Bond Market Hiccup

The bond markets have experienced a hiccup in the first part of this year, with the 10-year bond rising 45 basis points in yield, to 2.85% from 2.40%, and the 30-year bond rising 37 basis points in yield, to 3.11% from 2.74%. Our feeling is that these yields are rising in one measure to compete with the blistering start to the stock market (which itself has seen bouts of volatility in the past week).

It is ironic that, in Janet Yellen’s last week as chair of the Federal Reserve Board, a bond market that had focused on low economic growth and stubbornly low inflation was suddenly concerned about too fast a growth rate and inflation’s heating up.

Core CPI

Source: Bloomberg

However, core CPI is still well below where it was in 2016 at the time of Trump’s election. There has been some growth in wage inflation, but it is clear that so far it has not leaked over into the general inflation numbers.

Ten-Year Treasury Yield vs. Core CPI – Last Two Years

Source: Bloomberg

The spread between the 10-year Treasury bond yield and core CPI has risen sharply. There is a certain amount of logic in real yields rising relative to the jump in equities over the past year. This increase in yields reflects in part a continuation on the path to normalcy: This is the Fed continuing to slowly raise short-term interest rates and starting to shrink its balance sheet. (See my colleague David Kotok’s piece this week: http://www.cumber.com/market-violence-interest-rates/). David’s point is that a 3% 10-year Treasury note yield is not a shocking development.

Ten-Year Treasury Yield vs. Core CPI – Last Five Years

Source: Bloomberg

The bond market’s rise in yields has occurred without an accompanying jump in inflation. In the context of REAL yields, we can see in the above graph that bond market yields compared to core inflation are back near levels that we last saw at the end of the “Taper Tantrum” of 2013. Bond yields may move higher; but if they do, they will start to represent value.

On the municipal bond side we witnessed a January slump in issuance. December’s record $67 billion of new-money issuance in front of the new tax bill gave way to less than $17 billion of issuance in January. Municipal bond yield curves were marked down during the month – mostly out of sympathy with the rise in Treasury yields. There was markedly subdued trading in January, mostly because of the paltry supply. And usually when we see this type of a rise in Treasury yields, that rise is accompanied by municipal bond outflows (witness the post-Trump sell-off as well as the Taper Tantrum of 2013). January saw an INCREASE in net flows into bond funds, which belies the rise in overall yields. We think that some of the volatility witnessed in the equity market in the past week may result in some reallocation into bond funds. Cumberland spent the first part of January mostly selling to meet what retail demand was there post-January 1. That demand was somewhat muted this year as the traditional January 1 bond fund flow bought new issues that were pumped into the bond market in advance of the tax bill. We are waiting for more municipal bond supply (and it should now start to rise after the very low January), and we believe that some additional supply will bring clarity to the muni market. Certainly, if a temporary supply bulge plus some eventual bond fund selling were to push long tax-free yields to the 4% range (last seen in the Trump sell-off), then Cumberland would look to extend portfolios.

Finally, the dramatic volatility exhibited in the stock market this week certainly was ratcheted up by concerns over the rise in overall yields. In addition, investors are demanding an additional yield premium for their reignited concerns about inflation. The bottom line is that this rise in yields, while core inflation is not climbing, will provide an eventual opportunity for investors.

John R. Mousseau, CFA
Executive Vice President & Director of Fixed Income
Email | Bio


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Market Violence & Interest Rates

Fierce forces at work on interest rates … or are we just seeing a mild adjustment? There is no way to know. We are referring to US Treasury interest rates on bills, notes, and bonds. Some bullets follow.

1. It is clear that the newly installed leadership of the Federal Reserve want to raise short-term rates to what they believe is “more normal.” That path seems to point to another 3/4 of 1% higher rates in shorter-term T-bills during 2018. The recent employment report guarantees this outcome.

2. The Fed’s strongest force is applied to short-term rates. Essentially, the Fed can put them at any level it chooses. What happens to markets and economic growth is a derivative of that Fed short-term rate policy decision.

3. The global impact of the short-term rate change can be profound. About $150 trillion in US dollar-denominated debt and notional derivatives is tied to this rate policy. Thus about half of the entire world financial system and debt structure undergoes a shift between lenders and borrowers as short-term rates change. Each single basis point (1/100th of 1%) equates to an annualized rate of transfer of $15 billion. That is the first-order effect. The second-order effects are found in the actions of market agents as each responds to the Fed’s policy change. Economic agents like businesses and households react, too, but do so with a greater time lag than financial markets.

