Balancing Acts

China has been the focus for the past several years in terms of the percentage of GDP allocated to consumption, investment, and net exports.  As has been discussed countless times in the business press and academic literature, China’s allocation to investment-related activities and net exports has leaped quite dramatically over the past decade at the expense of consumption, prompting calls from policymakers in the developed world for China to “rebalance” economically, or enact policies to strengthen the currency.  Oftentimes, political actors threaten China with retaliatory action to offset perceived trade balance injustices, as witnessed during the US presidential elections.

Generally, when economists total up GDP using an expenditures method, they derive total GDP from four sources: consumption, investment, government, and net exports.  Let’s take a quick look in the following charts where China stood coming into the year on each of the expenditure measures relative to GDP:

Source: World Bank

Source: World Bank

Source: World Bank

As you can see, the top-down investment driven model in China has pushed investment as a percentage of GDP up approximately 12 percentage points since the start of the new century to 48.4%.  Consumption has dropped approximately 11% points over the same time frame.  The allocation of GDP to net exports has increased by about 1.5%, though the contribution was much higher just ahead of the global economic and financial crisis.  Net exports have moderated as a percentage of GDEP as China’s currency has strengthened and US and European economic problems have stunted trade.  

What’s been worrisome to many in the pundit class, and some in the economics profession, is the fact that China’s numbers for investment as a percentage of GDP have reached levels unseen by other rapidly developing economies at similar stages of economic progress.  Japan, for instance, during its rapid rise juggled similar dynamics as the Chinese, but investment peaked at a level below 40% as a percentage of GDP.  The Economist performed a nice job addressing these concerns earlier this year by noting among other things that capital stock per capita in China still lags the US and other developing countries dramatically (see: http://www.economist.com/node/21552555).  Whether a positive, negative, or neutral condition, we’ll still argue that at some point the mix will need to change; it always has in other countries on a similar development track, and we have no reason to believe it won’t be the case for China.  As for the implications, we’ll handle those in a bit.

Before dealing with potential implications, let’s look at the US mix.  As you see in the charts following, the current composition and the trajectory over the past 10 to 15 years is almost a mirror image of China.

Source: US Bureau of Economic Analysis and Bloomberg

Source: US Bureau of Economic Analysis and Bloomberg

Source: US Bureau of Economic Analysis and Bloomberg

US consumption as a percentage of GDP has risen from the mid 60s during the 1990s to nearly 71% today, though it has recently begun to trail off.  Investment as a percentage of GDP in the US has fallen from near 18% at the turn of the century to approximately 13% today, off the lows of about 10.5% observed in 2009.  Finally, net exports as a percentage of GDP has fallen since the mid-90s, though the figure has improved substantially since the beginning of the financial crisis.  As we discussed last week, heading into the financial crisis the US faced a massive credit bubble and a massive savings deficit.  The deeply negative net exports number above, and the subsequent recovery is a crude visual representation of the dearth of savings heading into the crisis and the subsequent deleveraging/rebuilding of savings in the aftermath.  

Like the China example, it’s probably not too much of a stretch to think that the US will slowly rebalance away from a consumption driven economic model, to one that better balances investment and net exports.  

Perhaps we’re already seeing rebalancing on both fronts.  There’s been much discussion in China as they moved through the recent leadership transition about changing the predominant economic model towards one favoring consumption growth.  Wages in China continue to rise rapidly, narrowing the cost differential, all things considered, between China and the US.  Thus, in the US numerous articles are popping up discussing a new trend towards “insourcing” manufacturing capacity, a resurgence and focus on exporting, and increases in manufacturing employment.

So, now, what are the potential intermediate-term implications if the US and China, the two biggest economies in the world work in tandem to shift the economic mix demonstrated above over the coming years and decades.  Overall, it’s more nuanced than just saying it’s an absolute positive or negative for either country.  If the glide paths are relatively smooth for both countries, the overall impact doesn’t necessarily have to be particularly destructive or disruptive.  On the other hand, a dramatic short-term shift in the mix due to an unforeseen, dramatic political, economic, or market/currency move would be problematic.  Predicting where the countries will fall on the “glide path” is difficult.  Instead, it may be more instructive to focus on what an inevitable mix shift means for certain actors within the respective economies.  

Therefore, if there’s a strong likelihood that consumption growth is going to outpace GDP growth in China in coming years, and underwhelm relative to the rest of the economy in the US (and other developing economies) it may be safe to say that US-focused consumer discretionary companies should be shunned in favor of companies focused on selling into China and other emerging markets, as well as nascent consumer companies in China that focus on the urban consumers in their own country.  Similarly, US manufacturers with a strong export model and ability to satisfy Chinese demand could fare well.  Conversely, state-owned enterprises in China focused on the export sector, and the stakeholders there that have been enriched by these dynamics, will face increasing pressures in the future.  These broad conclusions may seem obvious in certain respects.  Looking at the US in particular, though, the consumer discretionary names in the S&P 500 still command a significant portion of investor mindshare.  The ratio of the S&P 500 consumer discretionary index level relative to the broader index is still over two standard deviations above the norm as the consumer index marks new all time highs.  While there’s been plenty of discussion about constrained consumers in the US, it’s not being reflected in market action.  In China, there’s been much talk about reducing the role of massive state-owned exporters in the economy and increasing opportunities for small and medium sized entrepreneurs.  At this point, there hasn’t been significant progress; maybe that will change in short order.  

