Monday, October 29, 2012

The Near Poor

We hear about the poor and the rich all the time, but we seldom hear about the near poor.  

The article is in italics and the bold is my emphasis.  From CNN Money:

They aren't in poverty, but they are just a step away from falling into its clutches.
More than 30 million Americans are living just above the poverty line. These near poor, often defined as having incomes of up to 1.5 times the poverty threshold, were supporting a family of four on no more than $34,500 last year.

They are more likely to be white than those in poverty, according to a CNNMoney analysis of Census Bureau data. They are more likely to be elderly. They are more than three times as likely to work full-time, year-round. And they are more likely not to receive help from the government.

"People just above the poverty line are just one paycheck or health disaster away from poverty," said Katherine Newman, a dean at Johns Hopkins University. "They are still quite fragile."

The near poor have grown by about 10% in number over the past five years, as the Great Recession sent many people falling down the income ladder. The ranks of those in poverty, on the other hand, swelled 24% in the same period.

Half of the near poor are white, compared to just over two in five of those in poverty, according to Census figures. And only 16.7% are black, compared to 23.6% of those in poverty. The share of Latinos who are near poor is 27.8%, only slightly smaller than the share in poverty.

The fact that there are more blacks in poverty than among the near poor likely stems from the fact that the unemployment rate among blacks is nearly double that of whites, said Robert Moffitt, professor of economics at Johns Hopkins. And they have much higher rates of single motherhood, he said. Whites, on the other hand, likely have enough earnings to put them just above the poverty line (poverty line - $23,021 for a family of four, about 46 million people).

Another large group among the ranks of the near-poor are senior citizens. Nearly 17% of the near poor are elderly, while only 7.8% of those in poverty are.

Social Security keeps many of the elderly, particularly white seniors, above the poverty line ... but barely, said Arloc Sherman, senior researcher at the Center on Budget and Policy Priorities.  "Social Security is not an exorbitant program," he said. "People end up above the poverty line, but not necessarily far above it."

So it's not surprising that nearly 40% of the near poor who didn't work are retired, but only 6% say they couldn't find a job. On the flip side, 46% are employed and nearly half are working full-time.  Some of the near poor are eligible for income-based government assistance since certain programs allow those just above the poverty line to enroll. The food stamps program, for instance, is open to those who earn 130% of the poverty line, while Medicaid and child care subsidies let some of the near poor enroll, depending on the state.

But many are left on their own. Only 57% of the near poor receive public aid, excluding school lunches, compared with 70.3% of those in poverty. They are more likely to rely on churches or social service agencies for help.

"There are still a very large number of working families who are struggling and all but poor," Sherman said.

Newman calls this group "the missing class" because they can be overlooked by policymakers and advocates. They include home health aids, child care workers, teachers assistants and hospital orderlies, to name a few. They work full time, but often don't have employer benefits, which adds to their vulnerability, said Newman, whose research looks at those up to two times the poverty level.

"They are still low-income, but we tend to ignore them," Moffitt said.

Monday, October 22, 2012

Who Owns the US Debt - Part 2?

Another post about who owns the US debt.


China's massive stake in U.S. Treasuries gets a lot of attention. But it's Japan, and not China, that has been busy gobbling up U.S. debt over the past year.

In fact, Japan could soon pass China as the largest foreign holder of Treasuries. China held about $1.15 trillion in U.S. bonds through August, the most recent reading available from the Treasury Department. That's little changed from the start of the year and down from 12 months ago. Meanwhile, Japan has been steadily adding to its Treasury holdings. It now owns $1.12 trillion, up 24% from a year ago. . . .

. . . . . China had been buying Treasuries as a way to keep its currency, the yuan, pegged to the U.S. dollar. That helped lower the value of the yuan and made China's exports more competitive in markets such as the United States.

But over the past two years, partly due to US pressure and partly as an effort to curb its own inflation, has allowed the yuan to rise in value.

Kevin Giddis, head of fixed income for Raymond James Morgan Keegan, noted that China simply doesn't need to buy as much U.S. debt as it did in the past. . . .

. . . . But while China's Treasury holdings are down over the past year, Japan had little choice but to buy that U.S. debt, said Nick Stamenkovic, fixed income strategist at RIA Capital Markets in Edinburgh.

He noted that worries about the European sovereign debt crisis have pushed Japan back to dollar denominated assets like U.S. bonds.

"Japan has clearly pulled back from Europe and looked at other places to place their money," he said. "Treasuries have been a beneficiary of that." 

Who Owns the US Debt?

There is a lot of "noise" about who owns the US debt and whether or not that is a "good idea".  The issue of how much US debt the Chinese owns (in reality about 8% and declining) has become a large issue in the Presidential race.  Actually why a country owns another country's debt is far more complex issue than is portrayed on the news.  It has a lot to do with safety,  interest rates, balanced bond portfolio, risk, duration, etc.

