MANKIW RULE (CIM VARIATION) MANKIW WITH EMPLOYMENT/POPULATION = 0.25% MANKIW WITH UNEMPLOYMENT RATE = 2.45%

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May Nichols
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1 Daily Comment By Bill O Grady & Kaisa Stucke, CFA [Posted: November 20, :30 AM EST] Global equity markets are generally lower this morning. The EuroStoxx 50 is trading down by 1.2% from last night s close. In Asia, the MSCI Asia Apex 50 was lower by 0.3% from the prior close. U.S. equity futures are signaling a lower opening. With 95.6% of the S&P 500 companies reporting, actual plus projected earnings are $30.48 on a float-adjusted basis. This is above the $30.02 forecast. Of the 478 companies that have reported, 74.4% beat estimates while 16.4% were below forecast. Yesterday s FOMC minutes held no major surprises. Given the length of the statement, the committee had mostly communicated its stance. Still, the battle lines are fairly clear between the hawks and the doves. The former want to start raising rates soon and are arguing that the labor market improvement behooves tighter credit. They also downplay weaker global growth, suggesting that the foreign sector is less important to the overall economy. The doves point out that inflation expectations are declining, which could be troublesome in the future. If expectations fall, it will tend to drag long-duration rates lower and make the conduct of monetary policy more difficult. They are also more concerned about weakness abroad and the continued slack in the labor markets. In fact, the labor market slack may be the biggest issue MANKIW RULE (CIM VARIATION) MANKIW WITH EMPLOYMENT/POPULATION = 0.25% MANKIW WITH UNEMPLOYMENT RATE = 2.45% OFFICIAL TARGET RATE MANKIW USING EMPLOYMENT/POPULATION MANKIW USING UNEMPLOYMENT RATE Sources: Greg Mankiw, Haver Analytics, CIM 1

2 This chart is a new variation on the Mankiw rule. The Mankiw rule, developed by Greg Mankiw, a Harvard economics professor and a former chairman for the Council of Economic Advisors for the second Bush administration, developed a fed funds model based on the Taylor rule. The Taylor rule projects the neutral rate for fed funds based on core inflation and economic slack as measured by the difference between GDP and potential GDP. Mankiw noted that potential GDP can only be estimated, not observed, and decided to use the unemployment rate as a proxy for the spread between actual and potential GDP. The green line on the above chart shows what that calculation would generate, a neutral rate for fed funds of 2.45%. We have also calculated the rule replacing the unemployment rate with the employment/population ratio. The difference is striking based on the latter calculation, the neutral rate is 25 bps, near the current target rate. This shows how tricky changing monetary policy will be next year. If the unemployment rate is accurately estimating slack in the labor markets, the FOMC needs to start hiking rates. If the employment/population ratio is accurate, they should do nothing in fact, ending QE would mean that monetary policy is now neutral. The minutes make it clear that Yellen is weaving her way between both camps. By allowing the considerable time language to remain in the statement, she satisfied the moderates and the doves (except Minneapolis Fed President Kocherlakota, who dissented). By saying the Fed could raise rates quickly if conditions warrant, she offered support to the hawks. This drama will continue to play out in the coming months. We look for the Fed to begin raising rates in H2 of next year, but at a very slow and deliberate pace. U.S. Economic Releases October CPI remained unchanged from the month before compared to the 0.1% decline forecast. The core rate rose 0.2% from the month before, more than the 0.1% forecast. In the annual data, CPI rose 1.7%, more than the 1.6% forecast, while the core rate rose 1.8%, also more than the 1.7% forecast. 2

3 THOUSANDS The chart above shows the annual change in the overall and core CPI. Both turned up modestly in October but remain well behaved. Price increases were broad-based, while price declines were seen in energy, apparel and education. Initial claims fell 2k to 291k compared to the 284k level forecast. This is the tenth consecutive week that claims have come in below 300k, indicating sustained labor market improvements. 700 FOUR-WEEK AVERAGE OF INITIAL CLAIMS Sources: BLS, CIM 3

