Kamis, 28 Februari 2013

What claims say about investment strategy

First-time claims for unemployment remain in a downtrend, a clear sign that the fundamentals of the labor market continue to improve. This is the natural progression of any economic recovery, and strongly suggests that the economy remains in recovery mode, however weak it might be. 

The chart above shows the long-term trend of non-seasonally adjusted claims (white) and the 52-week moving average (purple). The pattern is clearly down, although the rate of decline appears to be slowing—which is natural, since claims are unlikely to ever fall much below 250K per week. At this time of the year, claims haven't been this low since 2007, a year before the recession began.

This next chart shows the non-seasonally adjusted number of people receiving unemployment insurance. Over the past year this number has declined by 1.24 million, or 18%. That is a very impressive change, and arguably one of the most impressive changes on the margin in today's economy, because it means that there are more people with a greater incentive to seek out and accept a new job. Changing incentives typically have very important impacts on the economy, and this is one good reason why the economy is likely to continue to improve, however slowly.

From the perspective of the market, which is still braced for economic deterioration, the most important thing is not the speed at which claims are falling, but the fact that they aren't rising. There is no sign here that the economy is losing vitality or at risk of slipping into another recession. Therefore, there is little justification for holding substantial assets in cash and cash-equivalent investments that pay virtually nothing, when there is a panoply of alternative investments that yield substantially more.

This is one message that the Federal Reserve is trying very hard to beat into the heads of the world's investors. It's a risky gambit, to be sure, because if substantial numbers of economic actors start getting the message, then the demand for cash and cash-equivalents will decline. This would be manifested chiefly in an increased velocity of money (money would circulate faster as people attempted to reduce their holdings of money relative to other things), which in turn would cause nominal GDP to accelerate.   Much of this acceleration in nominal GDP could come from a rising price level (i.e., inflation), and too much of this would present a real challenge to the Fed, since they would have to take measures to keep money demand from declining too much. This would entail hiking the interest rate it pays on reserves, ceasing its purchases of Treasuries and MBS, reducing (selling) its holdings of Treasuries and MBS, and/or not reinvesting principal repayments. Treasury yields could rise meaningfully.

For the past four years I've been worried about the Fed not being able to respond in a timely fashion to a declining demand for money, and thus allowing inflation to rise. Obviously, those concerns were premature, since inflation has been relatively subdued. But anyone concerned about an acceleration in nominal GDP, whether or not that meant an acceleration in inflation, would have taken the same steps that would have been appropriate had he or she merely anticipated an economic recovery, no matter how tepid. Since the market has been braced for deterioration for years now, those who have bet on recovery have been rewarded: virtually all risk asset prices are higher, and holders of non-Treasury bonds have been rewarded with substantial interest income in addition to higher prices.

I sense that we are now more rapidly approaching the point at which market psychology shifts from being passive/defensive to being more aggressive: from waiting for the train to slow down to get on board, to running to catch the train before it leaves the station. The bond market still expects the Fed to keep short-term interest rates near zero for a very long time, but those expectations could change dramatically, and the Fed's timetable for exiting QE3 could accelerate significantly. Lots of things could change, and in a big way. I'm not sure when, but more and more I think that it pays to be on the side of optimism than on the side of pessimism.

At the same time, it makes sense to retain a healthy fear of an unexpected rise in inflation, and that argues for investments in real (tangible) assets that could benefit from faster nominal growth and higher inflation. Real estate and commodity prices top the list of potential beneficiaries. Gold not so much, since I believe it has already risen by enough to anticipate a significant rise in inflation. Gold is very vulnerable to any sign of "good news," which in this case would take the form of an acceleration of the Fed's tightening timetable. That's how I read the latest decline in gold prices, as an early warning indicator of a shift in the Fed's strategy in response to improving economic fundamentals. TIPS, normally considered to be the classic inflation hedge, are also vulnerable, since real yields are very low and negative, and would likely rise if the Fed started raising rates sooner than is currently expected. TIPS investors would benefit from rising coupon payments if inflation exceeds expectations, but they would suffer from declining TIPS prices. In short, TIPS today are very expensive inflation hedges.

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