week and a half. But if there is continued improvement in the labor market and inflation marches towards the Fed’s desired 2 percent pace, the central bank may by eyeing April or June for the next increase.
MARKETS: HAPPY ANNIVERSARY! I hate to bring you back to a scary time, but seven years ago this week; US stock markets plunged to their worst levels of the entire bear market of 2008-2009. Although the entire financial system almost went over the cliff in September and October of 2008, it wasn’t until March 9, 2009 that stocks hit rock bottom. On that day, the Dow closed at 6547; the S&P 500 fell to 676; and the NASDAQ was at 1268. Time may not heal all wounds, but it certainly has helped investors...
- DJIA: 17,006 up 2.2% on week, down 2.4% YTD
- S&P 500: 2000 up 2.7% on week, down 2.2% YTD
- NASDAQ: 4717 up 2.8% on week, down 5.8 % YTD
- Russell 2000: 1081, up 4.3% on week, down 4.8% YTD
- 10-Year Treasury yield: 1.88% (from 1.77% a week ago)
- Apr Crude: $35.92, up 9.6% on week, up 37% from the 13-year low in Feb
- Apr Gold: $1,270.70, one-year high
- AAA Nat'l avg. for gallon of reg. gas: $1.81 (from $1.74 wk ago, $2.46 a year ago)
THE WEEK AHEAD: A few key speeches by Fed officials could provide the last clues before the central bank’s March policy meeting. All eyes will be on the ECB—it is expected that Draghi & Co will provide more stimulus to the ailing European economy.
3:00 Consumer Credit
Fed Governor Lael Brainard and Fed Vice Chair Stanley Fischer speak
6:00 NFIB Small Business Optimism
10:30 EIA Petroleum Status Report
ECB Policy Meeting
8:30 Import and Export Prices
There are just three more jobs reports before the December Federal Reserve policy meeting and each one is carries even more weight than usual. The September data are out this Friday and the consensus is for the economy to add 200,000 jobs and for the unemployment rate to remain at 5.1 percent. While the pace of job creation has slowed from last year (it was hard to imagine that we could sustain 300,000 per month), even the Fed had to admit that gains in the labor market have been “solid”. So what are the central bankers looking for to convince them that labor market slack is diminishing? My guess is that high on the list would be to see annual wage growth pick up from the sub-par 2 percent level and move towards 2.5 percent; an increase in the participation rate (the number of people employed or actively looking for a job); a continued drop in part time workers who are seeking full time positions; and a decrease in the number of long-term unemployed.
Although the jobs report is the main focus the week, the Fed is also likely to examine data on manufacturing. And spillover from the slowdown in China and other emerging markets is likely to be seen in that sector. If manufacturing indexes hold steady, it would likely provide some solace to Fed officials concerned about a global economic deceleration.
Meanwhile, last week, Yellen seemed to brush aside the China worrywarts, when she said “we do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy.” In that same speech, Yellen also said that she expects “inflation will return to 2 percent over the next few years as the temporary factors that are currently weighing on inflation wane”.
So if the labor market is solid, global slowdown worries are overblown and inflation is likely to gradually increase, why didn’t the Fed raise rates at the last meeting? As Weekend Update’s Emily Litella (Gilda Radner) would say “Never Mind”.
But wait; maybe Congress will trump the Fed’s rate increase mission. Even if lawmakers pass a continuing spending resolution to keep the Federal government open through December 11th, that’s just FIVE days before the last Fed meeting of the year. It could be déjà vu all over again (RIP Yogi), as we hurtle to the end of the year, talking about the raising the debt ceiling and defaulting on our obligations. Isn’t this fun?
MARKETS: The biotech sector is under siege again, as it has been at various times over the past couple of years. The biotech index tumbled 13 percent on the week and is now in bear market territory, off 22 percent from its recent high in July.