Anatomy of a Deflating Credit Bubble

Amid a constant barrage of news about fiscal cliffs, and government deficits, and confidence deficits, and European meltdowns, and “muddle through” economies over the past few years, it’s easy to lose sight of an issue that’s played an instrumental part in the massive economic headwinds in the first place.  Ultimately, the severity of the 2008-2009 recession and the subsequent economic malaise, at least in relative terms to the economic rebounds we’ve seen during past post-war episodes, was attributable in major part to the massive reversal of a US consumer credit bubble that was decades in the making.

Look at the first chart below, which represent total household debt relative to disposable income in the US.  The chart is based on data provided by the Federal Reserve Bank from 1965 through Q3, 2012.  Between the mid 1960s until the early 1980s, debt as a percentage of disposable income remained relatively stationary.  From the early 1980s until 2007, households piled on debt at an ever-increasing pace relative to incomes.  Granted, the near parabolic move higher during the last stretches of the credit bubble was mainly attributable to mortgages outstanding, but the point remains the same.  Accelerating debt dynamics provided a turbo boost to economic growth, and probably masked underlying structural issues with US economic growth, especially from 2000, or so, to 2007.  The level of household debt relative to income peaked out at 129.4% in Q3:2007.  Since that time, it’s fallen to approximately 108%.  Further demonstrating the dynamic, below the first chart providing total household debt, we’ve also provided a chart based on data from the New York Fed which breaks debt out into individual consumer components such as auto loan debt, credit card debt, revolving home equity debt, and student loan debt.  As you can see, the ex-mortgage consumer credit categories have been in steady decline for the past several years as well (except for one category: student loans).  

Just as increasing use of credit provided a tailwind to US economic growth for years, the subsequent deleveraging among households has been an albatross. The aftermaths of massive credit bubbles aren’t pretty and are historically marked by years and years of substandard economic growth.  The event unfolding in the US seems to be unfolding according to the template outlined in the Rogoff and Reinhart book, This Time is Different.  Massive private sector credit bubbles prick, creating financial crises.  As governments work to offset the negative effects of the crisis, the debt baton is passed on to sovereigns/governments.  Ultimately, overburdened sovereigns dispense of obligations through various strategies, such as financial repression, monetizing/inflation, or default.  Whatever the trajectory, economic growth usually remains subdued for an extended period as economies adjust, rebalance, and digest; there’s very little policy makers can do.

Source: Federal Reserve

Source: Federal Reserve Bank of New York

Where do we stand in the overall process?  What’s amazing is the fact that the US finished 1999 and entered the 2000s with a household debt to disposable income ratio of approximately 91.5%, nearly 20 percentage points below the current level.  It’s obviously impossible to make definitely predictions on a debt trajectory from here, but it’s not unfathomable to think that total household debt will continue to work lower, especially considering the general aging of US society and other dynamics.  Maybe consumers will dedicate more of their disposable income to debt reduction, or perhaps institutions will write off more debt, such as mortgage balances.  Either way, the headwinds will probably continue.  

Atlanta Fed President Dennis Lockhart’s comments below, made during a speech in late 2011, succinctly describe the deleveraging process and the ongoing ill-economic effects associated with the aftermath of a credit bubble:

"It is necessary that the process of deleveraging plays itself out, which may take several more years. When economies are deleveraging they cannot grow as rapidly as they might otherwise. It is obvious that as consumers reduce spending they divert more of their incomes to paying off debt. This shift in consumer behavior increases the amount of capital available for financing investment. But higher rates of business investment are not likely to fully offset weakness in consumer spending for some time, as businesses continue to grapple with uncertainties about the future.

…Rebalancing simply takes time. A 2010 report by McKinsey surveyed 32 international periods of deleveraging following financial crises and found that, on average, the duration of these episodes was about six and a half years. U.S. debt to GDP peaked in the first quarter of 2009. By that standard we are much closer to the beginning than the end of our deleveraging process."

If Lockhart is correct, the frustrations we’ve experienced over the past three years with the three steps forward, two steps back recovery will probably remain in place.  

Green Shoots in Global Performance?

Without a doubt, it’s been a frustrating few years for investors with a global orientation.  From the end of 2009 through yesterday (12/6/12), total return for the MSCI World has trailed that of the S&P by about 12.5 percentage points.  Of course, US stocks comprise nearly half of the MSCI World Index.  Isolate the ex-US component as represented by the EAFE, and the story is even more ugly.  EAFE returns have trailed over the past three years by nearly 25%!  In the 11 full quarters since the end of 2009, the MSCI World and EAFE have only outperformed the S&P 500 three times.  Here’s a table of quarterly returns:

	MSCI World	S&P 500	EAFE
Q1:10	3.37%	5.39%	0.98%
Q2:10	-12.47%	-11.43%	-13.69%
Q3:10	13.92%	11.29%	16.57%
Q4:10	9.08%	10.76%	6.67%
Q1:11	4.93%	5.92%	3.50%
Q2:11	0.66%	0.10%	1.80%
Q3:11	-16.50%	-13.87%	-18.92%
Q4:11	7.74%	11.82%	3.40%
Q1:12	11.73%	12.59%	11.00%
Q2:12	-4.85%	-2.75%	-6.93%
Q3:12	6.84%	6.35%	7.00%
Q4:12	1.04%	-1.37%	4.24%

A funny thing has happened of late.  For the first time since the end of ’09, the ex-US markets may outperform US markets for two consecutive quarters.  The EAFE and MSCI World as a whole outperformed slightly in Q3:2012.  Through yesterday, the EAFE has outperformed the S&P 500 by nearly 5.6 percentage points in the 4^th quarter.  Granted, there’s still plenty of time left in the month, but if things hold, this will mark the second biggest differential in performance between the EAFE and the S&P over the past three years (the biggest was an 8.4% point win by the S&P in Q4 of last year while Europe was struggling with most vicious news flow from the debt crisis).  

What factors have started to perk up global performance relative to the US?  Several issues could be at play.  First, from a news flow standpoint, though negative headline flow in Europe continues as the continent struggles with economic weakness and the ongoing political drama surrounding the debt crisis, the intensity has decreased.  Instead, global investors have found it’s the United States’ turn to absorb the brunt of negative headline flow as the President and Congress circle around the fiscal cliff issue.  Plus, the US economy remains sluggish and US earnings growth has been less than inspiring of late.  Second, the “herd” factor may be coming into play; individual and institutional investors entered 2012 with very negative sentiment towards ex-US markets.  Accordingly, equity investors have parked significant capital in US relative to ex-US markets.  As investors have voted with their feet in response to the debt crisis situation overseas, normalized multiples in overseas developed markets have become quite low relative to the United States, as we’ve discussed at several points this year.  Coming into November, the US held the highest multiple among all developed markets around the globe as illustrated by this chart from the World Beta Blog:

Source: World Beta Blog, www.mebanefaber.com

The US trades at approximately 21x.  In contrast, the European or Asian developed market with the highest normalized multiple is Hong Kong at 17x, decently below the US position.  The “Big 3” European markets, the UK, France, and Germany trade at 12.5x, 11.2x, and 13.4x respectively, far below the US.  Most emerging markets remain at low multiples.  Yes, economic/earnings and political conditions have been ugly overseas, especially in Europe.  Using multiples as a guide, it’s apparent that markets have priced in significant pain, meaning that hurdles are low.  When hurdles are low, it’s not particularly difficult to see a spark in performance with just the tiniest shift in news flow.  The opposite is true as well.  Hurdles are relatively high in the US and the tenor of news flow has been shifting, especially in earnings trajectory.  As we discussed recently, earnings news disappointed investors last quarter in the US, which we believe contributed significantly to weak performance.  Expectations are still reasonably optimistic for 2013 S&P 500 earnings.  Another round of earnings misses could result in P/E multiple compression in the US.

Sum it all up, and it could be time for global equities to gain a little bit of the spotlight relative to the US.  Global markets have underperformed US markets for quite some time.  We’ve said it before and it will continue to say it: multiples revert to the mean for various reasons over time.  It doesn’t necessarily happen quickly, and usually doesn’t happen in a neat, straight line.  But it happens.  There’s a wide chasm valuation-wise between US equities and global equities and that differential has developed over a long period of time.  We continue to expect that this course of events will reverse sooner rather than later.  Perhaps, the past two quarters of performance provide some indication that the ship is making its turn.  

We’ll leave you with one final visual representation of the performance differential between the S&P 500 the MSCI EAFE that shows where market currently stand and how the relationship has shifted over time.

Source: IronHorse Capital

Valuation, Market Performance, and Presidential Perception…

With nearly a month having passed since the Presidential election, we promise this will be the last post referencing the subject.  Before we could move on, however, we thought it would be interesting to explore total stock market returns by President within the context of valuation at the beginning of the term.  So much of perceived Presidential success can be attributed to economic success and the overall mood of the nation.  Oftentimes, it seems the mood over a Presidential term, especially in modern times, is guided or influenced by action in the equity markets.  People do see the headlines and can get caught in psychological frenzies, such as the tech boom in the late 90s, or the “Nifty 50” craze in the 60s, even if they’re not active investors.  The reverse is certainly true as well.  Crashing equity markets in late 2008 certainly provided a tangible, even visual, element to the perception of an economy coming off the rails globally, again even among those that weren’t actively participating in markets.  The Crash of 1929 is still identified among many as the beginning of the Great Depression, even though it would really be another year or two before the nation truly plumbed the depths in terms of economic malaise.  