4. The Fed is simultaneously engaged in QT (quantitative tightening). This is the shrinkage of the Fed’s asset holdings, and it translates into a different form of transfer. The Fed reduces its holdings of Treasury bills, notes, and bonds and federally backed mortgages. The market has no choice but to absorb them. QT is a directional force toward higher interest rates, and it will be an accelerating force if the Fed sticks to its presently stated path. We believe the Fed will not deviate from this QT path unless there is a market shock of some type. A single-digit percentage change in stock prices doesn’t qualify as a shock. Neither does a rise in yield to 3% on the 10-year benchmark Treasury note.

5. Coincidentally, the new tax bill and Trump administration deficit policy mean accelerating federal borrowing. Bigger deficits translate into larger Treasury auctions of bills, notes, and bonds. We already see that increased borrowing in an early stage, even though the Treasury’s debt management system is being messed up by Congress’s failure to pass budgets and workable debt limits. This political charade imposes a large cost on the US and its citizens, but that cost is not readily visible. Thus both houses of Congress get away with their behavior, and the public remains deceived and therefore ignorant of the cost.

6. Meanwhile the cost of rising deficits and restrictions on Treasury’s ability to manage the federal debt is expected to grow. This cost shows up indirectly in widening credit spreads, higher rates than would otherwise be, and changes in expectations as market agents adjust. We must add to that cost the impact on the federal budget as rising interest rates and increasing federal borrowing bring the US taxpayers’ interest cost from an annual level in the $400 billion range up toward $700–800 billion over the next few years. That trajectory is virtually assured.

7. Add into this mix a large foreign influence that originates in the eurozone. ECB President Mario Draghi is due to retire next year. He leans toward tapering up and away from negative rates and toward eventual normalcy. We don’t know what the new normal will look like in the eurozone or all of Europe.

8. What we do know is that eurozone low and negative rates have sucked US rates down. And we know that the sucking will now cease.

9. One final factor to consider is the interconnectedness of global finance. The old world is gone. In the new world, derivatives replace flows. We do foreign exchange swaps and forward contracts and settle the notional difference with a net payment between the counterparties. We do interest rate swaps the same way. We combine them into single instruments. We use these complex contracts in lieu of transferring actual payment. Only the net difference is transferred. This means FX and interest differentials show up first in derivatives. Expectations about them are captured there first. That is the new normal. Example: If you want to see how the market is pricing the expectations of changes in the dollar vs. the euro or the expectations regarding German–US interest rate differentials, look at the rate of change in the derivative for clues about tomorrow.

So where do these trends lead? Higher rates are already in play across the entire Treasury yield curve. Fed policy is likely to take them still higher over the next year.

In our bond portfolios we minimize holdings of Treasury paper. It is a bad deal. We favor well-selected credits with spreads to Treasury paper. And we manage duration risk actively with a barbell structure.

The fierce forces at work frighten many whose experience is limited to the last decade. This is new turf for Millennials. They will learn the hard way, just as they are receiving a lesson from Bitcoin.

We deployed some cash in the violence of the selloff. Some but not all was reinvested, as we will be scaling.

The vernal equinox brings volatility with it this year. That’s a good thing. It allows investment advisors to show what they’re made of.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Congressional Panel Confirmed for February 22

We have now confirmed a bipartisan congressional panel for the February 22 “Cuba and the Caribbean: What Now?” event. Florida Congressman Carlos Curbelo, whose district includes the Keys, which bore the direct hurricane hit, is joined by Virgin Islands Congresswoman Stacey Plaskett. The moderator of this session is Ben White, journalist from Politico and CNBC political correspondent.

What now, Cuba - USF Sarasota-Manatee

The full program and registration information can be obtained with this link: https://www.wusf.usf.edu/cuba_and_the_caribbean_what_now.

This full day is designed to inform a broad range of people — tourists, travel agents, investors, policy wonks, and weather-forecasting folks. And those who wish to think about the government’s responsibility and actions in the hurricane-damaged parts of Florida or Texas or Virgin Islands or Puerto Rico or Cuba or elsewhere in the Caribbean, this program is for you.

