Sunday, December 30, 2007

90% odds of Fed rate cut at end of January

Fed funds futures contract prices are now predicting a 90% chance that the Federal Reserve will cut rates by a quarter point at the next FOMC meeting at the end of January. A lot can and will happen in the next few weeks, but the economic outlook would need to improve substantially over the next few weeks to convince people, and the Fed, that another cut is not needed.

Personally, I do expect that the overall, non-housing economic data will show some amount of improvement over the next couple of weeks, but whether it will be enough to persuade market participants to raise their outlook remains to be seen.

Fed funds futures contract prices are usually a fairly accurate indicator of the target fed funds rate within 45 days in advance of an FOMC meeting.

The ISM Manufacturing and Non-Manufacturing reports and the December employment report due out this week, plus preliminary holiday retail sales reports, could seal the fate of the Fed for the January FOMC meeting.

The durable goods orders report last week was too weak and mixed to inspire any confidence in the economic outlook. On the other hand, the Chicago Purchasing Managers' Index rose fairly strongly last week. This mixed and uneven data is likely to lead to the Fed to give us an "insurance" cut unless the ISM and employment and other reports do in fact paint a picture of reasonably solid growth.

-- Jack Krupansky

Who is a sophisticated investor?

The investment world is split into two categories, retail and institutional. Retail is basically all of us little guys who rarely have $1 million or even $250,000 to "invest." Institutional includes pension funds, financial institutions, governments, and so-called "sophisticated" or high net worth individuals. Institutional investors are usually offerred higher rates of return and access to risky investments such as hedge funds on the theory that they are "sophisticated" enough to understand the higher levels of risks. Or at least that is the theory.

Alas, having a larger pile of money is not a very reliable indicator of sophistication and ability to adequately assess risk. To wit, we have seen numerous news stories in recents months about municipalities and even charities, not to mention large financial institutions, who have gotten screwed because they had no idea of the significantly higher risks with mortgage-backed securities and derivative securities and pseudo-money market funds such as cash-management vehicles, investment pools, and so-called "enhanced cash" funds. In truth, the only difference between your average municipality and your average retail investor is that the former have crossed the dollar-level threshold to be considered "sophisticated" (and that they are technically "institutions" as well.) Sure, a municipality can hire a consultant to advise on risk, but I suspect that the overall packaging and slick claims for these financial products coupled with "group think" lull even sharp city managers and financial analysts into believing that Wall Street "knows what it is doing" and that the products would not be offerred to them if they were too risky. Bad assumption.

The simple reality is that there is a wide swath of investors who are either institutional or simply have more than the threshold amount of money, but who still have too small an amount of money to hire the level of sophisticated risk managers who really can make technical sense out of the actual risk of many of the investments that are being peddled even today as "low risk." Rather than the financial threshold being at $1 million, I suspect it is closer to $100 million. If you have $25 million you can hire a full-time money manager, but they probably won't have the level of expertise to have understood bank SIV conduit risks over a year ago. Maybe at $50 million to $75 million you can hire a team of specialists, but still without the hard-core risk assessment skill needed to laser-drill through dense, opaque security documents. Somewhere closer to $100 million you can finally afford to bring in the elite levels of risk managers (ala Goldman Sachs) who could have told you exactly how Bear Stearns, Citigroup, and Merrill were at risk a couple of months before the liquidity problems became actual disasters. Sure, there were plenty of people touting subprime risk one, two, and even three years ago, a number of those people were also betting heavily on short-term sharp decline way too early. Sophisticated investors who invested in those early-bird short hedge funds lost as much if not more than some of the recent losses. Risk assessment does include a timing element.

Sure, now we are all so much more "sophisticated" than we were a year ago, but one does have to wonder what the term "sophisticated" even means when even Bear Stearns, Citigroup, and Merrill Lynch had so much difficulty with it.

So, tell me, how sophisticated an investor are you?

I did have a small amount of money in a pseudo-money market fund that invested primarily in floating rate high-yield corporate debt. It has lost money in terms of NAV, but actually not much more than the higher income that it pays out. At the time it sounded like a solid investment. I was quite aware of the risks with high-yield corporate debt, but the theory was that diversification over a large number of issuers would compensate for any defaults. That failed to account for the systemic risk of a wholesale writedown of all high-yield corporate debt that we are currently seeing. Maybe the lesson there is that even if you are relatively sophisticated, are you sophisticated enough for a particular investment.

Even if you are prepared for a rainy day, are you prepared for a cloudburst, flood, tornado, or hurricane?

-- Jack Krupansky

Saturday, December 29, 2007

Is the banking and credit crisis getting worse or better?

Although there continues to be a continuous stream of bad news about the banking and credit crisis, that per se is not an indicator about whether the financial system is traveling deeper into the woods or in fact is past the midpoint and closer to resolution than to where it started. I believe it is the latter. A significant number of the recent stories have been about writedowns, pulling SIVs onto balance sheets, buying assets from cash management pools, infusions of capital into banks, replacement of financial executives, actions by central banks, etc. All of these are signs of progress towards resolution rather than signs of further decay. Sure, there is still plenty of talk about bigger writedowns coming, but that is a side effect of an increase in information flow leading to more accurate asset pricing, which is progress, not an unravelling.