4 This chart shows the four-week average of claims, a more stable measure of claims. The fourweek average rose 2k to 288k, but remains near recent lows. For the rest of the day, at 9:45 EST, the November manufacturing PMI will be released, with a forecast level of 56.3, up from 55.9 the month before. At 10:00, the November Philadelphia Fed Business Outlook indicator will be released, with a forecast level of 18.7, down from 20.7 the month before. Also at 10:00, the October existing home sales report will be published, with a 0.4% monthly decline expected. Finally, at the same time, the October LEI report will be released, with an expected monthly increase of 0.6%. Foreign Economic News The big foreign news was the release of several manufacturing and service PMIs. Chinese and Japanese manufacturing weakened, but remained above the expansionary line of 50. European numbers disappointed, with weakness from both Germany and France. Manufacturing PMI Service PMI Composite PMI November October Expected November October Expected November October Expected China Japan Eurozone France Germany In other foreign news, in Asia, Japan s October trade deficit narrowed to JPY bn from JPY 1,067.7 bn the month before, narrower than forecast, with exports up 9.6% annually, more than forecast, and imports up 2.7%, less than forecast. Also from Japan, October machine tool orders rose 30.8% annually. In Europe, Germany s October PPI fell 1.0% annually, on forecast. Italy s September industrial orders fell 1.5% monthly, weaker than forecast, while industrial sales fell 0.4%. The U.K. s October retail sales rose 0.8% monthly, more than forecast. Switzerland s October trade surplus widened to CHF 3.3 bn from CHF 2.5 bn, wider than forecast, with exports up 4.7% and imports up 2.7%. Financial Markets In the financial markets, three-month Libor yields were unchanged at 23 bps and three-month T- bill yields fell 2 bps to 0 bps, widening the TED spread to 20 bps. The U.S. Libor/OIS spread narrowed 1 bp to 12 bps. The 10-year Treasury yield narrowed 4 bps to 2.32%. The Euribor/OIS spread narrowed 1 bp to 9 bps and the EUR/USD three-month swap spread rose 1 bp to 10 bps. The dollar is higher along with the pound and some of the commodity currencies. 4

5 Commodity Markets Commodity markets are mixed this morning. Crude futures are higher on buying opportunities that the three-day price declines have created. Forecasts for today s DOE natural gas inventory report are calling for a 14 bcf withdrawal. This would be the first withdrawal of the season. The nearby crack spread stands at $15.72, down $0.85 from the prior trading day, while the 12-month strip crack spread was $17.16, down by $0.51 from the last close. The ethanol rack prices fell three cents to $2.55. Precious and industrial metals are trading lower on speculation of Fed tightening. Grains are mixed, with corn and soybeans higher on commercial buying. The Baltic Dry Freight index was 1,306, higher by ten points from the prior trading day. Weather The 6-10 and 8-14 day forecasts call for warmer than normal weather for the western quarter of the country, with the rest of the country remaining colder than normal. Most of the country is expected to see dry conditions, with some precipitation in the forecast for the East Coast and the upper Midwest. 5

6 % Weekly Asset Allocation Commentary Confluence Investment Management offers various asset allocation products which are managed using top down, or macro, analysis. This year, we will start reporting asset allocation thoughts on a weekly basis, updating the piece every Friday. We hope you find this new addition useful. November 14, 2014 We plan on publishing our forecast for 2015 soon. A factor that will be prominently featured is the expected change in monetary policy next year. Since the Federal Reserve became independent in 1954, the fed funds target rate has never been this low for this long. However, in the pre-independence era, periods of low and steady interest rates did occur. And so, in this note, we will take a look at how the economy behaved during these periods. 3.5 THREE-MONTH T-BILL RATES Sources: Haver Analytics, CIM This chart shows three-month T-bill rates from 1930 to 1952 (recessions are shown in gray bars). Although T-bill rates were not directly managed by the Federal Reserve, they acted as a reliable reflection of monetary policy. The interest rate history is instructive on numerous levels. First, monetary policy during the Great Depression is a lesson on what to avoid. Milton Freidman and Anna Schwartz, in their masterwork A Monetary History of the United States, discussed in great detail the policy mistakes made by the Federal Reserve during the Great Depression. As the chart indicates, on two occasions, T-bill rates spiked during the Depression as policy was prematurely allowed to tighten. Second, after Franklin Roosevelt took office in 1933, T-bill rates generally held below 50 bps until he won a second term in Third, shortly thereafter, policymakers concluded that the economy had normalized. Interest rates were allowed to rise, fiscal spending contracted and taxes rose. The economy rapidly slipped into a second recession. Essentially, the increase in three-month T-bill rates from 10 bps to 70 bps, along with the fiscal measures, was enough to trigger a downturn. One of our concerns about the advent of policy tightening is a repeat of the experience. Essentially, the Fed moved too quickly to raise rates and triggered a downturn; in Amity Shlaes book on the Great Depression, The Forgotten Man, she reports that there was widespread 6

