Allan B Oulate : Northwestern Mutual - Economic Commentary - January 2010 : Article: Economic Commentary

Economic Commentary - January 2010

Christopher Bremer

Senior Investment Consultant

Between a rock and a hard place

When Odysseus and his crew passed through the Strait of Messina, they were confronted with two horrifying monsters, Scylla and Charybdis. Scylla, a six headed monster, eats men alive, while Charybdis sucks down water horribly. The close proximity – the two are close enough that you could shoot an arrow across – confronted the Greek hero with a precarious choice, “better to mourn six than the whole crew at once.”

One of the underlying themes of Homer’s Odyssey was that getting home again was just as great a challenge as winning the war. We may have won the war against another great Depression, but we have not yet completed our journey home.

Odysseus’ journey home from Troy to Ithaca occupies only 3 of the 24 books of the Odyssey. Likewise, the period from the beginning of 2010 to when the Federal Reserve unwinds stimulus or tightens monetary policy will only account for a small chapter in the history of this great recession.

Over the past few weeks, economists and market strategists have published 2010 outlooks. We monitor some of these publications, not for the purpose of developing our world view, but as a means of assessing market expectations, or more precisely, the dispersion and cluster of expectations. Is there widespread consensus over certain trends? If so, be skeptical. Is there a wide range of forecasts? If so, what are the outliers and what are the probabilities of outcomes?

The Fed has to navigate between two very precarious positions; keeping a low interest rate policy and risking asset bubbles and inflation (Scylla), or withdrawing stimulus too soon (Charybdis) and risk sinking the entire economy back into recession.

So far, the Fed has construed Scylla as the better of the two options, but that does not mean a change of course is not unprecedented. Like Odysseus, the Fed must take the route that enables the journey to continue, even if that means short-term trouble.

In 2009, the primary concern of most investors was how deep and how long the recession could last. How do we get out of this mess? In 2010 the markets are looking toward the inevitable unwinding of the massive monetary and fiscal stimulus that governments and central banks injected into the global economy. In the sections that follow, we examine two critical components of the journey toward unwinding fiscal and monetary stimulus; the current low rate environment and economic expectations.

Low rate environment

Low rates are supported by the delicate state of the economy. Global central banks have deliberately and collaboratively kept short rates low in an attempt to stimulate and reflate economies. The Federal Reserve’s current policy is to keep rates low for “an extended period.” (Fig. 1.)

In December, Fed Chairman Bernanke, despite pointing to signs of recovery becoming widespread, was still compelled to state that “formidable headwinds” are still very much present.

Seeking more return

Last year, the Fed focused on steering away from deflation. With global markets up more than 60% from the market lows of last March, concerns over renewed asset price overindulgence have surfaced. But such concerns may be premature. First, asset price appreciation has occurred within the equity markets, but housing prices have yet to recover meaningfully. Second, the stock markets have risen without the excessive use of leverage that preceded and contributed to the global recession and market dislocation periods of 2008-2009. Bank lending is contracting and consumer credit is declining at the fastest rate ever.

But sustained low rates and easy credit helped manufacture the financial destruction of 2008, and many with a bearish outlook argue that the economic recovery that equity prices have discounted is not yet supported by actual data. While still too early to tell, their concerns should not be discarded.

The equity markets’ price action is perhaps more reflective of a recovery off frightful lows than a potential bubble. As of mid-December, the Dow Jones UBS Commodity Index is still down 44% from its July 2008 peak. From these levels, the index would have to rise almost 80% just to reach the previous high. The S&P 500 would have to rise about 40% to reach its October 2007 high.

Certainly, low rates have encouraged many investors to seek alternatives to low yielding money market funds. Redeployment from money markets to risk assets has probably contributed to the rally as demand for risk assets has returned, helping push up prices. (Fig. 2.) And while money market funds have decreased concurrent with the equity market rally, a closer examination of money flows in 2009 reveals that the vast majority of money market assets have flowed into bond funds. Equity asset bubbles typically require a material shift from bonds and cash into equity funds.

Fears of better than forecast economic data and early Fed tightening have caused a few pauses in the market rally. The risk to equity markets is that the Fed tightens policy more aggressively than the markets anticipate on stronger than expected economic growth.

The Fed’s expectations

In December, the Federal Reserve maintained its intention to keep interest rates “exceptionally low” for “an extended period.” The Fed noted that economic activity continues to pick up and that deterioration in the labor markets is abating. However, household spending still remains constrained by a weak labor market.

The Fed continues to anticipate gradual economic recovery, “participants anticipated that economic recovery would be gradual, with real gross domestic product (GDP) growing at a moderate pace and the unemployment rate declining slowly over the next few years. Most participants also expected that inflation would remain subdued over this period.”

Based on the Fed’s November 2009 forecast (the December forecast is published in January), the Fed expects real GDP growth of 3.0% in 2010 and 3.95% in 2011, which would be a welcome improvement over where we were last year, but significantly below historical recovery periods after severe recessions. (Fig. 3.)