Just this week we had several stories about Warren Buffett jumping into the fray and buying up assets and even starting up a new bond insurance business. These are all signs of improvement, not further decay.

Sure, we have a large overhang of mortgage resets looming, but they will be more of an incrementally rising tide rather than a swift and overwhelming wave, so that will give market participants time to adjust and reprice mortgages and terms as the magnitude of the actual foreclosure problems incrementally unfolds. Don't forget, markets have been seeing a rising tide of mortgage resets for over a year now. There are more than enough plans and schemes being discussed, especially since a major election season is looming, so that it is virtually impossible to imagine that any number of fixes won't be put in place over the coming two years.

Also bear in mind that after dealing with the immediate and intense pain of a foreclosure, the prolonged period of anxiety of the pending foreclosure (and its impact on personal spending) gets fairly quickly replaced by a sense of relief and a resumption of spending as the houshold decamps to more affordable housing and "starts over." Yes, the pain of a foreclosure is quite unbearable, but it is what happens after that which impacts the overall economy.

Finally, bear in mind that there are two distinct banking issues in this "crisis": liquidity and credit. The Federal Reserve is doing a reasonable job of assuring that the banking system has enough liquidity to clear short-term banking transactions. That was a "crisis" back in August for a few days, but is now more of an ongoing adjustment process than a true "crisis." Credit is not a problem per se since that are still vast amounts of cash sloshing around the world in any number of markets, but there are niches of credit that will continue to go through an adjustment process to align asset pricing with reality and to assure that financial institutions are adequately capitalized. As we have seen with recent cash infusions, it is mostly a matter of time and pricing rather than a lack of overall credit availability around the world.

In short, virtually everywhere I look I see improvements or at least opportunities for improvements in the so-called banking and credit "crisis."

-- Jack Krupansky

What to think of declining home sales

Superficially, declining home sales are a significant black mark and drag on the U.S. economy. That said, the ongoing decline is not really that surprising or totally unexpected and really not that big a drag on the overall economy. Sure, the media and a lot of people on Wall Street and politicians are making a really big deal out of it, but the simple fact is that the actual data is not as scary as the stories that people are concocting and slinging around as if they were facts.

The good new is that the "bad" subprime housing market is virtually (if not absolutely) gone, mortgage rates remain quite low, and consumers are finally beginning to see some more attractive deals as prices moderate and even decline. The common story line we are hearing lately is that consumers are holding off as they wait for even better deals.

This is an adjustment, not an overall economic depression or even a recession.

Not only have we not seen even one down quarter for the overall economy in this business cycle, but nominal GDP growth has remained very strong even after the housing drag is accounted for.

I will refrain from trying to predict precisely when housing demand will stabilize, but will certainly not be a multi-year wait.

-- Jack Krupansky

Intrade odds for recession in 2008 at 47%

The Intrade Prediction Market pegs the odds of a U.S. recession in 2008 at 47%.

In other words, people are quite worried that a recession is possible, but not so worried that they consider it the likely scenario (50% or higher.)

Personally, I would still put the odds down around 25% (1 in 4 chance.)

-- Jack Krupansky

Misguided emphasis on holiday sales

Granted, consumer spending is 70% of GDP and consumers do spend a lot of money during the holidays, but there is a grossly misguided emphasis on holiday retail sales as a purported proxy for overall consumer spending. There is no known hard and fast ratio between total GDP or consumer spending and retail sales that occur during some relatively narrow holiday shopping season. Put simply, consumer spending habits are constantly evolving so that the fraction of spending during some artificial holiday shopping season compared to total consumer spending is itself constantly evolving.

In truth, Wall Street and the media are enthralled with simple rules and simple ratios and rules of thumb and adages that "seem" to work "most" of the time and with extremes of booms and busts, with no significant interest in how spending really plays out, especially if the results are... well... kind of boring.

The real bottom line on consumer spending this holiday season is that it was not a total disaster, and that is all we really needed to assure that Q4 GDP was not going to fall off a cliff. Whether Q4 GDP comes in at 2.0%, 2.5%, 2.75%, 3.0%, 3.25%, or 3.50% is not as important as the fact that it is unlikely to come in below 1.5%.

So, relax. There is no need to worry about whether gift cards can "save" holiday consumer spending. Consumer spending is consumer spending regardless of which week or month or quarter it occurs in.

And there is no need to worry about the impact of high energy prices on consumer spending since that actually counts when consumer spending and GDP are calculated.

Besides, we already know that consumer spending was okay in October and strong in November. Even a mediocre December will give us a modestly decent Q4 for GDP.