Sunday, October 21, 2012

Inflation Expectations are Higher, But Still Under 3%

A friend of mine sent me this a day or two ago and it is a really interesting analysis of how to project inflation rates in the near and medium term.  I would come at this issue from a more monetary view and note that inflation is still not an issue due to low money velocity and low multipliers, but the point is that the two methods give the same results.  Also I encourage you to visit the site called Investing Daily, the source of the article.  It appears to have some fairly high quality material.

The article is in italics.  From Investing

Rising inflation expectations are great news for stocks and commodity prices, but underlying economic problems remain unresolved and pose risks for investors.
In the wake of dramatic and open-ended monetary easing from both the US Federal Reserve and the European Central Bank (ECB), global markets are clearly growing more concerned about inflation. In particular, some have begun speaking of a policy accident in which the Fed overdoes the stimulus, pushing inflation well above its 2 percent target comfort zone in coming years.
One of the most important indicators to watch in coming weeks is the five-year breakeven inflation rate, which I’ve covered in previous issues of this publication. The chart below shows the difference in yield between a standard Five-Year US Treasury bond and the yield on a Five-Year Treasury Inflation-Protected Security (TIPS) bond.
The rates on an inflation-protected security are adjusted based on the consumer price index (CPI) rate of inflation. Consequently, the difference between the yield on a five-year bond and that of an inflation-protected bond gives a rough estimate of the market’s expectations for inflation rates over the coming five years.
As this chart shows, the five-year breakeven inflation rate in the US recently spiked to a high just under 2.4 percent, up from about 1.65 percent just two months ago. This is the highest reading on breakeven inflation since April 2011 and suggests that the market believes the Fed will be successful in pushing up inflation with its third round of quantitative easing (QE3), dubbed “QE Infinity” because the central bank has vowed to purchase $40 billion in mortgage-backed securities (MBS) per month until there’s a significant improvement in the labor market.

Two other signs that the market is looking for an uptick in inflation are the decline in the value of the US dollar and the sell-off in bond prices (rising yields). The US dollar index—a trade-weighted index of the US dollar against other major currencies—has quickly collapsed from two-year highs in July to new 52-week lows by September (see chart, below).
The dollar tends to sell off when the market expects inflation to rise or the US to monetize its debts by printing. Meanwhile, fixed income investments—government, municipal and corporate bonds—tend to get hit when inflation picks up. Rising inflation pushes down the real yield on fixed income products.

For example, with the current yield on the US Treasury bond at less than 2 percent, a spike in US inflation to well above the Fed’s current 2 percent target would push the real inflation-adjusted yield on US Treasuries well into negative territory.

To compensate for rising inflation, investors demand higher yields on fixed income products—when a bond’s yield rises, the price of the bond falls.

The spike in the US 10-Year yield—a decline in the price of these bonds—might seem counterintuitive when you consider that the Fed has been easing monetary policy by buying bonds. However, the market is demanding a higher nominal yield because it’s betting that QE Infinity will push up inflation.

The ECB’s pledge to buy up bonds of fiscally troubled EU nations in unlimited quantities to push down yields is also having its desired effect. Italy and Spain—the two countries at the center of the recent crisis—aren’t eligible for support from the ECB because neither country has yet applied for a bailout from the EU. The yield on the 10-year Italian government bond has tumbled from well over 7 percent in late 2011 to below 5 percent more recently (see chart, below).
Ironically, the decline in European sovereign yields takes pressure off the Italian and Spanish governments to apply for support from the EU. With borrowing costs down so sharply, there’s also less immediate pressure to push ahead with fiscal reforms.

The risk is that fiscal reforms stall in both countries under popular protest, prompting another spike in yields as the market essentially forces these countries to apply for a bailout and receive support from the ECB’s bond-buying program. Regardless, the recent decline in borrowing costs is a positive for the EU economy, but it’s not a true solution to the underlying debt problems faced by Madrid and Rome.

The Economic News: Still Negative

Rising inflation expectations are pushing up stocks and commodity prices independent of global economic conditions. With the possible exception of US housing data, most of the economic news released over the past few weeks has been negative. I’ve written extensively about initial jobless claims data in this publication over the past few months, because it’s one of the best leading indicators of US economic health. It’s worth repeating that the labor market continues to deteriorate (see chart, below).

The four-week moving average of initial jobless claims is a better measure than the raw data, because it smoothes out some of the week-to-week volatility. On this basis, jobless claims bottomed out in March and are approaching their 2012 highs, raising the risk that we could continue to see a few more months of lackluster employment reports from the Bureau of Labor Statistics.

Meanwhile, the Empire Manufacturing Survey of General Business Conditions, a survey of manufacturers in New York State, fell to -10.41 in September, its lowest level since early 2009 when the US was still in the midst of the Great Recession (see chart, below). While regional manufacturing surveys can be volatile, this doesn’t bode well for the next national Purchasing Manager’s Index (PMI) release early in October. Additional monetary easing may be pushing up stocks and inflation expectations, but it’s not yet having much of an impact on the labor market or manufacturing sentiment.