The event costs only 50 bucks, and that covers lunch. This open forum is made possible by USF Sarasota-Manatee, the Atlanta Fed Americas Center, and the Global Interdependence Center. All media are welcome to cover the panel, and the entire community is invited.

Cumberland Advisors provided a grant to USF Sarasota-Manatee and to GIC to assist this event aimed at public education. Please come.

Cumberland Advisors is a proud sponsor of the Global Interdependence Center.




Inflation and Fed

Don Rissmiller is a Camp Kotok fishing pal, the new chair of the Global Interdependence Center, and a senior personality at Strategas. He is also one very thoughtful economist.

In his Weekly Economics Summary published last week, Don sets forth a serious analysis of inflation and the Fed’s 2% target. He outlines his arguments succinctly. And he ends with a series of questions about what the inflation target should be and whether there are options. Don captures the arguments that several members of the Fed’s FOMC have articulated. We expect this subject to be discussed this week. Clearly, the new Powell Federal Reserve will have to engage in this debate. We asked Don for permission to quote his piece extensively and share it with our readers, and we thank him for saying yes.

Don Rissmiller of Strategas follows:

“So, we continue to write about inflation, not because inflation is high (or likely to be high any time soon). Instead, we are moving from low levels to a little less low – and while there’s reason to believe that’s not a problem for the stock market (where nominal growth will boost revenue and earnings), there remain issues in the bond market.

“There’s also an opportunity for the Fed and other central banks to consider the recent past, and with the global economy now in pretty good shape (eg, U.S. real GDP 2.6% q/q annual rate in 4Q, and the tax cut coming), study if anything should be done differently. The topic of the inflation target is likely to continue to attract attention.

“Put bluntly, should the inflation target be precisely 2%? We have noted previously that the Fed’s goal of 2% inflation seems so familiar that it frequently goes without question that it is a ‘good’ target. But recent academic literature has continued to question whether that 2% number is correct. The 2% inflation target could be too low, and the push to achieve this ‘too-low’ target (over numerous decades) helps explain some of the unique issues in this business cycle.

“One key issue is that there is not a great reason for the inflation target to be precisely 2%. The Fed’s mandate is ‘price stability.’ If ‘price stability’ has to be translated into a number, one might pick 0%, rather than 2%. There has (for quite some time) been concern that inflation is not measured correctly, but the concern was (and is) that price indexes yield numbers that are too high rather than too low.

“Out-going Fed Chair Janet Yellen had a conversation with Alan Greenspan on this topic in the 1990s, where she argued against pushing inflation all the way to zero. Given the inability to measure inflation correctly, as well as the desire to have some cushion against deflation, 2% became the number. To make matters more complicated, this 2% number has caught on around the globe (central bankers frequently talk to each other, attend the same schools, attend the same conferences, etc).

“There has been some survey work suggesting that consumers are comfortable around a 2% inflation rate. But these surveys generally cover consumers’ experience with an inflationary past (eg, the 1970s). When inflation is already low, or deflation present, it is not clear that these results are robust. Even if ‘around 2%’ is the right answer, ‘exactly 2%’ or ‘2% as a ceiling’ could have unintended consequences.

“So, how could 2% be too low? Put simply, there still appear to be too many central banks that are stuck at the ‘zero-bound’ (or slightly below, based on recent experiments with negative interest rates). That’s a key piece of evidence that something is amiss. With a 2% inflation target, if policy rates are cut to zero, there’s a -2% real rate to help kick the economy out of its doldrums. If the inflation target were instead 4%, a zero nominal rate would equate to a -4% real rate (ie, a bigger kick). The fact that many central banks are still at (or close to) the zero bound suggests that the ‘kick’ given to the economy this cycle was simply not big enough initially. There are certainly costs and benefits, but it’s worth noting that the historical average of U.S. CPI inflation is 3.5% (ie, the economy has functioned adequately at creating wealth, etc. with inflation above 3%).

“There are alternatives like price level targeting or nominal GDP targeting which could also guide monetary policy. The idea that something needs to change seems to be gaining traction, regardless. Fiscal policy, of course, is an alternate solution but the recently passed U.S. tax bill means some of this stimulus is coming early.