In all cases, the Fed’s forecast is more positive that the median forecast of survey participants.

Both the Fed and the survey participants forecast GDP, CPI (Consumer Price Index) and Unemployment to revert toward long-term averages at a slower pace than historical averages exiting recessions. For example, the average CPI year over year change over the past 10 and 20 years is 2.6% and 2.8%, respectively. The Fed’s forecast of 1.45% over 2010 and 2011 represents a significant deviation from historical norms. The longer core inflation remains low, the slower and more deliberate the Fed can be in unwinding the stimulus. Should inflation expectations remain anchored, the most critical and widely watched economic indicator in the coming months will be employment.

Unemployment

Improving and sustainable confidence in the economic recovery will depend in large part on the employment outlook. The November improvement in the unemployment rate from 10.2% to 10.0% is probably somewhat misleading, as many discouraged workers simply dropped out of the job market.

In the post war era, the Fed has waited an average of six months after the unemployment rate peaked to begin tightening monetary policy. Figure 4 shows the tendency of economic lagging indicators to recover before interest rates rise. Low inflation pushes the average waiting period out longer. Given the Fed’s history of not

raising rates during times of high unemployment, there appears to be an expectations gap between the Fed’s 2010 outlook for unemployment and the market’s expectations for a rate hike. As the year progresses, this gap is likely to narrow through either better than expected employment, or an adjustment to a more moderate or delayed tightening of monetary policy.

Given the dual mandate of fostering price stability (inflation) and maximum employment, and given the Fed’s outlook that inflation could actually move lower from here, it is hard to assign a high probability of aggressive interest rate tightening by mid-year.

Unemployment in historical context

The current unemployment rate of 10.0% represents an outlier compared to the historical data series (almost a three standard deviation event; in other words, over 99% of the outcomes are expected to be below the current level). Historically, when unemployment reaches 8.7% or higher, the average decrease in the unemployment rate 12 months later is 1.24%. This represents a significant move because as one may expect, the average 12 month movement in the unemployment rate going back to 1948 is virtually flat at 0.09%. Additionally, the unemployment rate 12 months out improved 79% of the time after ‘outlier’ occurrence.

At the time of this writing, the median forecast unemployment rate for the end of 2010 among a survey of Bloomberg economists is 10.0%, or no change from November 2009 levels. The historical move from current levels is for unemployment to drop 1.25%, which would result in a 2010 year end unemployment rate of 8.76%. While aggregate percentage level does not seem material, there is in fact a statistically significant difference between a flat unemployment rate over a 12 month span and an improvement of 1.24%.

Let us be clear. We do not know where unemployment is going. But it is useful to know that the general level of expectations calls for a significantly lower than expected recovery in aggregate employment. Economic observers call this “risk to the upside” and this risk has important investment policy implications. As observed from the March 2009 market lows, better than expected economic results can have material positive impacts on portfolios.

Monetary policy expectations

A key difference in the Federal Open Market Committee (FOMC) Dec. 16 statement centered around a more proactive policy in unwinding policy stimulus, “In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on February 1, 2010.” The direct mention of expiration of liquidity programs places emphasis on unwinding credit easing rather than using all tools available to stimulate growth.

The Fed can in fact withdraw stimulus in other ways other than increasing rates. The Fed concluded the $300 billion of Treasury purchases in October 2008 and is scheduled to complete the $1.43 trillion purchase of

agency mortgage backed securities in March. The unwinding of the mortgages will be a highly sensitive issue, as liquidating mortgage backed securities is likely to raise yields ultimately on mortgage rates. Favoring or the perception of favoring home purchases seems to be an easy way for Congress to score political points with their constituencies.

Still, the prospect of raising rates will continue to be at the forefront of the market’s expectations. Fed fund futures are pricing in an 80% probability of the Fed raising rates to 50 bps or higher by September 2010. (Fig. 5.)

What happens to equity markets when the Fed tightens?

According to a Northwestern Mutual Wealth Management Company study, since 1971, the average 12 month return for the S&P 500 for all periods has been 7.57%, with a 71% occurrence of positive returns. When the Fed has increased rates, the S&P 500 12 month forward return has averaged 7.3%, with a 75% successful positive outcome. The average return when the Fed lowers rates has been slightly higher, 8.05% with a slightly lower success rate, 73%.

Over the last 20 years, the results are vastly different. Since January 1990, when the Fed increases rates, the 12 month forward S&P 500 return averages 10.14%, with an 87% outcome of positive returns. When the Fed lowers rates, the average 12 month return is -0.65%, with a 61% probability of positive returns.

We cannot use this data to conclude that there is an above average probability of above average returns when the Fed begins to increase rates. Neither can we conclude that a tightening posture this year warrants caution with regard to investor’s allocation to equities. We can, however, conclude that these market relationships are dynamic and each situation brings its own unique set of circumstances.

What could be the factors for positive movement of risk assets upon Fed tightening? If inflationary forces remain subdued, the Fed would be in a historically unique position of tightening toward a more conventional monetary policy. In other words, the Fed’s focus is not on combating inflation, but rather on transitioning the economy from being propped up by extraordinary policy to standing on its own footing.