There’s an old saw on Wall Street that investors should never fight the Fed and that’s holding true these days, as investors shake off negative economic news and buy on expectations of more quantitative easing. Certainly, the rally could continue for at least a few more weeks; the S&P 500 has broken higher through key technical resistance at around 1,425.

However, there are many opposing forces at work that will likely come into focus before the November elections, including the looming fiscal cliff of tax hikes and spending cuts as well as a steady drumbeat of negative economic data. This raises the odds the market will see a significant pullback this autumn.

To play the current market environment, I continue to recommend staying defensive with large capitalization stocks and groups such as consumer staples that do not need a strong economy to post solid earnings results. In addition, the biggest beneficiary of rising inflation expectations is commodities including gold, gold mining stocks and the energy complex.

With interest rates ultra-low and inflation expectations on the rise, investors should largely steer clear of investment grade bonds. A better play for income-oriented investors is to look for stocks that have the potential to raise their dividends significantly; rising dividends provide an offset to rising inflation.

One of my favorite groups remains the Master Limited Partnerships (MLPs) that offer average yields of about 5.75 percent, with some yielding over 10 percent. MLPs also have a long history of growing their payouts and some have exposure to commodity prices, a hedge against inflation.

Thursday, October 18, 2012

Fiscal Cliff and Europe - An Interview with Jacob Frenkel

The video below is an interview with Jacob Frenkel on October 18, 2012 concerning the situation in Europe and the "Fiscal cliff" in the US.  The reason I have included this video is because of the clarity with which the various issues are discussed.  It is my experience that this is how these types of issues are discussed as opposed to the discussions that take place in the popular media:

From Bloomberg:

Monday, October 15, 2012

Crosscurrents in the Economic Data

As many understand there is considerable contradictory economic data coming from various sources.  1.  When you look behind the numbers the data is not as contradictory as it seems and 2.  when the data is contradictory this is to be expected in a slow growth scenario that we now have.  The article below gives a good analysis of the current economic data and indicates where there are crosscurrents or contradiction in the data.
The italics is in italics and the bold is mine.  From Market Watch:
If someone is cooking the books of U.S. economic data, all this person has managed to do is make things pretty confusing.
“The latest round of monthly and weekly economic data presents so much of a mixed picture of the economy that even an ardent follower of the numbers like myself is left scratching my head,” said Steve Ricchiuto, chief economist at Mizuho Securities.
On the one hand, it looks like exports and manufacturing are contracting, while on the other, consumer confidence appears to be firming. 

At the same time, the unemployment rate fell in September below 8% for the first time since President Barack Obama took office and jobless claims sank to the lowest level in four years. 

Ricchiuto said he is not implying a conspiracy theory like former General Electric CEO Jack Welch, who famously charged that the labor market improvement in September was a political fix.
“Instead, I believe that the data is simply being distorted by the powerful crosscurrents in the economy that have emerged as a result of several years of a sub-par recovery process,” Ricchiuto said.
This coming week’s data may only add to the confusion. At first glance, the data will show decent retail sales, high inflation, and relatively healthy manufacturing and housing reports.
But beneath the surface is a different story.
Economists surveyed by MarketWatch forecast that the Commerce Department on Monday will report that retail sales will rise 1.1% in September after a 0.9% gain in the prior month. But a lot of the increase is due to higher gas prices. For instance, in August, sales at gasoline stations increased 5.5%, the most in three years.
Analysts like to strip out sales of autos, gasoline and building materials to get a better sense of the underlying strength of consumer spending.
On that basis, “we’re looking for an modest 0.3% gain in core sales, not quite as gang-busters as the headline number,” said Michael Hanson, economist at Bank of America Merrill Lynch. Core sales fell 0.1% in August.
Overall consumer spending likely rose only 2% in the third quarter as modest job growth continues to restrain incomes, said Sal Guatieri, economist at BMO Capital Markets. This is up only slightly from a 1.5% rate in the April-June quarter.
Inflation, as measured by the consumer price index, is expected to pop 0.5% in September mainly due to a rise in gasoline, and almost matching its 0.6% gain in August. This data, due Tuesday from the Labor Department, would be the largest back-to-back monthly gain in the index in four years. Prices at the pump rose to $3.91 per gallon in September from $3.78 in August, according to economists at Credit Suisse. Measured from a year earlier, the CPI will edge up to a 1.9% rate from 1.7% in August.
Many economists believe the energy spike will not last.
By November and December, there should be some reversal in gasoline prices, said Nigel Gault, chief U.S. economist at IHS Global Insight.
Underlying inflation is probably less strong. Core CPI inflation, which excludes food and energy prices, is expected to rise a more modest 0.2% in September following a 0.1% gain in the prior month.
Industrial production should decline a slight 0.1% in September after a steep 1.2% drop in August, the biggest decline since March 2009. Production has slowed to a crawl in the third quarter, analysts said, hurt by the slowdown in Europe and Asia and uncertainty generated by the looming fiscal cliff. The U.S. is set for an outright decline in exports of goods in the third quarter, Gault of IHS said.
Housing starts should jump 1.7% in September to 763,000 units, the highest level in four years, following a 2.3% gain in the prior month.
After a sharp 7.8% gain in August, existing home sales should retreat by 2.5% in September to 4.70 million units, according to the MarketWatch survey.
But even these two housing reports come with a caveat. The housing gains remain modest relative to the steep drop in activity since the bursting of the bubble.
“Housing fell by much more than the rest of the economy, and at some point it ought to rebound much more strongly, but that has not happened yet,” Hanson of Bank of America said.
Overall, Ricchiuto said he was going to go with the goods data rather than the labor market data.
The concept of a sharp rebound in labor market conditions in the midst of a sharp global slowdown “is hard to imagine,” he said. 