“Given the maturing U.S. business cycle, rates may not stay in positive territory long – that is the consequence of starting out with a limited ability to pull the real economy back up (ie, an inflation target that’s too low). This final point helps explain why the Fed has been so focused on financial developments – the FOMC wants to know when the market is doing the tightening for them. For now, financial conditions remain easy, but this is likely to remain on the Fed’s radar for some time to come.”  Many thanks again to Don.

As for President Trump, SOTU, market volatility, and deploying the cash reserve, we will hold those words for another discussion.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio




Geography Matters

Strategas Research has compiled the year-to-date (through January 25) returns of major global equity markets. They point to Hong Kong and Brazil as the leaders, with returns YTD of around 10%. Of the others in the largest 20 markets, only two, Australia and the UK, were slightly negative. For reference, the United States was about 6% positive in the same time period. Strategas notes that this upward path occurred in the face of a rising trend in interest rates worldwide, US dollar pressure, and a rising gold price.

Strategas’ excellent research is a regular component of our reading list. They like the banks and the energy patch. So do we – both sectors are overweighted in our US ETF portfolios. We anticipate that will continue, but we must remind readers that our clients know our position can change at any time.

A geographical issue that was surfaced by Strategas caught our attention. They compared the returns of S&P 500 companies headquartered in Florida with those of S&P 500 companies headquartered in Illinois. They used the last decade as the reference period, so the starting time is January 1, 2008, in the thick of the financial crisis. In this piece of research brilliance, Strategas used equal weighting for performance measurement. The idea behind equal weighting is to look at the companies on a relative basis and not have a single dominant large company distort the comparison. Their surmise is that companies in states with “more favorable operating environments” will have relatively better share price performance (suggesting better earnings).

During the decade, Florida-based companies had a relative outperformance of about 50% over the companies in Illinois. That is a spectacular observation. We can argue about why the disparity occurred. Illinois critics point to budget failures, high taxation, and poor state debt management. But Florida’s critics talk about hurricane risk and major coastline issues, including rising sea levels. So the debate about the Illinois–Florida comparison is a multidimensional one.

Let’s set aside the debate over “why” and just draw an inference based on performance. Clearly Florida outperforms Illinois, suggesting that Florida is likely to be a preferred destination for businesses – and there is little likelihood that will change. The trend seems to be strongly embedded.

The new tax bill may work to widen the divide among states. The alteration of state and local income and real estate tax deductibility hits the executives of companies, their managers, and their employees. Over time, decisions will favor states that offer economic incentives. Thus we can expect an acceleration of migration from poorly performing states to the better-performing ones. It is not just Florida. For example, there are reasons that Utah is booming. And there are reasons that some states are barely staying even while the United States as a whole is undergoing an economic recovery.

That poor relative performance has implications for the creditworthiness of those states. Cumberland’s muni research team is tracking those states closely.

Yes, geography matters a lot. Whether globally or domestically, it is a factor in investment decisions or should be for any market agent willing to do the work. We congratulate Strategas Research for creating an index of corporate performance by state and using it to compare relative results.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Trade, Dollar, Trump

“In the long run we are all dead” was John Maynard Keynes’ famous criticism of economic models. The rest of the quote goes, “Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.” We thank Nick Colas and Jessica Rabe of Datatrek for the full quote of Lord Keynes. We find ourselves looking at Nick and Jessica’s daily missives with regularity. Here is their website: http://datatrekresearch.com.

So, is a dollar crisis coming? Are protectionist forces at work? Will that be the storm source described by Keynes? “Obviously a weaker dollar is good for us as it related to trade and opportunities.” Thus said US Treasury Secretary Mnuchin in Davos.

“The dollar is going to get stronger and stronger, and ultimately I want to see a strong dollar,” said President Donald Trump. Trump spoke right after Mnuchin made his remarks.

Peter Boockvar of Bleakley Advisory Group reminded readers that in April 2017 Trump said, “I think our dollar is getting too strong, and partially that’s my fault because people have confidence in me. But that’s hurting, that will hurt, ultimately.… It’s very, very hard to compete when you have a strong dollar and other countries are devaluing their currency.”

Is it any wonder that markets have been whipsawed by this mixed message about the world’s reserve currency from the president and the Treasury secretary of the United States? Is it any surprise that volatility measures rose?