The Fed has only increased rates one time since 1971 (June 1975) when Consumer Credit is contracting. The October 2009 report of the Federal Reserve Consumer Credit Outstanding showed a contraction of 3.6% in consumer credit, the most in the post war era.

Many market observers expect the Fed to tighten despite also expecting lower core inflation and continued high unemployment. If the Fed is forced to navigate closer to either Scylla and Charybdis, many of the disconnected expectations may represent currents that steer policymakers or markets off course. In its current charted course, the Fed remains sensitive to downside risks, particularly sustained high unemployment and a false recovery in housing prices.

However, Fed easing from August 2007 to the current levels was steeper than any previous easing period since 1971 (in percentage rate decline, not points), rendering any historical guidance speculative at best. Investors should recognize that the Fed must accomplish other things before raising the benchmark rate. First, the Fed must complete the current schedule of security purchases. Second, as the Dec. 16 statement, it must close the lending and liquidity facilities. It may then begin to unwind some of its balance sheet. Underlying all these tasks will be a focus on monitoring the labor markets and doing everything it can to ratchet the unemployment rate down. Finally, an increase in rates may be in order.

According to Deutsche Bank, six of the eight Fed rate hiking cycles did not have a discernible negative impact on the equity market recoveries.¹

This should not be surprising as traditional rate cycles saw the Fed begin raising rates well after the end of recessions and only once the recovery was well entrenched.

What to watch for

Now that readings of leading and concurrent economic indicators support economic expansion, the unemployment rate may be the most widely anticipated barometer in the first 6 months of 2010. For those who like to stay current, jobless and continuing claims are typically reported each Thursday, and many market participants will attempt to extrapolate pending unemployment rate trends from these numbers.

The monthly unemployment number is typically released early on Friday in the ensuing month. While the total current rate of 10% may seem somewhat daunting, it may be useful to look at components. Think baby steps. Positive “temp” hiring is generally a precursor to overall labor demand, as expressed through the total nonfarm payrolls. Currently, there is a wide gap, and while not always leading to improvements in payrolls, temp help is historically highly correlated with future movements in the total nonfarm payroll numbers. (Fig. 6.) Average work week and overtime are also good metrics to follow.

Investors will not need to be very proactive in monitoring the Fed. There will be plenty of Fed observers and the media outlets will inundate us with their comments, criticisms and recommended policy decisions. But as we monitor the unemployment situation, do not forget about other important economic indicators. For example, if the Fed tightens monetary policy and leading indicators roll over, the markets could experience heightened volatility and a potential correction. Should these indicators continue to trend toward economic growth, then tighter monetary policy may not be too much of a headwind. (Fig. 7.)

Finally, keep a watchful eye out for those multi-headed monsters that snatch returns from misguided and mortal portfolios. These come in the form of chasing yield without regard to quality, overextending duration in a rising rate environment, and the worst monster of them all, trying to tactically allocate portfolios in reaction to short-term sentiment or guesses on Fed policy actions.

Where are we headed?

Is there a disconnect between the Fed funds rate and the equity markets? The equity markets have led the recession out and, as interpreted by many observers, have priced in economic growth. But the Fed has not budged from 0% short term rates. What does the Fed know about the current state of the economy that the market does not?

If the Fed is keeping rates low because it still deems the economy as fragile, then what does that say about the prospects for corporate profits? Analysts have substantially revised earnings estimate higher, and since March, investors have yet to sell off stocks in reaction to earnings reports or expectations. The equity markets could be at risk of a correction should corporate profits disappoint.

On the other hand, what if the Fed is underestimating the economic recovery? If economic data comes in higher than expected and unemployment has peaked at 10.2%, then the markets could also be at risk due to concerns about inflationary pressures.

The Federal Reserve is faced with navigating the economy through this daunting strait. Keeping rates low for too long could create a harsher inflationary future, while raising rates too soon could derail the recovery we have already begun. In many ways, they must find the lesser of the two evils, and take that path, even if it means short term pain now.

The markets will react swiftly and sometimes irrationally based on short term data releases. Upon the release of a better than expected unemployment report on Dec. 4, the futures markets immediately priced in a higher probability of earlier rate increases.

Like the financial markets and the economy, eventually monetary policy will have to be “normalized,” by that we mean to be made more conventional and ordinary. This process is not likely to occur swiftly. 2010 may be more about the journey, not the destination.

We have focused on expectations, both the Fed’s and the markets’. But expectations only represent an assessment of probability. While equity markets demonstrated some resiliency during the Dubai debt crisis and the downgrade of Greece’s debt, there exists implacable unexpected risks of all kinds, from the aforementioned indicators the Fed is watching to global debt obligations to geopolitical events. The extreme market dislocations over the past two years only serve to magnify all such risks.

Odysseus won the Trojan War, but the journey home challenged the familiar and exalted the danger of taking it for granted. Odysseus learned that reaching the destination after an arduous journey did not mean the end of danger and risk.