7 DEVIATION REAL GDP (2005 $, LOG BASED) concern that aggressive monetary and fiscal stimulus would eventually trigger inflation, and thus the return to policy orthodoxy in 1936 was supported. However, it should be noted that GDP growth, though recovering, was still well below its long-term trend and households were still deleveraging. These conditions are also evident today. Still, it should be noted that the 1945 recession occurred without any increase in interest rates; it was triggered by war demobilization. However, even when rates rose in 1947, following the relaxation of war emergency measures which had kept rates steady from 1942 into 1947, a recession did not develop until Thus, raising rates after being stable for a long period of time isn t necessarily a consistent condition for recession. REAL GDP AND THE LONG-TERM TREND FORECAST IN SHADED AREA DEVIATION ACTUAL TREND Sources: Haver Analytics, Philadelphia FRB, CIM What is consistent with 1936 and today is that in both periods GDP growth was well below trend. We suspect that the FOMC is aware of the 1936 situation; clearly, when faced with conditions similar to the Great Depression, Chairman Bernanke aggressively cut interest rates and held them at low levels to support the economy. As the GDP shows, the current economic situation, though less than ideal is much better than the catastrophic drop in GDP seen during the early 1930s. If the FOMC has learned the lessons of 1936, expect the policy rate to be raised very slowly and cautiously. As the first chart shows, the economy may not be able to cope with even a modest rise in rates. Thus, the potential of the opposite problem may loom larger that the FOMC moves rates so slowly that it bolsters investor confidence and triggers a stronger than expected equity market, characterized by strong P/E expansion. Clearly, this is a wait and see situation but one that we are watching with great interest. Past performance is no guarantee of future results. Information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strateg y discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Opinions expressed are current as of the date shown and are subject to change. 7

8 Data Section U.S. Equity Markets (as of 11/19/2014 close) Health Care Utilities Technology Consumer Staples S&P 500 Financials Telecom Industrials Materials Consumer Discretionary Energy (Source: Bloomberg) YTD Total Return -10.0% 0.0% 10.0% 20.0% 30.0% Prior Trading Day Total Return Energy Consumer Discretionary Consumer Staples Utilities Materials S&P 500 Financials Industrials Health Care Technology Telecom -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% These S&P 500 and sector return charts are designed to provide the reader with an easy overview of the year-to-date and prior trading day total return. The sectors are ranked by total return, with green indicating positive and red indicating negative return, along with the overall S&P 500 in black. Asset Class Performance (as of 11/19/2014 close) YTD Asset Class Total Return Real Estate Large Cap Mid Cap US Government Bond US Corporate Bond This chart shows the year-to-date returns for various asset classes, updated daily. The asset classes are ranked by total return (including dividends), with green indicating positive and red indicating negative returns from the beginning of the year, as of prior close % 0.0% 10.0% 20.0% 30.0% US High Yield Emerging Markets Small Cap Cash Foreign Developed Commodities Source: Bloomberg Asset classes are defined as follows: Large Cap (S&P 500 Index), Mid Cap (S&P 400 Index), Small Cap (Russell 2000 Index), Foreign Developed (MSCI EAFA Index), Real Estate (FTSE NAREIT Index), Emerging Markets (MSCI Emerging Markets Index), Cash (ishares Short Treasury Bond ETF), U.S. Corporate Bond (ishares iboxx $ Investment Grade Corporate Bond ETF), U.S. Government Bond (ishares 7-10 Year Treasury Bond ETF), U.S. High Yield (ishares iboxx $ High Yield Corporate Bond ETF), Commodities (Dow Jones-UBS Commodity Index). 8

9 P/E P/E Update November 20, 2014 LONG-TERM 4Q TRAILING P/E Current = 16.8x as of 11/19/ Q TRAILING P/E AVERAGE -1 STANDARD DEVIATION +1 STANDARD DEVIATION Sources: Robert Shiller, Haver Analytics, I/B/E/S, CIM One of the new features we have added to the Daily Comment this year is the above chart, which offers a running snapshot of the S&P 500 P/E in a long-term historical context. We are using a specific measurement process, similar to Value Line, which combines earnings estimates and actual data. We use an adjusted operating earnings number going back to 1870 (we adjust asreported earnings to operating earnings through a regression process until 1988), and actual operating earnings after For the current and last quarter, we use the I/B/E/S estimates which are updated regularly throughout the quarter; for example, the current four-quarter earnings sum includes two actual (Q1 and Q2) and two estimates (Q3 and Q4). We take the S&P average for the quarter and divide by the rolling four-quarter sum of earnings to calculate the P/E. This methodology isn t perfect (it will tend to inflate the P/E on a trailing basis and deflate it on a forward basis), but it will also smooth the data and avoid P/E volatility caused by unusual market activity (through the average price process). Why this process? Given the constraints of the long-term data series, this is the best way to create a very long-term dataset for P/E ratios. Based on our methodology, the current P/E is 16.8x, up 0.1 from the last reading. The rising equity markets and lower earnings estimates account for the increase in the ratio. Still, the current reading remains below recent readings of +17. This report was prepared by Bill O Grady and Kaisa Stucke of Confluence Investment Management LLC and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell any security. 9

This chart shows the closes for the GBP; we are breaking out to new highs for this year and up over 5.5% since June 14.

This chart shows the closes for the GBP; we are breaking out to new highs for this year and up over 5.5% since June 14. Daily Comment By Bill O Grady & Kaisa Stucke, CFA [Posted: June 23, 216 9:3 AM EDT] Global equity markets are higher this morning. The EuroStoxx 5 is trading higher by 1.9% from the last close. In Asia,