Students of history are encouraged to focus on the dollar’s course since the collapse of the post-World War II, Bretton Woods fixed-exchange-rate regime. That collapse came in the 1970s during the Nixon presidency. History may not perfectly repeat, but it does rhyme, as the aphorism frequently attributed to Mark Twain goes. We think currency-related risk is now rising again.

Couple a mixed message on the dollar with rising protectionism, the imposition of tariffs, withdrawal from trade agreements, and threats made against our largest trading partners, Canada and Mexico, and the pot threatens to boil over.

Yes, there are tax-cut benefits coming; and, yes, global stock markets have been on a celebratory tear. We have been bullish and have participated in them.

But also yes to history as a guide that currency weakness and trade barriers work to raise inflation and to slow economic growth.

We suggest that readers take time to review the lessons from 1970–72. Specifically, read about comments made and policy originated by the French finance minister, Giscard d’Estaing, and US Treasury Secretary John Connally. I was a new and solo investment adviser in the years before Cumberland was founded (in 1973), and I recall vividly the negotiations and the volatility of the US dollar and other currencies and how they impacted markets. I specifically recall the fiery exchange between the two men in a Paris meeting.

Yes, history can guide those who take the time to learn from it. It does rhyme.

We have put a cash reserve in place. We are not fully invested in our US ETF portfolios. We are taking a pause in this bull market. We want to digest this anti-trade rhetoric and this dollar-value mixed message.

Of course, we could alter that position at any time. Trump’s speech this morning was presidential and well delivered. His Q&A excellent and he didn’t stray off message. Now if he doesn’t tweet away the gains, he may be able to build positively on this visit to Davos. We shall see. Meanwhile a little cash seems appropriate.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Report from San Diego

Dear Readers,

We had the wonderful opportunity to present the Heldring Award to Boston Fed president Eric Rosengren at the GIC meeting in San Diego, held on Friday, January 12, at the Rady School of Management. This is GIC’s second year in San Diego but the first time in partnership with Rady, which provided a first-rate venue.

The conference theme was “Money, Models and Digital Innovation” and included cryptocurrency issues and discussion of the outlook for the economy and interest rates and volatilities. Speakers included President Rosengren, Dave Altig of the Federal Reserve Bank of Atlanta, Don Rissmiller of Strategas, and Nobel Prize winner Harry Markowitz, professor of finance at Rady.  Imagine the thrill; we had lunch Harry M.  He is super sharp, quick wit and does it at age 90.

We are sharing links below so that you can join, after the fact, the 75 or so of us who packed the Rady business school to enjoy the excellent presentations. Links include the presentations themselves, press coverage, the Rady business school blog post about the event, attendees’ comments, and a photo of the award presentation.

The presentations: https://www.interdependence.org/events/browse/programs/gic-frederick-heldring-award-global-leadership/.

The press coverage: https://www.interdependence.org/news/money-models-digital-innovation/.

The blog post that the Rady School shared on January 17: https://t.co/7VaTuMfmWr.

Feedback from the guests, collected here in PDF format: Attendee Feedback

Photo of the award presentation with GIC’s board/advisory council members: http://www.cumber.com/wp-content/uploads/2018/01/Award-to-Rosengren.jpg.

Note that all GIC events may be found at www.interdependence.org. Next up for us is the event in Sarasota on February 22, when we will examine the issues surrounding Cuba and the Caribbean. The detailed presentations will include commentary on hurricanes and geopolitics, energy, and recovery. For the detailed agenda and registration see http://usfsm.edu/event/cuba-and-the-caribbean-what-now/.

Note that all GIC events may be found at www.interdependence.org. Next up for GIC is the event in Sarasota on February 22, examining the issues surrounding Cuba and the Caribbean. The detailed presentations will include commentary on hurricanes and geopolitics, energy, and recovery. I will deliver the opening remarks and Jill Fornito whom many of you have come to know at Camp Kotok events will be in attendance. For the detailed agenda and registration see http://usfsm.edu/event/cuba-and-the-caribbean-what-now/. The small collage shown here was made from Sharon Prizant’s photos taken during a brief discovery trip to Cuba. She’ll be happy to share many more if you’re able to make this event in Sarasota.

Visit Cumberland Advisors website to see pictures documenting the struggles of the Florida Keys after Irma and a handful from inside Cuba.