Wednesday, October 10, 2012

IMF Cuts Global Growth Estimates

The IMF is concerned about global economic growth and considers the major risks to be the on-going problems in Europe and the fiscal cliff in the US.
The article is in italics and the bold is mine.  From

The IMF cut its global growth forecasts as the euro area’s debt crisis intensifies and warned of even slower expansion unless officials in the U.S. and Europe address threats to their economies.
“A key issue is whether the global economy is just hitting another bout of turbulence in what was always expected to be a slow and bumpy recovery or whether the current slowdown has a more lasting component,” the IMF said in its World Economic Outlook report. “The answer depends on whether European and U.S. policy makers deal proactively with their major short-term economic challenges.”The world economy will grow 3.3 percent this year, the slowest since the 2009 recession, and 3.6 percent next year, the IMF said today, compared with July predictions of 3.5 percent in 2012 and 3.9 percent in 2013. The Washington-based lender now sees “alarmingly high” risks of a steeper slowdown, with a one-in-six chance of growth slipping below 2 percent.

The IMF’s 188 member countries convene in Tokyo this week as low growth damped by fiscal consolidation in the richest economies hurts developing counterparts from China to Brazil. As the IMF urged measures to boost confidence, uncertainties out of Europe show no sign of abating, with leaders still divided over a banking union and Spain resisting a bailout.

“Confidence in the global financial system remains exceptionally fragile,” the IMF said. “Bank lending has remained sluggish across advanced economies” and increased risk aversion has damped capital flows to emerging markets, it said. . . . 

. . . . In Seoul, World Bank President Jim Yong Kim told a forum today that he saw mildly encouraging signs in Europe. In Tokyo, IMF Chief Economist Olivier Blanchard indicated that yields on Spanish and Italian bonds, which decreased after the ECB’s bond-buying plan announcement, could rise if the countries don’t request bailouts.

The IMF report called for U.S. policy makers to find an alternative to planned automatic tax increases and spending cuts that would trigger a recession. Europeans must follow on their commitments for a more integrated monetary union, and many emerging markets can afford to cut interest rates or pause tightening to fight off risks to their economies, the IMF said.

The 17-country euro area economy will contract 0.4 percent this year, 0.1 percentage point worse than forecast in July, and grow 0.2 percent in 2013, less than the 0.7 percent predicted three months ago, the IMF said.

The U.S. is seen expanding 2.2 percent this year, higher than an earlier forecast, and growing 2.1 percent next year, less than previously predicted. Japan’s estimate was cut to 2.2 percent this year and to 1.2 percent in 2013.

Spain’s economy will shrink 1.3 percent next year, 0.7 percentage point worse than predicted in July. German growth is seen at 0.9 percent each year, with the 2013 estimate half a percentage point less than previously forecast.

“Spain and Italy must follow through with adjustment plans that re-establish competitiveness and fiscal balance and maintain growth,” Blanchard wrote in a foreword to the report. “To do so, they must be able to recapitalize their banks without adding to their sovereign debt. And they must be able to borrow at reasonable rates.”

Growth forecasts were also lowered for emerging markets, where domestic factors add to external constraints, the IMF said. Brazil had some of the steepest cuts, with growth seen at 1.5 percent this year from 2.5 percent and 4 percent next year.

India's economy may grow 4.9 percent this year and 6 percent next year, lower than previous forecasts of 6.2 percent and 6.6 percent respectively. China’s estimate was cut by 0.2 percentage point each year to 7.8 percent in 2012 and 8.2 percent in 2013.

Monetary policy should remain accommodative in developed economies, with expectations for slower inflation giving the European Central Bank “ample justification for keeping policy rates very low or cutting them further,” the IMF said. The Bank of Japan may need to ease further, it said.