-- Jack Krupansky

Friday, December 28, 2007

ECRI Weekly Leading Index indicator falls moderately and still suggests a very sluggish outlook

The Weekly Leading Index (WLI) from the Economic Cycle Research Institute (ECRI) fell moderately (-0.71% vs. -1.24% last week) and the six-month smoothed growth rate fell moderately (from -4.8 to -5.2, its lowest since the week of November 1, 2002), moderately below the flat line, suggesting that the economy will be somewhat sluggish in the months ahead, neither booming nor busting.

The WLI does indicate the economic outlook is rather weak, but not so weak as to suggest that a recession is imminent. The WLI growth rate has been this low before without being followed by a recession.

According to ECRI, "With Weekly Leading Index growth fast approaching its worst reading since the 2001 recession, the U.S. growth outlook continues to deteriorate. Nevertheless, it is still premature to predict a recession."

A WLI growth rate of zero (0.0) would indicate an economy that is likely to run at a steady growth rate, neither accelerating nor decelerating. A WLI fluctuating in a range from +1.5% to -1.5% would seem to forecast a relatively stable "Goldilocks" economy.

The current reading for the smoothed growth rate is still too close to zero to discern with any great confidence whether the economy is really trending downwards or upwards. We may need another month or even two before the trend becomes clear.

I will offer the caveat that the Weekly Leading Index and its smoothed growth rate do not tell us how strong the economy will be six or nine months from now, but do tell us whether whether weakness or strength is more likely a few months from now. It works best to tell us whether a "gathering storm" might be lurking just around the corner. It presently indicates "cloudy weather" for the next few months, but is still not forshadowing major storms in the real economy, even if financial markets and some sectors of the economy may continue to struggle.

-- Jack Krupansky

Wednesday, December 26, 2007

More investment tasks and goals for 2008

Here are a few more tasks and goals for investment in the coming year:

  1. Figure out a more streamlined approach to cash management that gives a reasonably high return and convenience and simplicity but without adding significant risk or inconvenience or complexity.
  2. Figure out a model for how to balance savings and investment in retirement accounts and non-retirement accounts. Contributions to my Roth retirement accounts grows tax free, but is not easily accessible. On the other hand, now that I have built up a fully-funded rainy day contingency fund and significant assets in non-retirement accounts, and will continue to do so, ease of access is less important, so I should probably up my retirement contributions, to the extent that I am not approaching the legal limit. I may have to wait until I do my taxes to determine how much I can contribute to a Roth IRA account. In any case, coming up with a model would be useful.
  3. Identify investment sectors or niches that have been out of favor in recent years and may be ripe for being targeted by investment managers and hedge funds in the coming year based on the evolution of the economy. Think"value investing" and look for deep undervaluations. I actually do not have discretionary funds to be going after such risky opportunities, but it is time to start developing and enhancing the analytical skills needed to identify and evaluate such investments, including risks and risk management.

-- Jack Krupansky

Tuesday, December 25, 2007

Investment tasks and goals for 2008

I will not offer any investment "resolutions" for 2008, but I will offer a set of tasks and goals for investment in the coming year:

  1. Think about various asset classes where money can be deployed
  2. Think about an asset allocation model using those asset classes
  3. Think about how the asset allocation model might shift in response to changing market and economic conditions
  4. Spend less
  5. Save more
  6. Review and revise target size for rainy-day contingency fund. Make sure it is big enough, but don't overdo it.
  7. Consider acceleration of paydown of back taxes and consider parameters for paying them off completely
  8. Spend less time worrying about fine tuning investments
  9. Spend more time seeking out major changes to investment strategy that could reduce net risk while enhancing long-term gain
  10. Continue focusing on career enhancement and net saving rate as the larger impact, relative to investment strategy tuning, on my annual increase in net worth for the next several years
  11. Consider diversification that significantly raises return while significantly reducing risk, but avoid mindless diversification for the sake of diversification
  12. Simply my overall investments and investment strategy, but not so simple that it adds significant risk or significantly reduces return
  13. Learn some new things about investing, broaden my horizons
  14. Read more
  15. Write more
  16. Become more disciplined

-- Jack Krupansky

Do consumer sentiment surveys predict changes in consumer spending?

I have gotten very tired of reading an endless stream of press accounts that misguidedly imply or outright state that some latest reading in a consumer sentiment survey indicates a causal effect on consumer spending in the coming weeks or months, when studies have shown that no such causal relationship exists. In fact I added this as one of my "predictions" for 2008: "Consumer sentiment surveys will continue to be proven as a poor indicator of future consumer spending." Imagine my surprise when I read an article in The Wall Street Journal by Kelly Evans entitled "Holiday Spending May Defy Gloom Of Consumer Polls" that details the case for my view. Thank you Kelly!

She does not list the specific study from the St. Louis Fed that debunks the myth of a causal relationship between current consumer sentiment and future consumer spending, she does note the contributions of the St. Louis Fed to this effort.

The really good news is that she first reports that holiday spending was reasonably decent and in defiance of the recent consumer sentiment surveys:

Early indications that Christmas sales have been decent -- though not spectacular -- suggest that Americans may be opening their wallets wider than consumer-confidence barometers have been signaling they would.