Cumberland Advisors is a proud sponsor and member of the Global Interdependence Center.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Potential Fed Vice Chairman

Reports are that John Williams, president of the Federal Reserve Bank of San Francisco, has been targeted as a potential candidate for Fed vice chairman. President Williams is scheduled to vote as one of the five sitting reserve bank presidents on the FOMC in 2018. What would his appointment mean as far as the Fed and FOMC policy is concerned?

First and most importantly, John is a first-rate monetary economist who has been in the Federal Reserve System his entire career, spanning more than 20 years. He spent four years at the Board of Governors before returning to his native California. He held various research positions at the Federal Reserve Bank of San Francisco before transitioning from director of research to president in 2011. Unlike some reserve bank presidents, he has maintained an active research agenda in addition to authoring many communications on Fed policy via the Bank’s outreach publications.

Because of his background, he is intimately familiar with the system, the Board of Governors, the policy environment, and all that was involved in the financial crisis and subsequent recovery. In this sense, John might be viewed as an ultimate insider candidate, even more so than Marvin Goodfriend, who is awaiting confirmation as a governor. These two would address the departures of economists on the Board, but with people whose policy views are basically consistent with policies that have been pursued since the end of the crisis.

Former Chairman Bernanke suggested at a January 2018 Brookings meeting that incoming Chairman Powell would likely “commission” an internal study of alternatives to targeting a 2% inflation rate. To that point, President Williams commented at that same meeting that he would be open to other alternatives. One alternative he had been asked to comment on, presumably because of previous research and speeches he gave, was price-level targeting. His discussion at that Brookings conference points to two assets that President Williams would bring to the Board. First is a willingness to examine evidence and critically evaluate past polices. What has worked and what has not worked?  Second is an openness to new and alternative approaches to policy.

Some register concern that President Williams is an insider because they fear he may be subject to groupthink when it comes to FOMC policy which has become one criticism of policy lately. However, his speeches and writings evidence his willingness to dig into the data to better understand why the models are breaking down and why inflation has remained persistently below target. For example, in recent speeches he has focused on reasons why the economy may be likely to grow more slowly, such that the equilibrium real rate may be as low as 0.5%. Here he has conducted recent research that supports this view of the real rate rather than relying upon the work of others. With respect to the inflation objective, he and the staff of the San Francisco Fed have done a deep dive into the components of inflation to identify which components may be providing better signals about true underlying inflation trends and which may be clouding the measurement of inflation. They have concluded, for example, that component prices that tend to move in sync with movements in the economy have apparently recovered. Whereas prices for items less sensitive to general movements in the economy, such as cell phone services, airline tickets, and healthcare, etc., have either fallen or tended to remain low.(1)

As for where President Williams may stand on the issue of the desirability of continuing the FOMC’s 2% inflation objective, Chairman Powell might find in him a partner willing to reassess the FOMC’s 2% inflation objective, as part of both evaluating existing policy and preparing for the next policy crisis, if and when an abrupt change in policy may be appropriate. In both research and speeches John Williams has examined how a price-level target versus an inflation target might work going forward and/or how it might have performed in the past. To some, targeting the rate of growth in the price level as opposed to targeting the rate of inflation may seem like a distinction without a difference. After all, isn’t inflation just the rate of growth in the price level? However, the difference from a policy perspective is how one treats deviation from the target. A policy maker targeting inflation is willing to forget past misses of the target, whereas a policy maker targeting the growth rate in the price level commits to reversing past misses to ensure a long-run average rate of growth in the price level.(2)(3) Williams’ and his colleagues’ research argues that had price-level targeting been in place in the 1960s and 1970s, the inflation environment would have been much more stable than was realized.(4) President Williams’ evidenced and scientifically based approach would be a solid anchor for any work that might be done to modify or change FOMC policy approaches and how those might be communicated to the public.