Other risks to the global economic outlook in the short term include a renewed increase in oil prices and an inability to raise the U.S. debt ceiling, it said.

The IMF forecasts assume oil at $106.18 a barrel this year and $105.10 next year, based on the average prices of U.K. Brent, Dubai and West Texas Intermediate crude. That compares with estimates of $101.80 and $94.16 in July.

In economic releases in the Asia Pacific region today, Japan reported a larger-than-estimated 454.7 billion yen ($5.8 billion) current-account surplus. In Australia, business confidence recovered in September as the prospect of interest- rate reductions overshadowed weaker sentiment among miners and manufacturers, a private survey showed.

In South Korea, the central bank said today that the nation’s economy faces increased external risks and the finance ministry said it will step up efforts to boost growth.

Tuesday, October 9, 2012

The "Gang of  8" Work on the Fiscal Cliff

More news on the fiscal cliff.  In case you have not heard of the Gang of 8, the Senate is trying to work through some issues.  Sounds to me like they are laying the groundwork for the post-election resolution process.  From Bloomberg:

Monday, October 8, 2012

Is There Inflation in Our Future?

Below is another article from the Global Economic Intersection and from author Gene Balas.  This article answers in detail whether or not there is inflation in our future.  The analysis is thorough and covers both the monetary issues and the issues that drive inflation at the business and consumer levels.  Once again I encourage you to visit the Global Economic Intersection.  It has some good stuff.

The article is in italics and the bold is mine.  From GEI:

We see a few signs of budding inflation.  But will it bloom? Survey data point to businesses’ higher costs in recent months.  The key question is whether those cost increases are temporary or persistent, and whether they will be passed on to their customers in higher prices.  That, in turn, depends on the cause.

Let’s take a closer look. We do see signs of increasing cost pressures in both the goods and the services sectors, in data from the Institute for Supply Management.

Manufacturers reported paying higher prices recently, and the trend is moving up a bit.  The ISM-Manufacturing Prices Index registered 58 in September, which is an increase of 4 points compared to August, and follows a 14.5 point increase in August compared to July.  In June, it printed 37.0.  Readings above “50” indicates more businesses than fewer are reporting higher input costs. In September, 27% of respondents reported paying higher prices, 11% reported paying lower prices, and 62% of supply executives reported paying the same prices as in August.

They seem to be passing along some of those price increases to their customers.  The ISM-Non Manufacturing Survey, which includes retailers and wholesalers, among other services industries, shows even more cost pressures.  ISM’s Non-Manufacturing Prices Index for September registered 68.1, an increase of 3.8 points from the 64.3 percent reported in August. It is considerably higher than the 48.9 in June.  In September, 28% of respondents reported paying higher prices, 71% indicated no change in prices paid is 71%, and 1% of the respondents reported lower prices.

If these price increases are seen as persistent, rather than transitory, will they pass on those higher costs to their customers?  Here’s what the Atlanta Fed recently reported on a study of firms that were presented with a hypothetical increase in their costs by either 2% or 6%, with the goal of finding out pricing power and cost pass-through to the end customer:

On average, firms faced with the 2 percent cost increase were likely to pass about 1.3 percentage points (or 66 percent) to their customers. In the portion of our panel considering the 6 percent cost increase, the average impact on customer prices was 3.8 percentage points (or about 63 percent of the cost increase). So in the aggregate, firms think they can pass about two-thirds of any cost increase through to prices, and that belief holds roughly true whether the cost increase is relatively modest or somewhat large.
So, we see that businesses are reporting that their costs are going up, and that they believe they can pass along much of those cost increases. (The difference, of course, would be reflected in reduced profit margins.)  How do businesses see these costs, as something to pass along – which can hurt sales, if customers switch to a competitor – or to absorb perhaps temporary cost increases to maintain market share? The answer is what is perceived as the cause, and how long that condition is perceived to last.
What many observers might blame, rightly or wrongly, are the actions of the Fed.  In the minds of many observers is the monetarist view of inflation, and some may say something to the effect of, “All that money the Fed is ‘printing’ will cause prices to rise.  Inflation is a monetary phenomenon.”  Many people equate QE with an expansionary monetary policy.  But is that really true with the Fed’s quantitative easing programs?  Or, are other factors instead more of a concern?
Let’s put to rest that notion that QE directly causes inflation.  As many investors, if not the general public, recognize, the Fed’s asset purchases aren’t intended to expand money in circulation, but instead to bring down longer term interest rates through longer duration bond purchases.  (M2 money supply has grown 6.3% in the year to August, mostly in the form of savings deposits.)