- DJIA: 16,314 down 0.4% on week, down 8.5% YTD
- S&P 500: 1,931 down 1.4% on week, down 6.2% YTD
- NASDAQ: 4,686 down 2.9% on week, down 1% YTD
- Russell 2000: 1122, up 3.5% on week, down 6.8% YTD
- 10-Year Treasury yield: 2.17% (from 2.19% a week ago)
- November Crude: $45.70, up 1.5% on week
- December Gold: $1,145.60, up 0.6% on week
- AAA Nat'l avg. for gallon of reg. gas: $2.29 (from $2.30 wk ago, $3.34 a year ago)
THE WEEK AHEAD:
8:30 Personal Income & Spending
10:00 Pending Home Sales
9:00 Case Shiller Home Price Index
10:00 Consumer Confidence
8:15 ADP Private Payrolls
9:45 Chicago PMI
3:00 Fed Chair Janet Yellen speaks at Conf of State Bank Supervisors
Thurs 10/1: 9:45 PMI Manufacturing Index
10:00 ISM Manufacturing Index
10:00 Construction Spending
8:30 September Employment Report
10:00 Factory Orders
The Greek debt crisis is temporarily on the back burner, so back to our regularly scheduled fixation: When will the Federal Reserve raise interest rates? During her semi-annual testimony before Congress, Federal Reserve Chair Janet Yellen said “If the economy evolves as we expect, economic conditions likely would make it appropriate at some point this year to raise the federal funds rate.” After Representative Scott Tipton (R-CO) got testy and said that the Fed is keeping rates low, because “our economy stinks right now,” Yellen responded by underscoring that the central bank is on the cusp of a rate lift off and when that happens, the Fed will be saying: “No, the economy doesn’t stink”.
There is plenty of corroborating evidence that Yellen can trot out to make her case. Last week, home builder confidence jumped to a 10-year high; Housing Starts and Permits showed continued progress; a report on consumer prices showed that core CPI was up 1.8 percent in June from a year ago, within striking distance of the Fed’s 2 percent target; and the Fed’s Beige Book indicated a general tightening of labor market conditions around the country.
When I discuss these improving trends on the air, I inevitably receive nasty-gram tweets or long-winded e-mails explaining that I am sugar coating “the truth about the economy”. My favorite last week was “Do you ever say anything not officially handed to you by someone inside a #CentralBank? FYI, OUR ECONOMY SUCKS. #cheerleader”.
The rancor is understandable: just because the economy is on a positive trajectory does not mean that it is on fire. Pokey growth, combined with flat productivity is not on any economist’s wish list. As the WSJ’s Timothy Aeppel pointed out, with productivity “at a 2 percent annual growth rate, it takes 35 years to double the standard of living; at 1 percent it takes 70. Low productivity slows the economy and holds down wages.”
Yet despite relatively slow growth, low productivity and lots of disgruntled Twitter users, there is enough evidence of economic progress to prompt the Fed to start nudging up rates as early as September.
MARKETS: Investors breathed a sigh of relief after Greece and the Euro Group agreed to fresh bailout. The deal will not resolve the long term issue that there is no chance that Greece can repay the more than $330 billion to the Europeans, but for now, the heat is down. With the inking of the Iran nuclear deal and the end to economic sanctions, the International Energy Association forecasts Iran, which has the fourth largest proven crude oil reserves in the world, will ramp up production and bring new supply to the market. Crude oil is down by over 10 percent over the past two weeks.
- DJIA: 18,086 up 1.8% on week, up 1.5% YTD
- S&P 500: 2,126, up 2.4% on week, up 3.3% YTD
- NASDAQ: 5,210 up 4.3% on week, up 10% YTD (New closing high)
- Russell 2000: 1267, up 1.2% on week, up 5.2% YTD
- 10-Year Treasury yield: 2.35% (from 2.41% a week ago)
- September Crude: $51.21, down 3.5% on week
- August Gold: $1,131.80, down 2.2% on week
- AAA Nat'l avg. for gallon of reg. gas: $2.76 (from $2.76 wk ago, $3.59 a year ago)
THE WEEK AHEAD:
Halliburton, Hasbro, Morgan Stanley
Apple, GoPro, Microsoft, Yahoo
10:00 Existing Home Sales
3M, Amazon, AT&T, Caterpillar, GM, McDonald’s, Starbux, Visa
10:00 New Home Sales
Since the Great Recession, the Federal Reserve has worked hard to boost the economy. Part of the Fed’s mission was to keep core inflation (the price of goods and services excluding food and energy), at a pace of two percent annually. Although there have been instances over the past six years when either energy or food prices jumped, temporarily raising the specter of inflation, throughout the financial crisis and the recovery, the central bank has been much more focused on deflation, which is defined as a drop in the price of goods and services. For those who were around during the inflationary 1970s and 1980s, deflation is an alien concept. But according to data released by the government last week, the near-60 percent plunge in oil prices pushed down consumer prices by 0.4 percent in December from the previous month, leaving the CPI just 1.6 percent above where it stood a year ago, below the 1.9 percent annual rate over the past ten years.