Certainly, there is a “correlation does not imply causation” element to linking market performance, economic fortunes, and national mood.  We’re not interested in producing a complex treatise trying to make predictions about future elections, or even the current President’s term.  We do know a couple of truths, though, one universal and one data driven.  First, in politics, business, or any other endeavor for that matter, timing and luck often play a significant role in success and failure.  Second, we know that valuation matters in markets when it comes to future returns as we’ve discussed in a few of these blog posts before.  Trying to quantify or qualify how much influence market action on each President’s success if far outside the scope here.  But, looking at some data to see if maybe the cards were already stacked against a candidate from the get-go could be interesting.  In general, it seems one would much rather take over the office when market valuations were low and the potential hurdles in terms of national mood were low as opposed to taking over with a backdrop of wildly overvalued markets and expectations.  We’ve compiled data below showing the 10-year normalized P/E at the time the President entered office and the real, total return (inflation adjusted including dividends) over the course of that term.  Do the Presidents that entered office at times where valuations were particularly low/high have more/less favorable treatment in the history books?  You be the judge.

President	Start P/E	Total Real Return:	Annualized	Years In Office
Hoover	27.68	-52.96%	-17.18%	4
Roosevelt	7.87	161.48%	8.28%	12.08
Truman	12.63	67.07%	6.77%	7.83
Eisenhower	12.86	164.17%	12.91%	8
Kennedy	19.23	25.21%	8.26%	2.83
Johnson	21.04	35.83%	6.11%	5.17
Nixon	20.9	-30.38%	-6.37%	5.5
Ford	9.82	25.86%	9.64%	2.5
Carter	11.01	2.69%	0.67%	4
Reagan	8.83	105.81%	9.44%	8
Bush	15.47	42.27%	9.21%	4
Clinton	20.55	164.71%	12.94%	8
Bush	35.84	-37.09%	-5.63%	8
Obama	14.12	73.25%	15.78%	3.75

There are a few things to keep in mind.  First, the median P/E since 1925 is approximately 16.5x.  Second, median total, real return over the same time frame is approximately 6.5% per annum.  Finally, running a very simple correlation analysis on annualized performance relative to valuation at the beginning of a Presidential term shows a decent correlation of -0.637 (negative correlation: higher valuation means lower returns).  There are plenty of factors to adjust for and the sample size is small, but on the surface the statistical relationship between valuation and returns seems to poke its head out even in an exercise such as this.

Looking at the data, the extremes in terms of valuation are very interesting.  Herbert Hoover and George W. Bush had the misfortune of entering office at the two highest valuation periods in the table, and at the very end of secular bull cycles, which as we’ve discussed in the past have consistently alternated on 15 to 20 year cycles.  In both cases, almost immediately after taking office, equity markets began to descend rapidly as the valuation bubbles were pricked.  To this day, many historians saddle Hoover with the Great Depression.  With the economy in shambles and markets down precipitously, he was soundly routed in the 1932 election, a one-term President.  Bush’s first term is complicated by geopolitical factors.  Markets were lower at the end of the term relative to the beginning, but the economy had started to pick up.  Even so, he won reelection in one of the closest winning contests for an incumbent.  Markets moved to lofty valuations again early in the 2^nd term, but fell dramatically as the global subprime crisis combined with high valuations to create a devastating brew for equity markets.  Fair or not, both exited office associated with crisis.

On the other end, Roosevelt and Reagan entered office with the two lowest valuation figures in the modern era and exited with annualized returns that were strong.  Both were reelected easily for 2^nd terms.  In Roosevelt’s case, equity market performance gets lost in the shuffle in the post-1932 period; the lingering depression and the onset of World War II dominate the history books.  Buying and holding equities in the 1932/1933 timeframe, though, was a good long-term decision.  Roosevelt’s reputation is generally positive historically, but most of the positivity is focused on the management of the war effort.  Market perception and performance was a back burner issue.  Reagan exited with a strong and positive reputation for economic growth, an image enhanced by strong equity market returns over the course of his Presidency.  In all, market performance probably had much more effect in terms of public perception in the Reagan presidency than the Roosevelt Presidency.  Considering the fact that market-oriented policymaking was a cornerstone issue for the Reagan team, the market performance narrative was more powerful.

The three strongest performers present an interesting lot.  Eisenhower, Clinton, and Obama have produced the strongest annualized equity market performance in the market era.  All three are two term presidents.  Eisenhower and Obama both entered office with valuations below historical averages, but not rock bottom by any means.  When Clinton entered office, valuations were not far from where we find them today.  Eisenhower and Clinton benefitted mightily from being in the middle of positive economic storms whereby secular bull markets combined with transformational economic shifts to produce positive outcomes.  In the 1950s, expanding population (Baby Boom!), technological innovation, and other factors that coalesced in the post-War environment created strong markets and positive psychological conditions.  Clinton benefitted as the economy was coming out of a cyclical trough, the secular bull was still intact, and the economy was entering the internet/computing boom.  The investment frenzy surrounding that boom was responsible for driving valuations to the high levels discussed above when Bush entered office.  Obama entered office in the middle of a cyclical and secular bear market.  The economy was plumbing the lows.  With hurdles low and strong policy responses enacted across two administrations, it wasn’t surprising to see markets move sharply higher.  Economic growth has remained muddled, a big issue in the recent election.  Did strong market performance contribute to the victory last month?  Obviously it’s very hard to quantify, but campaign officials cited market performance on numerous occasions as evidence to counter the negative economic arguments.  Moving forward, Obama enters a second term facing the headwinds of a continuing secular bear market and valuations that are back above historical average.  Will this come into play over the next four years and alter the historical perceptions of the Presidency?  We’ll see.