She then delves into the central issue of "a long-running debate about whether confidence numbers are useful in predicting how freely consumers will spend."

She summarizes some of the academic views:

Jeremy Piger, an assistant professor of economics at the University of Oregon who studied consumer sentiment while working at the Federal Reserve Bank of St. Louis, explained that early academic studies of consumer surveys found that there was a correlation between the level of consumer confidence and future economic activity.

But, he said, later studies "got more sophisticated." They took a close look at other economic data released each month to see whether the confidence surveys, in and of themselves, had any predictive power. "The answer has pretty uniformly been, 'No,'" he said. The consumer numbers reflected other developments, on jobs and prices, for example.

A 2006 study by Dean Croushore, an associate professor of economics at the University of Richmond, concluded, "If you are forecasting consumer spending for the next quarter, you should use data on past consumer spending and stock prices and ignore data on consumer confidence."

She provides additional background and a number of other interesting and useful tidbits on this issue. One quote I thought was particularly direct:

Joshua Shapiro, chief economist at the research firm MFR Inc., parses the surveys for his clients but has a disclaimer at the end of his comments: "In our view, consumer sentiment and confidence indicators have never been more than loosely correlated coincident indicators of economic activity, and this relationship has become even weaker in recent years."

Thank you again Kelly for helping enlighten readers on a point that so many so-called "professionals" on Wall Street are so ignorant about.

I just realized that my 2008 prediction should have been worded as "Most of the media and so-called "professionals" of Wall Street will continue to falsely claim that consumer sentiment surveys are a good indicator of future consumer spending."

-- Jack Krupansky

Monday, December 24, 2007

My 2007 Q4 GDP prediction is growth of 3.5%

Although the Q4 GDP report does not come out until the end of January 2008, and is therefore an "event" that happens in 2008, it feels more as though it is a 2007 event that is happening right now. Some people had been forecasting that Q4 GDP would come in at 1% or less, but then consumer spending came in fairly strong for November, on top of a decent gain in October as well, so now all bets are off. Some are now forecasting Q4 to come in at 2.5%, while some continue to claim that a recession has already begun.

To repeat, both the October and November readings for personal outlays were quite decent, and as we are continually told, consumer spending is 70% of GDP.

Of course, December is a real wild card and there have been a lot of reports that holiday spending is "off" or "weak." Please note that some are asserting that holiday spending is down due to high gasoline prices, but retail gasoline expenditures do really count as consumer spending in GDP. The bigger issue might be whether heavy discounting merely shifted a heftier chunk of holiday spending from December into November and even October.

The other big wildcard is the level of inflation in Q4. I would note that despite the sharp rise in the price of crude oil, retail gasoline prices have not reflected the full gains in crude oil prices. As with consumer spending, we do not yet have a clear reading on how inflation will play out in December.

I am going to conjecture that nominal annualized GDP growth for Q4 will come in between 5% and 8%, with 6.5% being a likely midpoint.

I am going to conjecture that (headline) inflation will come in between 2% and 4%, with 3% being a likely midpoint.

Subtracting inflation from nominal GDP, that gives a range for annualized real GDP growth in Q4 between 1% and 6%, with 3.5% being a likely midpoint.

So, my forecast for Q4 2007 is that nominal GDP growth will come in around 6.5% and inflation around 3%, so that my forecast for annualized real GDP growth for Q4 2007 is around 3.5%.

That is a fair bit higher than most forecasts, but it is what it is and was based on two realistic forecasts for nominal GDP growth and inflation.

OTOH, even my optimistic 3.5% gain is still a significant slowing from the 4.9% growth rate seen in Q3.

Meanwhile, even as the prospects for Q4 continue to improve, the cynics are simply shifting their game and are now talking about Q1 or Q2 as when the "real" slowdown will occur.

-- Jack Krupansky

More market and economic predictions for 2008

A few other finance and economic predictions for 2008 have come to mind:

  • The limits for mortgages that Fannie Mae and Freddie Mac can purchase and securitize will be raised significantly, to somewhere in the $500,000 to $850,000 range, and the limit to the volume of mortgages they can acquire will be raised substantially as well. Today these government-sponsored enterprises (GSE) can buy mortgages only up to $417,000, which does in fact cover most mortgages, but there are a significant number of mortgages in the $450,000 to $650,000 range that are more difficult to finance today since they are classified as "non-conforming" since they are over that $417,000 limit. In addition, the regulatory oversight rules will be modified to permit the GSEs to acquire and securitize (with an implicit government protection against loss) a significantly larger volume of mortgages. Wall Street had lobbied heavily to limit the GSEs in recent years so that Wall Street could capture this lucrative business, but then Wall Street bungled everything by focusing far too much energy and capital on dubious subprime mortgages. Now, Wall Street doesn't have much of a leg to stand on to argue against unleashing the GSEs so that they can "save the Middle Class mortgage markets." We can count on unleashed Fannie and Freddie to save the day.
  • Commodities speculation will continue to garner a lot of attention, but less so as returns begin to fray if not crumble. The resulting bitterness of those buying $90 oil expecting it to reach $150 within the next year or two will ultimately break the back of the commodities speculative bubble, maybe not within the next couple of months, but certainly within the next two years.
  • The media will continue to be a poor source of information on investments and investment strategies. There will continue to be an extreme focus on a combination of short-term and transient noise and unlikely long-term fringe scenarios, with virtually no attempt to truly enlighten investors. Many investors will miss out on many investment opportunities simply because the media misleads them into looking into all the wrong places and refusing to recommend that they look in any of the right places. Rather than focus on accurate reporting of facts, most media "stories" will be densely peppered with the language of speculation: "could", "may", "might", "if", "expected", "will"
  • None of the big banks, not even Citigroup, will "fail" in 2008.
  • People will continue to chatter incessantly about the "weak" and "falling" dollar in 2008, even though the dollar will strengthen (modestly) in 2008.
  • Consumers will continue to baffle and befuddle even the most sophisticated of Wall Street "analysts." Wall Street will continue to do a lousy job of forecasting consumer spending.
  • Consumer sentiment surveys will continue to be proven as a poor indicator of future consumer spending.
  • Some enterprising journalist will "discover" that a new "baby boom" is underway in 2008.
  • The reputations and perceived value of Wall Street "analysts" will continue to decline.
  • Very few Wall Street "analysts" will correctly call the U.S. economy in 2008 until well after their initial outlooks are proven very wrong.
  • The vast bulk of Wall Street's so-called "professionals" will continue to second-guess and criticize the Federal Reserve and its Chairman, even as such criticisms continue to be proven to be way off mark.
  • The vast bulk of Wall Street's so-called "professionals" will continue to be baffled at the resilience of the U.S. stock market even as these "professionals" continue to misguidedly push unsuspecting investors into all manner of "emerging markets", "alternative investments", and hybrid "products" which combine high fees, unclear risks, and terms that no mere mortal investor could ever be expected to comprehend.

Other than that, I expect that 2008 will be mostly "business as usual."

-- Jack Krupansky

Sunday, December 23, 2007

Market and economic predictions for 2008

About the only safe predictions I can make about the market and economy in 2008 is "anything goes" and "all of the above." Seriously.

I am fairly confident that the economy will not fall into recession (as determined by the NBER Business Cycle Dating Committee), but there is enough uncertainty in credit markets that it is a possibility. On balance, I will predict that we will avoid recession in 2008.

I can with great confidence predict that the stock market(s) will... gyrate wildly throughout 2008. Whether the stock markets finish 2008 higher is a real crap shoot. The stock markets have risen recently in anticipation of economic improvement in 2008, but the markets will end 2008 based on expectations for where the economy will be headed in 2009. I continue to predict that the stock markets will overall trend modestly higher over multi-year periods, but we could also see temporary downward trends at shorter time intervals up to a full year or even 15 months due to the vast amounts of short-term "hot money" being deployed by hedge funds, in-house trading desks at banks, and like-minded speculators. Nonetheless, I will go out on a limb and predict that the stock markets will close out 2008 modestly higher, a gain of between 5% and 15%. OTOH, if markets do in fact decline, it will be no great surprise.

I can with great confidence predict that the euro will... be quite volatile throughout 2008. It may continue to climb and hit $1.50 or even $1.65, but is just as likely to pull back. I will predict that the euro will decline as the U.S. economy creeps back to health and interest rates rise again. I predict that the euro will close out 2008 closer to $1.20.

Speculators may in fact finally succeed in pushing crude oil up to $100, but such efforts will ultimately backfire as the high price for gasoline and other refined products will continue to strongly incentivize consumers and businesses to seek alternatives that reduce their demand for such products, with the net effect that there will be a weakening or even outright decline in real demand growth for crude oil in the coming year. On the one hand, there is a good chance that speculators will continue to push crude oil up beyond the level supported by real demand, but I will go ahead and predict that crude oil will close out 2008 closer to $50 than $100. Retail gasoline prices will pull back somewhat, but not dramatically, maybe to the $2.50 to $2.75 range. I'll go ahead and predict that retail gasoline will close out 2008 closer to $2.50 than $3.00.

Demand for gold is quite irrational to say the least, so it could spike higher, but I strongly suspect that the speculative interest will decline as the Fed succeeds at getting the economy and financial system back on an even keel and pushing inflation down a bit more. Although I wouldn't be surprise to see gold spike to $875 or even $900, I will go ahead and predict that gold will close out 2008 closer to $700.

I predict that the housing market will roughly stabilize in 2008, although some sub-sectors will show continued weakness while other will start bouncing back.

I predict that nonresidential construction may see a pause as projects financed before the credit crunch are completed, but then we will see a resurgence of nonresidential construction for the rest of 2008 as credit markets recover and large amounts of credit become available from "alternative sources."  Noveau investors from China, Russia, and other emerging economies, not to mention growing sovereign investment funds will find investment in high-profile U.S. construction projects to be irresistible. Also, there is a huge inventory of "tired" and "dated" properties in the U.S. that are ready for renovation and offer quick returns.