Although the idea of falling prices seems like a good thing, when deflation is persistent, it can put into a motion a scary, downward spiral. It starts when the economy cools, which prompts companies to reduce prices in the hopes of luring customers and maintaining sales volume. But as companies make less money, they could then cut jobs and/or wages, which could then cause consumers to spend less in order to service their fixed costs, like taxes and mortgages/rents.
The longer that deflation goes on, the higher the risk that consumers’ and businesses’ become accustomed to the situation and delay spending, hoping they will eventually be able to buy goods more cheaply and to invest more efficiently. They also become less willing to borrow.
The vicious deflationary cycle can mire an economy in a deep recession or even worse, a depression. As an example, between 1929 and 1933, US consumer prices fell by a cumulative 25 percent. More recently, Japanese consumer prices have been stuck for the past 20 years and the Euro Zone and the United Kingdom are both currently battling falling prices.
Besides the obvious harm that deflation can cause, the other problem is that central bankers have limited tools to fight it. (In contrast, when there is inflation, hiking interest rates may hurt in the short-term, but it is effective in combating higher prices.) In a deflationary environment, policy makers would likely return to bond buying (Quantitative Easing), which depending on the magnitude of price declines, may not stop the downward spiral. (FYI, there will be an excellent test case in the efficacy of QE coming up. This week, the European Central Bank is expected to unveil its version of bond buying to boost prices in the euro zone.)
Back to the US, where the big question is whether the current drop in prices is temporary or whether there is something scary brewing. Analysts at Capital Economics believe that odds are that while negative readings on headline inflation could persist at least for the first half of the year, “it is hard to see why this renewed slump in oil prices, which is developing against a backdrop of a rapidly improving real US economy, will lead to anything more than a temporary drop in inflation.” They are quick to point out that even when crude oil collapsed from a 2008 peak of $140 per barrel to $40, amid a deep recession, prices recovered and the economy avoided a prolonged bout of deflation.
That said, they also add that “Deflation may be just one recession away,” which is probably why Fed officials continue to err on the side of adding more stimulus to the economy than less and are taking a “wait and see” attitude towards increasing short-term interest rates. Currently, the consensus is for the first rate hike to occur in the third quarter of this year. But any indication of an economic slowdown, accompanied by a more substantial drop in core prices, could put the Fed on hold longer, to avoid a dangerous deflationary downward spiral.
MARKETS: Last week, the Swiss Central Bank’s decision to discontinue its 3½ practice of pegging the Swiss Franc to the Euro sent ripple effects throughout global markets. (The policy was intended to halt the rise of the Swiss currency, which made it difficult for Swiss exporters to remain competitive in the global market.) Meanwhile, the punk US Retail Sales report unnerved investors, who continue to worry about a slowdown in global growth.
- DJIA: 17,511, down 1.3% on week, down 1.8% YTD
- S&P 500: 2019, down 1.2% on week, down 1.9% YTD (still within 4% of all-time highs)
- NASDAQ: 4634, down 1.5% on week, down 1.5% YTD
- Russell 2000: 1176, down 0.8% on week, down 2.3% YTD
- 10-Year Treasury yield: 1.84% (from 1.97% a week ago)
- February Crude Oil: $48.69, up 0.7% on week (oil CAN rise!)
- February Gold: 1,276.90 $1,216.10, up 5% on week
- AAA Nat'l average price for gallon of regular Gas: $2.08 (from $3.33 a year ago)
THE WEEK AHEAD:
Mon 1/19: Markets closed in honor of MLK Day
Baker Hughes, Coach, Haliburton, Morgan Stanley, Netflix
2014 Tax Season begins
10:00 NAHB Housing Market Index
State of the Union address
American Express, eBay
8:30 Housing Starts
Southwest Air, Starbux, Verizon
European Central Bank Policy meeting
8:30 Weekly Jobless Claims
General Electric, McDonald’s
8:30 Existing Home Sales
Two years ago, when the Federal Reserve announced that it would engage in its third round of bond buying (“Quantitative Easing") to spur economic growth and help reduce unemployment, fears of runaway inflation bubbled up. As a reminder, inflation occurs when the prices of goods and services rise and as a result, every dollar you spend in the economy purchases less. Despite the Fed’s actions, headline inflation (CPI), which includes everything you care about, is up about two percent year over year, but that doesn't mean that there will never be inflation again. Even central bank officials expect prices to rise over time, so if inflation is coming, what should you do? Hopefully wages will start to increase to account for the extra money that you are shelling out. As an investor, especially a retired investor who relies on portfolio income to supplement Social Security, you can be more proactive. While there is no perfect inflation hedge, the following five assets are those that are most frequently used to protect portfolios:
1. Commodities: When inflation rises, the price of commodities like gold, energy, food and raw materials also increases. Many investors therefore turn to investments in these assets for protection, but as a former commodities trader, I must warn that this is a volatile asset class that can also stagnate or worse, lose money, over long stretches of time. Therefore, investors would be wise to limit commodity exposure to 3 - 6 percent of the total portfolio value.