Again, this obviously isn’t a definitive scientific exercise to attempt to “suss out” definitive truths about valuation, market moves, and Presidential success.  There are plenty of problems when putting data like this out there, such as different term lengths, domestic and geopolitical events that intervene over the course of a Presidency, and myriad other factors.  It’s fun and interesting to take data such as this and see what types of narratives, if any, develop.  That being said, ambitious Presidential candidates might be wise to pay attention to factors such as these, especially when conditions have reached extreme levels.  Taking the Presidential baton while markets are skyrocketing, valuations are lofty, and prosperity seems unstoppable may not be the smartest career move!

US Valuations are Stretched vs. ex-US...By the Numbers

It’s been several weeks since we’ve run through long-term valuation metrics and predicted values for future ten-year returns.  With markets, especially indices in the US, having corrected since mid-September, this seems to be a good time to check back in.

As we’ve mentioned several times in the past, we prefer longer-term “normalized” P/E ratios.  To come up with a “normalized” earnings number, we take an average of trailing earnings over a designated time frame.  Some analysts prefer 5-year average trailing earnings because that time period roughly conforms to a typical business cycle.  Professor Robert Shiller of Yale University has famously presented a ten-year normalized earnings number for many years.  As it turns out, Professor Shiller may have a point; 10-year normalized P/E ratios have a stronger statistical relationship historically with future 10-year annualized returns.  For the US, we’ll present both.  For the global indices, we’ll present the 5-year, owing to the fact that the amount of available earnings data for global indices isn’t as robust as the US dataset.  The point of “normalizing” earnings is to smooth out the earnings kinks that result from the ebb and flow of the business and earnings cycle.  When analyzing returns, we usually refer to “real total 10-year annualized returns.”  What does this mean in layman’s terms?  We are interested in looking at returns that include dividends (total return) and that take inflation into account (real return). 

In the United States, long-term P/E ratios still remain in heady territory.  The recent correction has made a slight dent, but predicted values for future annualized returns still remain below historical median.  As of this morning (Friday), the 5-year normalized P/E ratio for the US is 21.4x and the 10-year normalized P/E is 20.1x.  Historically, the median 5-year P/E is 15.9x and the median 10-year is 16.4x.  At these levels, the 5-year model predicts 3.2% real total annualized returns over the next 10 years versus a historical median of 6.4%.  The 10-year model predicts 3.8%.  Either way, the return environment looks like it could remain subdued in coming years relative to historical returns.

Keeping with the US, we’re fortunate to have agencies that release massive amounts of economic and market data.  Because of data released regularly by the Federal Reserve, we’re able to calculate a Q-ratio for the US.  The Q-ratio is similar to a traditional price to book value ratio, but uses current market values for corporate net worth instead of the static values we typically find on many balance sheets.  Like the normalized P/E ratios above, we can analyze the relationship between historical values and future returns and generate a predicted value.  Currently, the Q-ratio in the US is approximately 0.89x versus a historical median of 0.75x.  At current levels, predicted ten year real annualized total returns for the US come in at 3.44%, roughly in line with the numbers generated from the normalized P/E ratios.  Of note: the statistical relationship between the Q-ratio and future 10-year returns is stronger than the relationship between P/E ratios and returns.  Take it all into account and it seems like a 3% to 4% total real return environment is a strong possibility going forward in the US versus the 6.5% return environment we’ve typically witnessed over historical 10-year periods. 

Moving to global indices, the picture looks slightly better.  The MSCI EAFE index, which covers developed markets in Europe and Asia, currently sports a 5-year normalized P/E of 16.6x.  At current levels, predicted future 10-year real total annualized returns come in at approximately 5.5%.  The MSCI Emerging Markets index currently trades at a 5-year normalized P/E of 13.8x.  Predicted 10-year returns for the emerging markets index are approximately 11%. 

With economic and earnings deterioration in Europe and parts of developed Asia over the past few years, market performance has lagged behind US markets.  Perhaps investors have “over-discounted” negative outcomes in certain corners of the ex-US developed world.  Accordingly, valuations have become more attractive on a relative basis.  The same effect is in place in emerging markets.  In essence, emerging market indices have been flat over the past three years while the economies continue to grow, albeit at a slower pace that witnessed in the past.  As such, emerging market normalized valuations have become attractive relative to US valuations.

None of the major global indices trades at levels one would consider “washed out” or extremely cheap.  Ideally, investors would be able to pick up equities at valuations in the single digits.  Nonetheless, we continue to maintain that higher valuations in the US means there’s less room for error and more of an air pocket underneath US markets should economic and corporate results not meet expectations.  For instance, US earnings expectations for 2013 remain optimistic, as we discussed briefly in our recent monthly commentary.  Analysts expect 10% earnings growth in the S&P over the next 12 months, a strong number considering margins remain near peak levels and earnings momentum has stalled for two straight quarters.  Investors in higher valued US stocks may be prone to punish earnings “misses” more so than overseas companies where hurdles are generally lower.  There’s no shortage of pessimism directed towards overseas developed and emerging stock indices and economies (especially China).  On the contrary, global investors have been hiding out in a variety of US asset classes, including equities, while Europe and parts of Asia work though various macroeconomic and political headaches.  Now, the US seems to be facing a few macroeconomic and political hurdles of its own. 