I predict that overall employment will continue to rise in 2008, driven by healthy gains in service-based and export-based businesses.

I predict we will see a resurgence of U.S.-based manufacturing as the backlash against imports begins to grow and technology advances, rising transportation costs, and rising wages and benefits in emerging economies enable manufacturers to produce at least niche products more effectively here in the U.S. Net U.S. manufacturing may still see a decline, but the list of growing sub-sectors will expand.

Inflation will be extremely volatile in 2008, especially as the prices of commodities are driven by trigger-happy speculators and as the Fed starts hiking its target rate again, but overall inflation will start to trend down again in 2008. I predict that core inflation will be in the 1.5% to 2.5% range for 2008. I predict that headline inflation will be in the 2.0% to 4.0% range for 2008.

Real GDP is driven not only by nominal economic growth, but by headline inflation as well, so significant volatility is to be expected. For example, the economy was probably weaker in Q3 of 2007 than in Q1, but a temporary spike in the headline inflation reading led to real GDP growth in Q1 looking to be much lower than in Q3. I predict that overall nominal GDP growth in 2008 will be 4% to 7%, meaning inflation-adjusted real GDP will be in a range of 0% to 5%, with 2.5% being the likely level of growth over 2008.

-- Jack Krupansky

Euro once again stagnating

For a few weeks there it looked as if it were a "slam dunk" that the euro would rise to $1.50,but it simply did not happen. Traders and speculators pushed as hard as they could, but the $1.48-$1.49 range was all they could manage. Now, the euro is back down where it was at the end of October, with the March euro futures closing at $1.4370 on Friday.

A big part of the loss of momentum and the pullback was the fact that the Fed did not cut its target rate as aggressively as many people expected this month, economic reports were not as weak as feared, and in fact people are actually chattering about the very real possibility that the Fed might not even cut its target rate at the end of January. Lower interest rates make the U.S. dollar look less attractive to investors, or so the "story" goes.

Meanwhile, U.S. exports are getting a healthy boost from the "weak" dollar.

Where the euro goes from here is up in the air since we no longer have a solid consensus on what the Fed will do with interest rates, where the overall U.S. economy is headed, or how deep-pocketed the speculators are who have been pushing up the euro.

As far as where speculators think the euro may be headed, euro futures out at June 2009 were only at $1.4264 on Friday, so there isn't exactly a lot of "slam dunk" enthusiasm for betting on an aggressive ongoing upwards trend, so far.

The good news about the decline of the dollar is that it puts downwards pressure on imports and upwards pressure on exports which combine to put upwards pressure on GDP. It also puts upwards pressure on the revenue and earnings of multinational companies.

-- Jack Krupansky

Saturday, December 22, 2007

ECRI Weekly Leading Index indicator falls sharply and still suggests a very sluggish outlook

The Weekly Leading Index (WLI) from the Economic Cycle Research Institute (ECRI) fell sharply (-1.20% vs. -0.21% last week) and the six-month smoothed growth rate fell moderately (from -3.9 to -4.6, its lowest since the week of November 1, 2002), moderately below the flat line, suggesting that the economy will be somewhat sluggish in the months ahead, neither booming nor busting.

The WLI does indicate the economic outlook is rather weak, but not so weak as to suggest that a recession is imminent. The WLI growth rate has been this low before without being followed by a recession.

According to ECRI, "With Weekly Leading Index growth not far from its lowest reading since the 2001 recession, U.S. growth prospects have clearly darkened, but a recession is still not inevitable."

A WLI growth rate of zero (0.0) would indicate an economy that is likely to run at a steady growth rate, neither accelerating nor decelerating. A WLI fluctuating in a range from +1.5% to -1.5% would seem to forecast a relatively stable "Goldilocks" economy.

The current reading for the smoothed growth rate is still too close to zero to discern with any great confidence whether the economy is really trending downwards or upwards. We may need another month or even two before the trend becomes clear.

I will offer the caveat that the Weekly Leading Index and its smoothed growth rate do not tell us how strong the economy will be six or nine months from now, but do tell us whether whether weakness or strength is more likely a few months from now. It works best to tell us whether a "gathering storm" might be lurking just around the corner, but presently indicates "cloudy weather" for the next few months, but is still not forshadowing major storms in the real economy, even if financial markets and some sectors of the economy may continue to struggle.

-- Jack Krupansky

Sunday, December 16, 2007

Is the economy holding up nicely or spiraling into a recession?

An article in The New York Times by Vikas Bajaj entitled "Economy Holding Up, Reports Find" simultaneously offers up evidence that the real economy is holding up better than expected while noting some serious economists are raising their odds that the economy is spiraling into recession.

On the plus side:

Maybe the American economy is not going to keel over just yet, after all.

Government reports released Thursday showed surprising resilience in the broader economy, even as the financial system and the housing market continue to weaken. Retail sales rose 1.2 percent in November, and even housing-related areas like furniture and building materials were up.