Here’s what happens when the Fed buys financial assets, whether they be Treasury bonds or mortgage instruments.  The party, perhaps an institutional investor or a financial institution, that receives the cash from the Fed then takes those proceeds and buys another investment security.  Some of those funds could be used for new loans, if both borrower and lender alike are willing and able to transact.
Unless it is lent out, where is the cash? It is held all along in the banking system, parked right back at the Federal Reserve, in the form of banks’ “excess reserves,” where it currently earns 0.25% interest.  Those monies were never “printed,” because they haven’t left the financial system.
The only way those funds can become inflationary is if they leave banks’ excess reserves.  One way might be if perhaps a person sells a security to the Fed, receives the cash and buys, say, a car. However, there is little reason to think people are buying toasters with funds they receive by selling bonds to the Fed.  The savings rate is still positive, meaning the Fed’s purchases are not being used by consumers for shopping sprees as consumers are still adding financial assets to their balance sheets, not selling them.
Instead, the biggest way those funds can become inflationary is if banks start making substantial new loans from those excess reserves.  Right now, we see that data from the FDIC shows that loan growth in the 12 months through June was 2.7%, aggregated among all bank loan types.  Over the past two years, loan growth totaled just 1.6% – and that is not an annualized figure.  Aggregate loan growth so far is tepid, especially compared to nominal GDP growth, which was 3.9% year-over-year to the second quarter 2012. (Loan data are not adjusted for inflation, hence the use of nominal GDP.)
With income growth stagnant and many people not quite creditworthy, banks might not find many suitable customers.  That may keep supply of credit low, at the same time demand to borrow funds is similarly restrained.

Consumers are more focused on paying down debt than they are in taking out more loans, except for two categories: auto and student loans.  Consumers have been buying more cars, most likely because the average age of cars on the road is at a record high.  Unemployed workers may take out student loans to upgrade their skills to find a job.  Combined, the category of non-revolving loans that includes this debt rose by 5% so far in 2012 and is up 22% from 2008.
However, credit card debt hasn’t grown by much since the end of 2011, and is 17% less than its 2008 peak.  Outside of cars, banks don’t appear to be granting loans to fuel consumer spending, especially for unsecured credit products.  Thus, unless both banks and consumers change their view of consumer debt, spending gains here will need to come primarily from income or savings.  See Steve Hansen’s report today for the latest consumer credit data.

Businesses aren’t borrowing as much, either. Big corporations have a treasure trove of just over a trillion dollars in cash, and hardly need to borrow.  (And I might also add this might keep supply of new corporate bonds less than what it would be otherwise.)
Meanwhile, the National Federation of Independent Businesses reports more than half of small businesses explicitly stated in the group’s survey that they do not want a new loan.  Thus, even if banks were willing to lend, their potential customers are not enthused to borrow.  So those funds in excess reserves are lying fallow.

Perhaps at some point those reserves might get lent.  However, should the economy show signs of any inflationary pressures, the Fed can take action to reduce the economy’s inflationary potential.  Besides actually selling bonds in the open market or hiking the Fed Funds rate, the Fed can simply, and quite easily, increase the interest rate it pays on those excess reserves. This reduces the incentive for a bank to lend funds to Sally to buy a car when it can earn risk-free interest from the Federal Reserve.
That said, investors can take the proceeds from selling bonds to the Fed and invest them into other assets, like stocks or commodities.  In that vein, we must consider the extent to which QE could trigger commodity price spikes. That is a concern, but recently, however, commodity prices have been coming down.  Additionally, commodities and basic material inputs tend to be a small component of the final price of a good or service.
An intervening factor is currencies.  A stronger dollar compared the euro from weakness in Europe would tend to keep commodity prices lower, as many commodities are priced in dollars.  A stronger dollar(vs. what it would be otherwise) means more expensive oil in Europe, all things equal, and that means relatively lower commodity prices as global traders tend not to bid up prices as much.  Overall, the U.S. dollar index against a basket of currencies is little changed from a year ago, though has bounced around a bit in between.
And a stronger dollar relative to what it would be otherwise can keep inflation in the U.S. under control by making imported goods cheaper.  So far, quantitative easing hasn’t prompted the amount of dollar weakness that some had forecast, again, because it is not intended to increase money supply.  That means inflation from imports is tame, decreasing 2.2% over the past year.  Of course, when the Fed is a ready buyer of bonds, it may give foreign investors greater confidence to maintain their own purchases.
Considering all of these factors, consumers, businesses and investors aren’t expecting increases in certain inputs or commodity prices (gas, food, etc.) to be long lasting.  These prices have a way of bouncing around that don’t always affect expectations over the long run, say more than five years or so.  And indeed, inflation expectations have been contained.  Expectations have probably been influenced by the inflation experienced in the past couple of years with CPI fluctuating above and below 2.5% and PPI declining sharplyfrom above 7% to approaching 0% for finished goods and actually deflating in 2012 for crude materials after inflating at double digit rates in 2011.