2. Real estate investment trusts (“REITs”): The ultimate “real asset”, REITs tend to perform well during inflationary periods, due to rising property values and rents. The nation’s housing bubble cured most of us of the notion that one “can’t lose with real estate,” because as we know, real estate prices can stay depressed for a long period of time.
3. Stocks: Many investors don’t think about stocks as an asset class to combat inflation, but the long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, stocks can plunge quickly before reverting to the longer-term trend.
4. Treasury Inflation Protected Securities (“TIPS”): Bonds are susceptible to inflation, because rising prices can diminish a bond’s fixed-income return. But the US government issues inflation-indexed bonds, or TIPS, which proved a fixed interest rate above the rate of inflation, as measured by the CPI. If inflation rises, payments rise, but TIPS provide little return above the inflation rate.
5. International Bonds: One of the dangers of inflation is that it destroys the value of the U.S. dollar. As a result, there is an argument to allocate a portion of a bond portfolio to a small percentage of international bonds, which are denominated in a foreign currency. This is another one of those asset classes that tends to be volatile.
While inflation may be looming, it’s important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way towards providing protection.
If the past week’s news cycle did not rattle investors, what will? Oh sure, on Thursday when it seemed like the world was spinning out of control, the CBOE Volatility Index (VIX), which helps gauge investor fear, surged 32 percent, its biggest jump in more than a year. Then on Friday, it fell 17 percent to 12.06, far below historical norms of around 20. Evidently, geopolitical events are not sufficient to cause more than a one day stock sell-off and flight to quality, most of which was reversed on Friday. So what would it take? Maybe run of the mill inflation, which has been almost absent for the past six years, would spook investors.
Headline inflation (CPI), which includes everything you care about, is up about two percent year over year. I know what you’re thinking: Why would the central bank exclude the stuff that impacts my daily life? Surely when I am spending more on food and gas, I have less money to spend elsewhere in the economy. (A recent Gallup poll found that 1/3 of Americans said higher prices are impinging on their ability to spend on travel, dining out and leisure activities.) But the Fed is not tasked with addressing short-term price increases, like those at the pumps, or even for agricultural items like beef, pork or chocolate -- the central bank can’t be at the mercy of the weather or events in the Middle East.
That’s why during the recovery, when prices have increased sporadically, the Fed downplayed the idea of broad-based inflation, calling the higher readings transitory (like when gas spiked due to the Arab Spring). More recently after the Fed’s June policy meeting, Chair Janet Yellen said that while “Recent readings on, for example, the CPI index have been a bit on the high side,” the data are “noisy.” Translation: Stop worrying about inflation—we have it under control.
The Fed is looking for a gradual increase of core inflation, which excludes food and energy, to a pace of two percent annually. Over the past six years, core inflation as measured by the CPI or by the Fed’s preferred metric, the Commerce Department’s personal consumption expenditures price index (PCE), has remained below that level. But over the past three months, core prices have started to accelerate across a variety of categories, including shelter, airfares, clothing and medical care.
It’s not so far-fetched to see how as the economic recovery accelerates, a chain of events is likely to spur price increases. Here’s what could happen: as the labor market improves, there is likely to be an increase in wages. As people earn more money, they may be willing to spend more. An uptick in spending could be the opening that retailers have been waiting for since the recession and allow them to finally increase prices for all sorts of stuff.
While it is unlikely that any of this would create runaway inflation, despite what some inflation hawks (including the usually wrong CNBC editor Rick Santelli) have been arguing for years. Remember we’re talking about what could spook investors, who are hyper-focused on when the Fed will begin to raise interest rates. It is widely believed that the central bank will begin to nudge up rates at the beginning to the middle of next year. But if prices rise faster than expected, it may prompt the Fed to hike rates sooner and more aggressively than widely expected. If that were to occur, stock investors might take a time out from the bull market and wait to see how things shake out.