Recent returns may indicate that a shift is underway.  Since the middle of September, the S&P 500 is down 7.3% versus 5.2% for the MSCI EAFE and 3.7% for the MSCI Emerging Markets index.  Of course, it’s too early to make ironclad judgments, but this will be a trend worth watching.

Lost in the Shuffle:

This has been an incredibly eventful week in the US.  There’s obviously no need to rehash the election or the talk about the so-called “Fiscal Cliff” because they’ve been covered, and will continue to be covered, in nearly every possible venue. 

In the background, the S&P 500 in the US and the broader global indices have experienced a mini-correction since the second week of September.  Over the past two months, the S&P has declined approximately 5%; approximately one-third of the declines during the recent correction have come this week, post-election.  The MSCI World is down a similar amount.  In essence, markets have basically taken back the gains investors here and abroad picked up in the wake of major European and US monetary policy announcements.  Technically, markets were rather overbought to begin with, at least on a short-term basis, making it somewhat unsurprising that the market is letting a little air out of the tires.

Nonetheless, it’s been interesting to watch those in the media whose jobs revolve around ascribing stories to every market move breathlessly talk about the election and the Fiscal Cliff as the primary, A1 catalysts for this week’s downward action.  In reality, the election result was probably already baked into general market expectations.  Prediction markets, such as Intrade, remained firmly in the camp for the President’s reelection for months.  A number of statisticians had been forecasting the margin in the Electoral College and general national vote tally for weeks.  In nearly all cases they were proven correct, with nearly all of the statisticians coalescing around a national vote margin of 2.5% and an electoral college count for the President of 303 to 332 votes depending on which way Florida fell.  They nailed it.  In the end, I’m not convinced that markets were truly “surprised” or “disappointed” by the result.  Furthermore, pundits for weeks have sliced and diced the election and the implications for the Fiscal Cliff from every possible angle.  Nothing we’re seeing today should surprise anybody. 

On the other hand, with everything going on here, investors in the US largely ignored several overseas developments that actually may have generated a few negative surprises and contributed to market declines.  Perhaps confirming the notion that US election results were anticipated, markets in the US were relatively unperturbed after the election, with futures in the US basically flat early on Wednesday relative to the prior day’s market close; European markets were up for approximately the first half of the trading session on Wednesday.  Then, European Central Bank President Mario Draghi spoke and laid out the following statement at a conference in Germany: “Germany has so far been largely insulated from some of the difficulties elsewhere in the Euro area.  But the latest data suggest that these developments are now starting to affect the Germany economy.”  Almost immediately, futures in the US and European markets began a quick descent.   The statement seems rather innocuous, and maybe a bit obvious.  It was an important shift for markets, though.  It was the first time the ECB head had truly acknowledged publicly or officially that Germany growth was eroding and at risk.  This is important because German economic strength has been a bulwark.  Furthermore, Europeans are looking to Germany and Germany President Angela Merkel to prop up and support the rest of Europe as the continent works through a difficult economic transition period.  Alas, a look at German economic releases this week shows a wheezing economy.  Year over year industrial production declined again in September; year over year numbers have been negative three months running and five out of the past six months.  Germany’s exports went negative year over year in September, the first time this has happened since the 2008 global recession.  Services and manufacturing PMIs/surveys remain in contraction territory. 

Matters certainly weren’t helped by developments in Greece.  While many expected the Greek Parliamentary vote on a new €13.5 billion austerity package to come down to a few votes (and expected protesters to unleash their venom), investors were surprised yesterday by a statement from an EU official stating that European finance ministers weren’t ready to sign off on the release of €31.5 billion in EU funds until the “end of November.”  A positive parliamentary vote was supposed to ensure quick release of the funds.  Market declines subsequently accelerated in the US.  This is just further indication of the general confusion and mistrust that’s occurring at all levels between Greek lawmakers and European policymakers.  While I’ll go out on a limb and say that there’s a very strong chance that European ministers eventually release the bailout tranche, the damage is done.  In the face of massive electorate dissatisfaction with the austerity program in Greece, it’s been incredibly difficult to keep the current parliamentary coalition intact.  Face slaps and delays after hard decisions have been made are going to make it that much more difficult.  The delay once again required investors to discount the increased probability of a Greek default or exit and work through all scenarios surrounding these potential outcomes. 