Wholesale prices surged, indicating strong demand and raising cautionary flags about inflation, and a weekly report found that new unemployment claims fell by 7,000, suggesting a healthy job market.

On the downside:

... Kenneth D. Lewis, the chief executive of Bank of America, told investors on Wednesday that the odds of a recession were "getting closer and closer to 50-50." On Thursday, CNBC reported that Alan Greenspan, the former Federal Reserve chairman, had raised his prediction for a recession to 50 percent, from 30 percent.

To be honest, I'm not exactly sure how any mere mortal (or even an honest economist) could accurately discern the risk factors that differ between a 1 in 3 and a 1 in 2 chance of recession. The important thing is that the odds are not substantially above 50% even after all that has happened and all that people fear will happen.

Needless to say, I personally do not believe that a recession is the likely scenario over the next twelve months.

-- Jack Krupansky

Will the Fed HIKE rates at the end of January?

Although the credit and bank liquidity crunch continues, there are plenty of signs that the bank liquidity issues are being addressed (e.g., SIV bailouts) and that the real economy is exhibiting significant resilience despite the ongoing subprime mortgage resets. I am sure that there will continue to be ongoing credit anxiety over the next couple of weeks, but I fully expect a significant portion of that anxiety that focuses on liquidity and the health of the banking system will really turn the corner by the middle of January. Given the growing drumbeat of concern about rising inflation, I fully expect that the Federal Reserve will feel enough relief on the bank liquidity and real economy fronts and enough anxiety on the inflation front that the thought of another cut in rates will not even be seriously considered. Rather, a hike in the target rate for fed funds will be the preferred option.

I won't go so far as to suggest that a quarter-point hike at the end of January is a "slam dunk", but it does appear to be a more likely option and I strongly suspect that its likelihood will grow quite quickly as we get near the middle of January.

The Federal Reserve FOMC meets on Tuesday and Wednesday, January 29/30, 2008.

-- Jack Krupansky

Enhanced cash funds vs. money market funds

There has been some amount of press coverage concerning problems with enhanced cash funds. In particular, failure to be able to fully redeem cash from such funds due to liquidity problems with asset backed securities. Sometimes people ignorantly or misguidedly or even intentionally "suggest" that enhanced cash funds are the same as money market funds and that money market funds may have the same problems, but it simply isn't true. Yes, there are some similarities, but beyond the superficial, the two types of funds are significantly different. The basic difference is that there are strict SEC regulations on what can go in money market funds while investors in enhanced cash funds are not offered similar protections.

Now, to be clear, even retail money market funds can have some amount of exposure to asset-backed securities, typically in the form of short-term commercial paper and so-called medium-term notes (originally medium-term when issued but acquired by the fund as it nears its maturity date and is effectively short-term), but again under the SEC regulations and not with the large scale exposure to mortgages typical of institutional enhanced cash funds. Typically, commercial paper in money market funds matures within 30 to 90 days.

No doubt there are and will be some retail money market funds that get into some trouble, but not on the same scale as the institutional enhanced cash funds, where even there the problems are relatively limited and frequently the investors are bailed out and made whole.

Bloomberg has an informative article on recent problems entitled "Federated Investors Bails Out Cash Fund After Losses" that also explains some of the differences.

-- Jack Krupansky

Saturday, December 15, 2007

ECRI Weekly Leading Index indicator falls modestly and still suggests a very sluggish outlook

The Weekly Leading Index (WLI) from the Economic Cycle Research Institute (ECRI) fell modestly (-0.19% vs. +1.21% last week) and the six-month smoothed growth rate fell moderately (from -3.2 to -3.8, its lowest since the week of November 15, 2002), moderately below the flat line, suggesting that the economy will be rather sluggish in the months ahead, neither booming nor busting.

The WLI does indicate the economic outlook is rather weak, but not so weak as to suggest that a recession is imminent. The WLI growth rate has been this low a number of times without being followed by a recession.

According to ECRI, "With WLI growth falling to a new five-year low, U.S. economic growth prospects continue to worsen."

A WLI growth rate of zero (0.0) would indicate an economy that is likely to run at a steady growth rate, neither accelerating nor decelerating. A WLI fluctuating in a range from +1.5% to -1.5% would seem to forecast a relatively stable "Goldilocks" economy.

The current reading for the smoothed growth rate is still too close to zero to discern with any great confidence whether the economy is really trending downwards or upwards. We may need another month or even two before the trend becomes clear.

I will offer the caveat that the Weekly Leading Index and its smoothed growth rate do not tell us how strong the economy will be six or nine months from now, but do tell us whether whether weakness or strength is more likely a few months from now. It works best to tell us whether a "gathering storm" might be lurking just around the corner, but presently indicates "partly cloudy weather" for the next few months, even if the interval is occasionally punctuated with financial market "gyrations."