- DJIA: 17,100, up 0.9% on week, up 3.1% YTD
- S&P 500: 1978, up 0.5% on week, up 7% YTD
- NASDAQ: 4,432, up 0.4% on week, up 6.1% YTD
- 10-Year Treasury yield: 2.48% (from 2.52% a week ago)
- August Crude Oil: $103.13, up 2.3% on week
- August Gold: $1309.40, down 2% on week
- AAA Nat'l average price for gallon of regular Gas: $3.58 (from $3.67 a year ago)
THE WEEK AHEAD: The SEC is poised to impose new requirements on the $2.6 trillion dollar money-market mutual fund industry, when it votes on whether the riskiest money-market funds will have to let their share prices fluctuate; and charge investors withdrawal fees during times of stress. The government was forced to provide a backstop to money market funds during the 2008 financial crisis.
Haliburton, Hasbro, Texas Instruments, Netflix
8:30 Chicago FedNational Activity Index
Altria, Dupont, Kimberly Clark, McDonald’s, Apple, Microsoft, Coca-Cola, Verizon
8:30 Consumer Price Index
10:00 Existing Home Sales
AT&T, Boeing, Facebook, Pepsi
SEC vote on Money Market funds
Ford, GM, Hershey, Starbux, Visa, 3M, Amazon, Caterpillar
8:30 Weekly Jobless Claims
10:00 New Home Sales
8:30 Durable Goods
Inflation is tame by almost any measure. Prices are up by less than 2 percent over the past year, despite the Fed’s purchase of more than $2 trillion dollars worth of bonds. In fact, for all of the hand wringing over the Fed’s “money printing” monetary policies, the weak economy has kept wages flat and forced many businesses to cut prices, which has kept a lid on overall prices. But when conditions improve, inflation could rear its ugly head. As a reminder, inflation occurs when the prices of goods and services rise and as a result, every dollar you spend in the economy purchases less. The annual rate of inflation over from 1914 until 2013 has averaged about 3.35 percent annually. That might not sound like much, but consider this: today you need $7,606.96 in cash to buy what $1,000 could buy in 50 years ago.
Currently, inflation is running well below the long-term average pace. As of April, the government’s measure of inflation, the Consumer Price Index (CPI), has increased only 1.1 percent over the last 12 months (1.7 percent without food or energy costs included.)
However, the Fed’s strategy to flood the economy with money could eventually unleash inflation in the future, an event against which every retirement investor must guard. The key is to attempt to grow your portfolio at a quicker pace than the rate of inflation, while keeping focused on the total risk level you are willing to assume. Not an easy puzzle to solve! And here’s one more sobering thought: there has not been any single asset that acts as a perfect inflation hedge.
The following are the assets most frequently used to protect portfolios against inflation:
Commodities: When inflation rises, the price of commodities like gold, energy, food and raw materials also increases. Many investors therefore turn to investments in these assets for protection, but as a former commodities trader, I must warn that this is a volatile asset class that can also stagnate or worse, lose money, over long stretches of time (see the massive drop in the gold market this year). Therefore, investors would be wise to limit commodity exposure to 3 - 6 percent of the total portfolio value.
Real estate investment trusts (“REITs”): The ultimate “real asset”, REITs tend to perform well during inflationary periods, due to rising property values and rents. But the nation’s housing bubble has cured most of us of the notion that one “can’t lose with real estate.” Real estate prices could stay depressed for a long period of time.
Stocks: Many investors don’t think about stocks as an asset class to combat inflation, but the long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, the stocks might plunge before reverting to the longer-term trend.
Treasury Inflation Protected Securities (“TIPS”): Bonds are susceptible to inflation, because rising prices can diminish a bond’s fixed-income return. But the US government directly offers investors inflation-indexed bonds, or TIPS, which proved a fixed interest rate above the rate of inflation, as measured by the CPI. Sounds great, right? When the expectation of future inflation is runs high, investors pay up for TIPS, which in the past year, has driven the interest rate on these bonds below zero. [In April, five-year TIPS drew a yield of negative 1.311 percent.] That’s not a typo: when investors get worried about future inflation, they are willing to pay the government now to protect them later. The current pricing of TIPS makes them hard to recommend, even as an “insurance policy” against inflation.
International Bonds: One of the dangers of inflation is that it destroys the value of the U.S. dollar. As a result, there is an argument to allocate a portion of a bond portfolio to a small percentage of international bonds, which are denominated in a foreign currency. This is another one of those asset classes that tends to be volatile.
While inflation may be looming, it’s important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way towards providing protection. If you are worried about inflation, these other asset classes should be used sparingly to round out your overall allocation.