In the Consumer Confidence Survey from The Conference Board, consumers’ inflation expectations have remained stable, even dropping a bit to 3.3% from 3.6%, for the next 12 months.  Investors’ inflation expectations, per the TIPS breakeven rates, are also stable, have been in the range of about 2.2% to 2.4%, though they spiked higher (and then retreated) immediately following the announcement of QE3.  The Atlanta Fed reports that businesses have expected inflation to be between 1.5% and 2.0% in a remarkably stable range over the past year.

Inflation expectations often tend to lead actual inflation, as the expectation of higher prices tends to be a self-fulfilling prophecy. Quite simply, people are more willing to pay higher prices when they expect them to be as such.  Workers are more likely to demand higher wages when they expect their expenses to climb. Wages are a bit different from other cost inputs for a company, however.
In contrast to commodity prices, wages tend to make up around two-thirds of the cost of goods and services, economy-wide.  And also unlike commodity prices, which can rise and fall on a daily basis, wages are sticky.  Companies cannot change workers’ salaries the same way the crude oil trades in the commodities pits.  Thus, employers will think twice about granting pay raises, and for the time being, companies in most (though not all) industries are able to avoid doling out more money to their staff.
High unemployment means more competition for jobs and smaller pay raises, and this limits companies’ cost components.  Fewer pay raises means less demand for goods and services, and this means less ability to pass along higher prices. Low wage growth, for both the cost and revenue side of companies’ income statements, argues for continued lower inflation and interest rates.
Thus, this thesis of resource slack is one of the competing theories for whether inflation will become problem.  Monitoring how much slack in the economy – particularly for labor – is perhaps key to determining when inflation from rising wages might take hold.
What do we see right now for resource slack?  The Atlanta Fed polled businesses and found that, on average, companies say their current sales are about 8% below what they say is a “normal” level.  However, business’ industry matters.  Sectors in services are seeing a different pattern than goods-producing sectors.

Retailers, for example, say their current sales are a little less than 2% below normal. And firms in the leisure/hospitality and the transportation/warehousing sectors say they are operating at, or just a shade above, normal levels.  Not coincidentally, job growth in these services sectors has been strong in recent months, outpacing overall job growth.  In food services alone, the job growth rate has been double total job growth since the end of 2009.  Wage increases could occur in these often low-wage, labor intensive industries.

On the other hand, durable goods manufacturers report that their current sales levels are nearly 12% below normal, and finance and insurance companies say their sales are almost 17% below normal.  Housing is a long ways off – construction firms are 28% under capacity according to the Atlanta Fed’s survey.  Thus, even if the Fed’s moves to lower rates triggers more housing construction, there is scant pressure to grant wide-scale pay increases there.  Some manufacturing companies, though, report some difficulty in finding talent with the right technical backgrounds, so certain occupations may see rising wages here.

Without rising incomes, whether or not companies believe that they can increase prices acting individually, consumer spending cannot support spending in volume terms at current levels if all companies increase prices, in aggregate.  Thus, there is a limit to pricing power when one views the economy as a whole instead of individual companies.

That said, more consumers are expecting their incomes to increase.  The proportion of those expecting that outcome rose to 16.3% in the latest Consumer Confidence Survey from The Conference Board, up from 16.0% last month, reaching the highest level of the year.

However, until and unless pay raises actually become a reality – and that might be less likely until the supply of labor is more balanced with the demand – then it is hard to expect substantial inflation.  Consumers’ response to rising prices will be to purchase fewer goods and services, which then begs the question of whether price increases would stick.
In the meantime, since inflation expectations are generally stable and low, the Fed to continue its easy money policies.  Should those expectations increase, the Fed can moderate its stance before those expectations become reality.  I believe that slack in the economy is the driving force keeping inflation suppressed, while QE is not, in itself, inflationary.

Friday, October 5, 2012

The Best Analysis of Gold Prices, Including a Section on a Gold Standard

Years ago I was a metals analyst for one of the major banks supporting their mining portfolio. As a result I read a lot about gold, silver, and other metals over the years.  The article below is one of the best articles I ever read about gold.  Spend the 5 minutes it will take to read this article, it is worth it.  Also this article comes from PIMCO, which publishes a series called Viewpoints, which are usually excellent.  Check them out.
The article is in italics and comes from a couple of authors from PIMCO:
When it comes to investing in gold, investors often see the world in black and white. Some people have a deep, almost religious conviction that gold is a useless, barbarous relic with no yield; it’s an asset no rational investor would ever want. Others love it, seeing it as the only asset that can offer protection from the coming financial catastrophe, which is always just around the corner.

Our views are more nuanced and, we believe, provide a balanced framework for assessing value. Our bottom line: given current valuations and central bank policies, we see gold as a compelling inflation hedge and store of value that is potentially superior to fiat currencies.
We believe investors should consider allocating gold and other precious metals to a diversified investment portfolio. The supply of gold is constrained, and we see demand increasing consistent with global economic growth on a per capita basis. Regarding inflation in particular, we feel that the Federal Reserve’s decision to begin a third round of quantitative easing makes gold even more attractive.