Finally, the US isn’t the only major power working through a leadership change.  China began the process this week of transitioning the nation’s leadership at the Communist Party’s 18^th Congress.  With the controversy surrounding Bo Xilai and his wife earlier this year, protests in various parts of the country, and several major stories in the Western press outlining the corruption and capital accumulation of several important top officials, it hasn’t been a smooth year to say the least.  Observers inside and outside of China have speculated (maybe “hoped” is a better word) that the leadership would use the Congress as an opportunity to incrementally open up the political system to accommodate more voices.  Instead, President Hu Jintao delivered a 100 minute speech at the opening of the Congress that largely affirmed a status quo stance and a hard line against any major political reforms.  On the surface, this doesn’t seem like a game changer.  Investors, however, are worried about political unrest, corruption, and general economic imbalances continuing to derail China’s growth story.  Without change, investors worry the economic situation may not improve.  GDP growth this year is already forecast to decelerate to approximately 7.5% from 9.3% last year and 10.4% the year before.  China’s growth has been an important crutch for global GDP growth as developed economies muddle along.  A prolonged dent in growth rates would be problematic.  China’s equity markets are trading near the 2009 lows and thus have discounted a significant amount of negativity.  It remains to be seen whether other global markets, especially those in the US, have fully incorporated this downshift.  US multiples are elevated as we’ve discussed in the past. 

Again, it was easy to focus on the election and developments in the US this week and blame the election for volatile market moves this week.  It’s important, though, to see the forest for the trees and recognize that several significant international developments were likely more responsible for uncertainty in US and global markets this week.  Investors were reminded that there are still some thorny issues to work out abroad that could have substantial influence on US economic growth prospects in the coming year or two.  

NAIRU: An Awkward but Important Acronym!

With an election mere days away, today’s release of the non-farm payrolls number and the broader unemployment rate takes on added significance.  Understandably, most people will pay attention to the headline numbers and the overall trend.  There’s a concept, however, underlying the general employment figures both here and abroad that’s not broadly recognized or understood by the broader public.  NAIRU, the “Non-Accelerating Inflation Rate of Unemployment,” in basic terms is the level of “full employment.”  Government economists, academics, private sector economists, asset managers, and policymakers have spent a significant amount of time trying to understand true NAIRU levels in countries around the world.  Estimation of this metric is difficult, but important; the estimate of NAIRU could have serious implications, for instance, when it comes to the future path of monetary policy and could influence how policymakers approach unemployment issues in developed countries.  

Why is the estimated level of full employment important for monetary and fiscal policy authorities?  First, for monetary policy authorities at the Federal Reserve and ECB, for instance, NAIRU helps determine how much room policymakers have in terms of monetary accommodation before prices start heating up.  Labor remains the biggest cost for many companies.  In macro terms, when general unemployment is higher than NAIRU, labor cost pressures should be relatively non-existent, i.e. deflationary or disinflationary.  Simplistically, there’s an excess supply of labor.  On the contrary, general unemployment under the NAIRU rate leads to inflationary pressures.  Labor markets are deemed “tight.”  If NAIRU is estimated as being relatively high, and the gap between NAIRU and the unemployment rate is low, e.g. NAIRU falls at the 6% unemployment rate instead of the 4% unemployment rate, monetary authorities have less wiggle room to use expansionary policy. Alternately, a low NAIRU and big unemployment gap means that the authorities can (and probably should) use the big monetary guns to drive economic growth and drive labor markets back towards full employment.  When Ben Bernanke talks about using QE until labor markets improve to a satisfactory level, Bernanke and the Fed governors have NAIRU in mind.  For fiscal authorities and policymakers, understanding NAIRU is important because once an estimate is determined, it’s important to know what factors are causing a relatively high or low NAIRU so they can address the situation appropriately and create the correct policies to deal with the labor market situation.

Speaking of, what factors drive NAIRU higher or lower?  According to OECD economists, a rise in NAIRU is oftentimes tied to statistically significant increases in the ranks of the long-term unemployed, a condition we’ve witnessed in the US and many developed markets around the world.  Increases in the long-term unemployed are generally attributed to structural factors.  The OECD describes how structural factors can have an effect:

Workers who have been unemployed for some time tend to become less attractive to employers.  Not only the human capital of the unemployed diminishes over time, but also, as a result of recruitment costs, potential employees are frequently evaluated on the basis of frequency and duration of their periods of unemployment. Job search may also diminish as the unemployed lose contact with the labour market and awareness of job offers. There is indeed empirical evidence that long-term unemployed have a smaller influence on wage bargaining than the short-term unemployed (Guichard and Rusticelli, 2010, Llaudes, 2005 and Elmeskov and MacFarlan, 1993). As a result real wages do not fall sufficiently for the long-term unemployed to be “priced back” into the labour market.  Hence increases in the proportion of the long-term unemployed may push up the structural unemployment rate consistent with a stable inflation rate (i.e. the NAIRU).

Other factors, related and unrelated to the above, can influence NAIRU as well.  For instance, significant skills mismatches between the labor-force and industry (i.e. businesses across various industries demand skills that the labor force is having a hard time providing) can push NAIRU higher.  Demographic factors can affect NAIRU.  For instance, the Federal Reserve Bank of San Francisco identified that NAIRU might rise as the proportion of young workers rises as a percentage of the overall workforce.  This is salient now as the Baby Boomer generation retires en masse and younger workers begin to constitute a higher percentage of the force.