-- Jack Krupansky

Sunday, December 09, 2007

Fed likely to cut again as post-crisis transition period continues

Although the real economy is actually doing reasonably well despite the so-called subprime mortgage crisis, the Federal Reserve FOMC will likely cut the fed funds target rate by another quarter point on Tuesday. The real economy does not need lower interest rates, but Wall Street and other parts of the financial system need another dose of financial morphine to continue the cleanup of the financial mess created by the liquidity credit crunch mini-crisis that occurred in mid-August.

The latest monthly employment report was neither strong nor weak, which allows the Fed a free pass to give Wall Street more financial morphine to tide it over until enough writedowns of mortgage-related securities can be completed. The real economy doesn't need it (as evidenced by the relative strength of the stock market), but Wall Street banks do, or at least appear to need it or at least claim to need it.

To be clear, the actual credit crisis really is over, but there is still a lot of mopping up to do.

The big mortgage bailout being orchestrated by the U.S. Treasury is really simply a palliative to shore up confidence, but really is not necessary. Sure, there will be plenty of mortgage interest rate resets and foreclosures in the coming months, but the individual mortgage firms will more than likely fix up the mortgages that can and need to be fixed up and let the unfixable mortgages (fraud, speculators, income problems, falling home prices and equity, etc.) proceed with foreclosure as they ultimately will even with a so-called "bailout." Sure, this is a big problem, but it is not a true crisis and not is not anywhere near as big a problem as the worst-case analysis and pundits suggest.

Although there is a plausible chance that the Fed will make another rate cut at the end of January, I strongly suspect that the economic data and incremental improvement of balance sheets on Wall Street by then will actually have the Fed more worried about how quickly they can start raising rates again.

-- Jack Krupansky

Saturday, December 08, 2007

ECRI Weekly Leading Index indicator rises sharply but still suggests a very sluggish outlook

The Weekly Leading Index (WLI) from the Economic Cycle Research Institute (ECRI) rose sharply (+1.31% vs. -1.56% last week) but the six-month smoothed growth rate fell moderately (from -2.2 to -2.7, its lowest since the week of November 22, 2002), modestly below the flat line, suggesting that the economy will be somewhat lackluster and rather sluggish in the months ahead, neither booming nor busting.

The WLI does indicate the economic outlook is rather weak, but not so weak as to suggest that a recession is imminent.

According to ECRI, "With WLI growth falling to a five-year low, the U.S. economic growth outlook has clearly faded."

A WLI growth rate of zero (0.0) would indicate an economy that is likely to run at a steady growth rate, neither accelerating nor decelerating. A WLI fluctuating in a range from +1.5% to -1.5% would seem to forecast a relatively stable "Goldilocks" economy.

The current reading for the smoothed growth rate is still too close to zero to discern with any great confidence whether the economy is really trending downwards or upwards. We may need another month or even two before the trend becomes clear.

If I were looking at this one indicator alone, I would say that the Fed is succeeding at its goal of moderating the economy to a sustainable growth rate.

I will offer the caveat that the Weekly Leading Index and its smoothed growth rate do not tell us how strong the economy will be six or nine months from now, but do tell us whether whether weakness or strength is more likely a few months from now. It works best to tell us whether a "gathering storm" might be lurking just around the corner, but presently indicates relatively "clear weather" for the next few months, even if the interval is occasionally punctuated with financial market "gyrations."

-- Jack Krupansky

Saturday, December 01, 2007

Back from NYC

My apologies for my lack of posting over the past three weeks. I was in the New York City area for the holidays plus some vacation. I got back to Bellevue, WA late Tuesday evening, but I am still adjusting and trying to catch up even now. Relaxation can be so exhausting!

You wouldn't have guessed that the economy was "weak" by looking at consumer activity in New York City. Plenty of people on the streets and in stores and restaurants. Same here in Bellevue, WA.

But... there were some recent economic reports that were in fact weak:

  • The ECRI Weekly Leading Index six-month smoothed growth rate has been modestly negative for 12 consecutive weeks and this past week dropped down to -1.8%, which is modestly below the -1.5% threshold where we start to get a little concerned. ECRI says that "With WLI growth at its worst since just before the Iraq War, U.S. economic growth prospects have deteriorated further, yet fall short of a recession forecast."
  • Construction spending declined in October. The good news is that non-residential construction spending continues to rise as it has for the past year, but residential construction spending had a bigger decline in October.
  • Real Disposable Personal Income declined slightly (-0.14%) in October, but personal spending continues to grow.
  • Unemployment Insurance Jobless Claims have risen modestly, but are still rather tame.

None of this is yet negative enough to suggest that a true recession is likely, but is worth watching a bit more closely.

OTOH, that kind of weak data plus the daily drumbeat of the so-called "credit crunch" means that it is highly likely that the Fed will cut interest rates by a quarter-point again at the FOMC meeting on Tuesday, December 11, 2007.

It is interesting that the Fidelity Money Market Fund (SPRXX) has a 7-day yield (4.82%) which is substantially higher than the Fed's fed funds target rate of 4.50%.

Both crude oil and the euro have lost their recent "meteoric" upwards momentum. Gasoline prices have already started to decline, which should inspire a little more consumer spending.

-- Jack Krupansky