We see the Fed’s actions in the wake of the financial crisis as a paradigm shift whereby the Fed is attempting to ease financial conditions and encourage risk-taking by increasing inflation expectations. Its policies will likely result in continuous negative real interest rates because nominal rates will be fixed at close to 0% for the foreseeable future.

To be sure, gold isn’t the only asset with the potential to hold its value in inflationary times. For U.S. investors, at least, Treasury Inflation-Protected Securities (TIPS) offer an explicit inflation hedge. What’s more, TIPS tend to be less volatile than gold and, if held to maturity, are guaranteed to receive their principal back – barring a U.S. government default (which we see as incredibly improbable). Still, history shows that gold is highly correlated to inflation and has unique supply and demand characteristics that potentially lead to attractive valuations.  
A unique store of value
For more than a millennium, gold has served as a store of value and a medium of exchange. It has broadly managed to maintain its real value, even as various currency regimes have come and gone. The reason is that the supply of gold is not at the whim of any governmental power; it is fundamentally supply constrained. Total outstanding above-ground gold stocks – the amount that has been extracted over the past few millennia – are roughly 155,000 metric tons. Each year mines supply roughly 2,600 additional metric tons, or 1.7% of the outstanding total. This is why gold can be thought of as the currency without a printing press. 
The downside of gold is that it generates no interest. One ounce of gold today will still be only one ounce next year and the year after that. Because of this, gold is sometimes referred to as a non-productive financial asset, but we feel this characterization is misleading. Rather, we believe gold should not be thought of as a substitute for equities or corporate bonds. These have equity or default risk and therefore convey risk premiums. 

Instead, gold should be thought of as a currency, one which pays no interest. Dollars, euro, yen and other currencies can be deposited to receive interest, and this rate of interest is meant to compensate for the decline in the value of paper currencies via inflation. Gold, in contrast, maintains its real value over time so no interest is necessary.

Today, the forward-looking return on holding U.S. dollars, and most other major currencies, has been artificially lowered by the Fed’s commitment to keep interest rates pegged at near zero for the next few years; real yields on U.S. government bonds are negative out to 20 years. In such a world, we believe the desire and willingness of investors to hold gold relative to other currencies increases dramatically, creating the potential for continued price appreciation.

The real price of gold
Of course, investors must also consider valuation, especially since some believe gold is overpriced. Figure 1 shows the inflation-adjusted value of gold since 1970. There is no doubt that gold prices, which averaged $1,630 in August, are high. However, in inflation-adjusted terms, gold is 12% below its 1980 peak. Inflation in 1980 hit 15% year-over-year, and inflation today is running much lower so some may question the validity of comparisons to 1980. While we believe that inflation over the next several years is likely to be higher, on average, than it has been over the past 20 years and that the tail risks are for much higher inflation, this speaks more to the outlook for the nominal price of gold.  

The price of gold in real or inflation-adjusted terms is less affected by the rate of inflation and more impacted by the level of real interest rates because as discussed previously, it is the real interest rate that drives the relative attractiveness of holding gold relative to other currencies. With real interest rates negative on average for the next 20 years, it is of little surprise that gold is trading near its all-time inflation-adjusted high.
Even the inflation-adjusted value of gold doesn’t tell the whole story, however. Thanks to productivity gains and economic growth, per capita GDP is significantly higher today than 30 years ago. Thus, the average person today has more wealth and, all else being equal, can afford to pay relatively more for gold.
To Chinese, gold has never seemed less expensive
Figure 2 shows the ratio of gold prices to per capita GDP in the U.S. and China. In dollar terms, gold is still 34% below its 1980 peak, as U.S. per capita GDP is higher today. Furthermore, this is a relatively U.S. centric view, and considering that China represents the largest source of global gold demand, we believe investors take an overly myopic view at their peril. Chinese per capita GDP has grown at an 18% annualized rate for the past 10 years, compared with just 3% per year in the U.S. Thus, while gold might seem quite expensive to those of us in developed economies, its price seems much less expensive to those in faster-growing emerging economies like China.

 Another way to think about the relative value of gold is to consider what a return to the gold standard might look like. In other words, what if the entire world’s gold were used to back the global supply of fiat currency? Globally there are roughly $12.5 trillion in physical and electronic currency reserves. Given that there are 155,000 metric tons of gold above ground, this equals an approximate price of $2,500 per ounce if all of the world’s reserves were to be backed by the entire stock of above-ground physical gold.  

Not really so pricey
These points lead us to believe that gold valuations are not as stretched as a naïve look at its nominal price might suggest. Central banks globally are seeking to depreciate their currencies in a beggar-thy-neighbor attempt to stimulate their domestic economies (the Swiss National Bank is a prime example). Therefore, we believe investors should consider owning gold, precious metals and other assets that store value as long as central banks continue to print and maintain negative real interest rates.