For whatever reasons, and probably because of a combination of factors listed above as well as other factors, NAIRU has risen across the developed world.  Coming back to the recent OECD research, across the OECD as a whole, NAIRU increased close to three-quarters of a percent between Q4:2007 and mid-2011.  In the US, NAIRU has increased from approximately 5.5% in 2006 to 6.1% today, based on OECD estimates.  In the UK, NAIRU has increased from approximately 5.5% in the mid-2000s to 6.8% today.  In Germany, on the other hand, NAIRU has fallen from about 8.25% in 2005 to 7.1% today.  

NAIRU: US vs Germany

Source: OECD

What are the current implications for higher NAIRUs?  In the US, it means that inflationary pressures could increase at higher levels of unemployment than we were accustomed to pre-crisis.   As of right now, there’s still a decent gap between the current unemployment rate of 7.9% and estimated NAIRU just north of 6%.  A move in unemployment towards the 6% to 6.5% level might provide an indication to the broader investing public that the Federal Reserve is prepared to move towards a more hawkish and restrictive monetary stance.  In Europe, ECB policymakers have a tricky road to navigate; employment gaps are substantial in the peripheral countries such as Spain and Greece, but narrow to nonexistent in countries such as Germany and Finland.  Hence, we’ve witnessed serious conflict in the Euro Zone over the future path of monetary policy.  Expect the bellyaching to continue.  For policymakers in general around the developed world, if we accept the OECD’s notion that higher NAIRUs are tied to higher long-term unemployed, and that high levels of long-term unemployment are tied to structural factors, then it becomes imperative to institute policies that can help bring the long-term unemployed back into the workforce.  Perhaps significant job training and similar initiatives could help.  Maybe policies shifting current unemployment benefit structures will have an effect to encourage people to reenter the workforce.  Some deeper understanding, though, of the carrots and sticks needed to get the long-term unemployed back in productive roles is required of politicians and their advisors.  Short-term lurching from problem to problem is insufficient to get these metrics moving back in the right direction.


References/Sources:

Guichard, S. and E. Rusticelli (2011), “Reassessing the NAIRUs after the Crisis”, OECD Economics Department Working Papers, No. 918, OECD Publishing. http://dx.doi.org/10.1787/5kg0kp712f6l-en

Walsh, Carl E. (1998), “The Natural Rate, NAIRU, and Monetary Policy”, FRBSF Economic Letter, 98-28, Federal Reserve Bank of San Francisco.  http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-28.html

Moody Blue

Look around at the broader market and economic landscape, and there’s a good bit to feel uneasy about.  In Europe, even though sovereign debt/yield troubles have been under control of late, very few policymakers, or investors for that matter, feel that we're out of the woods.  Spain continues to engage in a convoluted dance with the ECB.  In the US, approximately 65% of S&P 500 companies reporting so far have missed revenue estimates; year over year earnings are looking at a second flat to down quarter.  The election and the subsequent fiscal cliff situation continue to inject broader uncertainty.  In China, manufacturing indicators continue to hang around in worrisome territory, though in fairness companies and economists feel that there may be a light at the end of the tunnel.  Now, Japan may have its own fiscal cliff to worry about.  

Despite all the negatives that have piled up over the past quarter or two, the market keeps pushing higher, this week's corrective pullback notwithstanding.  The MSCI EAFE has rallied over 15% from the early summer low.  The S&P 500 in the US has been on a similar trajectory.  

Here's what's been particularly interesting.  Normally an improvement in market price action leads to a commensurate improvement in various market sentiment indicators.  While they aren't perfect, generally indicators such as the AAII bull/bear and the put/call ratios in the US have provided decent contrarian signals.  Almost across the board, market sentiment indicators that we follow here are at or near the lows witnessed last fall.  For instance, 4-week average bullish levels in the AAII survey are currently a standard deviation below normal, while the 4-week average of bears is running a standard deviation above normal.  Similar negative readings are evident in the ISE Sentiment Index, which measures the numbers of calls traded per 100 puts in the options marketplace.  During the summer correction this year, sentiment was worse than last fall in several instances.  

Sure, at various points this year during rally periods, indicators have perked up.  The first sign of trouble, however, sends investors almost immediately into a psychological rut.  In the past, levels such as those recently seen have been associated with stabilization in past market price action.

This doesn't necessarily mean that everyone should get out there and load the boat with equities.  But, the quick downward shifts in psychological momentum whenever headlines and market action gets a little hairy seems to indicate there could be some additional upside in equity markets and that a “wall of worry” is in place and ready to climb.  It's never time to get complacent, but markets generally seem to move, rule of thumb, in the direction that causes the most pain to the greatest number of investors.  Sentiment among investors is still seemingly dour.  The pain trade, at least in the short run, would seem to be markets that grind higher.  Below, we've included some of the relevant sentiment indicators.

AAII Bull Bear Data
Source: American Association of Individual Investors, Bloomberg

Bullish levels in the US have remained under historical averages all summer and fall, despite the fact that markets have marched steadily higher. Bearish levels, except for a few weeks following the QE3 announcement have been elevated, significantly so as of late.

ISE Sentiment Indicator
Source: International Securities Exchange, Bloomberg

BNP Paribas Europe Love-Panic Market Timing Indicator
Source: BNP Paribas, Bloomberg

Not necessarily in “total panic” territory relative to where markets were in early 2009, but sentiment overseas remains subdued and near last fall’s lows.