One last observation regarding what President Williams might bring to the FOMC. In his work and speeches, he has continually emphasized the importance of Fed independence, accountability, and transparency. However, he has also expressed caution when discussing recent proposals mandating that the Fed follow a mechanical policy rule. He has emphasized issues that proponents often overlook. First, rules like the Taylor rule rely upon unobservables such as the natural rate of growth in the economy and the equilibrium interest rate. Would these estimated unobserved inputs change over time, and who would set them? There is, as yet, no one best-agreed-upon formulation of a policy rule, and many such proposals exist.(5)

In John Williams the Fed would get a vice chairman who has been comfortable with the present policy stance but who has also forecast slow growth for an economy at full employment and now sees a relatively low equilibrium real interest rate and hence a low policy rate for the foreseeable future. Williams would thus likely be cautious when it comes to the number of rate hikes for 2018 and likely favor at most three moves rather than the four implied in the latest Summary of Economic Projections. However, his elevation would create a vacancy at the San Francisco Bank just when its president is entitled to vote.  That vote would thus be exercised by the Bank’s first vice president.  A similar issue will exist when the New York Fed’s President Dudley retires mid-year.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio

(1) See John C. Williams, Remarks at the 54th Annual Economic Forecast Luncheon, Phoenix Arizona, November 29, 2017.
(2) See https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/
(3) Those who favor pure price stability would inflate if the price level decreased and force an actual decline in the price level if it had increased.
(4) See Orphanides, Athanasios, and John C. Williams. 2013. “Monetary Policy Mistakes and the Evolution of Inflation Expectations.” In The Great Inflation: The Rebirth of Modern Central Banking, eds. Michael D. Bordo and Athanasios Orphanides. Chicago: University of Chicago Press.
(5)  See https://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2015/may/monetary-policy-independence-dilemma/


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US Competitiveness – A Global Comparison

Next week the World Economic Forum (WEF) will host its 48th annual meeting in Davos, Switzerland, drawing together a large number of leaders from governments (including President Trump), international organizations, business, academia, and civil society. The title for this year’s meeting is “Creating a Shared Future in a Fractured World.” This global networking event will generate a lot of press but is not a forum for taking action. Trump will certainly be praising his own actions to reduce corporate tax rates and excessive regulations in order to improve the ability of US firms to compete internationally.

In this note we look at the WEF’s annual publication, The Global Competitiveness Report 2017–2018, a comprehensive analysis comparing the international competitiveness of some 137 economies.[1] The definition of competitiveness used in the World Economic Forum report is “the set of institutions, policies and factors that determine the level of productivity of an economy, which in turn sets the level of prosperity that the economy can achieve.” They look at some 114 indicators that are grouped under 12 headings: institutions, infrastructure, macroeconomic, environment, health and primary education, higher education and training, goods market efficiency, labor market efficiency, financial market development, technological readiness, market size, business sophistication, and innovation. This is indeed a wide range of factors said to affect competitiveness. This list and the above definition make clear that the WEF’s focus is on the productivity of an economy, its ability to generate economic growth and prosperity. This is central to the ability of an economy’s firms to compete in global markets.

The Global Competitiveness Index 2017–2018 Rankings, which were published September 26, 2017, indicate that among the 137 economies analyzed, the United States has the second-most competitive economy, behind that of Switzerland. The third through tenth rankings go to Singapore, Netherlands, Germany, Hong Kong, Sweden, United Kingdom, Japan, and Finland. The economies in this top ten list are not surprising – their overall scores are close. Some other interesting rankings are Taiwan’s (15), Israel’s (16), South Korea’s (26), China’s (27), Russian Federation’s (38) and India’s (40). The lowest-ranked economies – the bottom 20 out of 137 – are Haiti, Venezuela, and eighteen Sub-Saharan African economies.

Looking at details of the Global Competitiveness Index with regard to the United States[2] reveals the depth and complexity of the analysis that produces these rankings. We find that the US ranked first in just nine areas: inflation, venture capital availability, local equity market financing, international distribution, buyer sophistication, marketing, redundancy costs, cluster development, and airline seat miles per week. The US ranked second in the broad categories of business sophistication, innovation, market size, and financial market development. It ranked third for labor market efficiency and higher education and training. The quality of primary education earned a rank of 11. The US ranked 6 in technological readiness but achieved a rank of only 39 for internet users/population. The rank of 7 for goods market efficiency was understandably kept down by the rank of 95 for the total tax rate as a percentage of profits. The rank for female participation in the labor force was also low, 56.

The US’s burden of government regulation, another priority issue for the Trump administration, ranked 12th among the 137 economies, suggesting that we are already doing relatively well in this area. That category is included under the broad heading “institutions,” for which the US has an overall ranking of 20. As investors, we find it disturbing that under the same heading, the US managed only a ranking of 31 for strength of investor protection. Also troubling are the ratings of 34 for irregular payments and bribes, 61 for business costs of crime and violence, and 57 for organized crime. Thus, for example, 56 economies have less of a problem of organized crime than the United States does. An unsurprising reading is that 86 economies have lower business costs of dealing with the threat of terrorism.

Taken as a whole, the “competitiveness” of the United States economy – that is, its productive capacity to generate growth – is very high in comparison with other economies. Of course, there continue to be areas where improvements would be desirable, some of which are noted above. The recent corporate tax cuts in the US will register as a plus in the next global ranking. But the tax rate is just one of some 115 factors that enter into the WEF’s analysis. Moreover, the ability of US firms to compete in international markets is also affected by external factors such as exchange rates and the trade measures of other countries, including those determined by international trade agreements and global trade rules. Were the United States to impose significant trade restrictions and were other countries to respond in kind, as they surely would, the domestic economy’s competitive edge would not be sufficient to prevent serious harm to the country’s exports.

Bill Witherell, Ph.D.
Chief Global Economist
Email | Bio


[1] Sources: The World Economic Forum, The Global Competitiveness Report 2017–2018, Geneva, September 26, 2017; available for download at http://www.weforum.org/gcr.
[2] The Global Competitiveness Report 2017–18, page 303


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Value vs. Equal Investing: It’s More Than Just That Month

The US stock market had a marvelous year in 2017. The major benchmark S&P 500 returned 21.60%[1] including dividends. But savvy investors probably noticed that there were some significant discrepancies among the major indexes: If you chose the tech-heavy NASDAQ composite, you would have made 29.58%[2] last year, while if you invested in the small-cap Russell 2000, you would have profited only 14.52%[3].

It appears that volatility wasn’t the only number that was suppressed in the stock market last year: Stock correlations also remained low. So what does it mean to investors when stock correlations are low?

Simply put, stock correlations measure the contemporaneous movement among stocks and explain why stocks move in different directions. Stock correlations are particularly important statistics for portfolio weighting, while weighting is important for portfolio returns. For example, the large-cap S&P 500 is value-weighted, meaning that each stock makes up a portion of the index according to its market cap. Therefore, the mega-caps in the S&P 500 are capable of single-handedly driving up the index. However, if the S&P 500 were equal-weighted, then all the stocks would contribute in the same way to move the overall market.

How much does the weighting scheme matter to a portfolio? Let’s compare the value-weighted and equal-weighted S&P 500 performance history, as shown in Figure 1 below. Starting from the bottom of the financial crisis in March 2009, the equal-weighted ETF RSP outperformed the value-weighted ETF SPY by 30%, simply due to the weighting difference.

 


Figure 1. SPY vs. RSP since March 2009
Source: Yahoo! Finance
To form a comprehensive picture of the value vs. equal investing difference, we construct a 30-year portfolio starting from 1986. We include all stocks listed on the NYSE, NYSE American, NASDAQ, and ARCA markets, excluding ADRs. Both portfolios are monthly, including distributions. The difference between the two portfolios after 30 years is quite significant: While the value-weighted portfolio generated an 1,838.66% return, the equal-weighted portfolio returned 2,443.71%. We notice that value outperformed equal rather well during the tech-bubble period, when stock correlations were relatively low due to the crowded trade in the Technology sector. Nevertheless, during the following years, when stock correlations reverted to normal, the equal portfolio outperformed the value portfolio.

Figure 2. Value vs. Equal Since 1986
Source: Center for Research in Security Prices

Is there anything else that explains the equal weighting outperformance besides stock correlations? Yes. The answer is January. We notice that the equal-weighted portfolio averages a 3.98% return in January across the 30 years, 3.11% above the value-weighted portfolio, while there is no dramatic difference for the rest of the year. This pattern suggests that the difference between the value-weighted and equal-weighted portfolios comes mainly from just one month. In fact, this “January effect” has long been documented by academic research. Scholars find that while stocks generally rise in January, small-caps tend to be more affected than large-caps are. Generally, low stock correlation dictates the divergence between value and equal investing. Beyond that, low stock correlation signals a stock picker’s market – more specifically, one needs to choose the right sector to generate alpha.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


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[1],[2],[3] – Source: Bloomberg