Indexology^® Blog

In her testimony to the House Financial Services Committee on Tuesday, Fed Chairwoman Janet Yellen commented that with interest rates near zero the Fed must rely on such less traditional tools of monetary policy as forward guidance and asset purchases. Asset purchases are being phased out as tapering slowly ends quantitative easing. That leaves the Fed with forward guidance: telling the market and the world what it will do when a chosen economic indicator hits a particular number.  In December 2012, the Fed offered forward guidance when it said that the Fed funds rate would remain between zero and 25 basis points until the unemployment rate dropped below 6.5%, as long as inflation was projected to remain below 2.5% and long term inflation expectations remain well anchored.

Inflation is one percent and long term inflation expectations are well anchored in low numbers.  Now that the unemployment rate is 6.6% and trending down, the Fed is revising its forward guidance. Chairwoman Yellen, in the same testimony, noted that the FOMC said in December and January that its current expectation “is that it likely will be appropriate to maintain the current target range [0 to 25 bp]for the federal funds rate well past the time the unemployment rate declines below 6.5%.”  Meanwhile, analysts are  debating the accuracy and utility of the unemployment rate. These developments leave us with less trust in the monthly employment numbers and less comfort about what the central bank might do next.

For the Fed, the answer may be to be vague.  We should stop kidding ourselves that the Fed, or anyone else, can confidently and competently forecast the reaction of the unemployment rate to monetary policy, economic shifts and politics a year or more in advance.  For most of the history of the Fed, markets accepted that the Fed couldn’t offer precise schedules for future policy adjustments. Forecasting has improved, but not enough.  A comment attributed to John Maynard Keynes, “When the data change, I change my mind; what do you do?” summarizes the difficulties with forward guidance.

Given cold and snowy weather in large parts of the nation, the weather is a favorite reason to not believe the employment numbers.  Other arguments focus on why a person should be looking for a job as well as out of work to be counted as unemployed; if we counted full time students and retirees as unemployed, the number would be larger and meaningless.  Behind all these explanations there is a Murphy’s Law of economic indicators, and the unemployment rate may be the current corollary.   When the market focuses on a particular number as the key to understanding the future, that number loses reliability.   Past efforts at gauging monetary policy tried various definitions of money and each was abandoned as it lost meaning.

Whether we like it or not, the economy, the future and especially the future of the economy is uncertain.  A little obfuscation in pronouncements about future policy might acknowledge the uncertainty.

Historically (from 1928), as defined by the S&P 500, 52.1% of the trading days are up (average +0.745%) and 46.2% are down (average -0.789%).  For Valentine’s day there is a thorn. On February 14th the market has been up only 40.0% of the time and down 56.9% of the time (it was flat in 1944 and 1935; it was down for the Saint Valentine’s Day massacre in 1929).  The DJIA 30 was up 43.1% of the time (for the same time period), and down 56.9% of the time.

Oh well, the market is still our sweetheart, even if the returns are shorts.

Source: S&P Dow Jones Indices

The Congressional Budget Office (CBO), the government’s bi-partisan budget researchers released its latest report and projections for the federal budget deficit.  The deficit is back to the average percentage of GDP experienced since 1974.  The bulge in spending and the drought of revenues caused by the financial crisis is behind us.  The chart shows that the current gap is back to its average.

Fiscal policy – using taxes and spending adjustments to help guide the economy — has been pretty much off limits in recent years because the financial crisis pushed the federal deficit to almost 10% of GDP in 2009.  That was the highest level since the second world war when, with a largely controlled economy, the deficit was close to 27% of GDP in 1943. This doesn’t mean that we can spend like it was 2008 again.  In fact the CBO analysis points to a rise in the deficit as a percentage of GDP in another couple of years.  The “culprits” are an aging population, social security and health care spending.

There was other encouraging news about the deficit: the House of Representatives agreed to raise the debt ceiling through March 2015 without any conditions.  This means that citizens and investors will be spared battles and grand-standing about government shutdowns for a year.  A couple of words about the debt ceiling:  First, the deficit is not the same as the debt.  The deficit is the difference between government revenues and spending – if the government spends more money that it collects with taxes and fees, there is a deficit.  It borrows money to make up the difference instead of stopping its spending (although there are some politicians who would like it to just stop spending no matter who wouldn’t get paid.) The money the government borrows is the debt.  Some time ago, Congress began to worry about the growing government debt, even though the growth of the debt was due to laws for spending and taxes passed by Congress. So they passed a law to put a cap on the debt.  Now, whenever that cap is hit by growing debt the Congress debates and then raises the cap. If the cap weren’t raised, the US government wouldn’t be able to borrow to pay its bills,

Hopefully the recent progress on the deficit may inspire Congress to focus on spending, taxation and fiscal policy instead of the debt ceiling

There are too many funny coffee jokes to single one out but this one I found seriously relevant:

Though I take my coffee black, I also take it seriously since it is one of the commodities in the S&P GSCI and DJ-UBS. Coffee has been the best performing commodity this year, up 23.9%.  As I mentioned in a prior post,  Coffee is up since the consumption of coffee in China is expected to grow by an annual rate of 9% for the next five years. This is not only from China’s large population but it’s rising middle class, which is expected to grow to 630 million people from 230 million.  Further, the International Coffee Organization reported “annual consumption should continue to grow at around 2.4% per year, and demand for coffee remains buoyant and should provide potential for further growth in the long term”.

Additionally, dry weather in Brazil has supported coffee returns this year. According to the International Coffee Organization, “The recent publication of official Brazilian production estimates for crop year 2014/15, which is due to start in April, suggests that output could fall for the second consecutive crop year, giving an initial forecast of between 46.53 and 50.15 million bags. This uncertainty over the 2014/15 crop, exacerbated by notably dry weather in some coffee-producing regions, has given support to coffee prices over the last month.”

However don’t be fooled by the seemingly supportive economics. Let’s take a look at history because it looks like the 30.1% increase since October 2013 could be a head fake.  Below is a cumulative return chart of monthly index levels since the index inception in 1981:

Historically, the major drawdowns have lasted on average about 5.5 years with a loss of 81.1%. The gains from trough to peak on average with the exception of the 2008 financial crisis period lasted 4.8 years with average gains of 387.1% that includes the gain between 2001-2011.  The last drawdown ending 10/31/2013 only lasted 2.5 years and was only down 64.8% before gaining 30.1% until now.  If the next drawdown looks like the past, it is possible to see a downward spiral for another 2.5-3 years with a loss of 58.6%.  Please see the table below:

Recently I had the pleasure to visit some of our key exchange partners in Asia and kick-start some milestone initiatives there. Our strategic agreements with the Korea Stock Exchange (KRX) and the Taiwan Stock Exchange (TWSE) further strengthen our presence in this fast-growing region and boost our profile as a leading international financial market index provider. Meanwhile, I’m equally excited to see that such relationships bring substantial benefits to the local markets.

On January 20, we formalized the agreement with the KRX to collaborate on global marketing and sales of KRX indices including the flagship index, the KOSPI 200. This agreement positions S&P Dow Jones Indices at the forefront of facilitating greater access to South Korea’s dynamic marketplace for global investors. Our proven experience in global sales and marketing will be put into full use to license and promote the KRX indices. The agreement also paves way for both parties to build a joint team for effectively developing new indices and knowledge sharing.

Following the KRX ceremony, we signed a strategic agreement with the TWSE on January 27. The agreement brings both parties to a closer working relationship for index maintenance, development, distribution, and co-branding. In conjunction with this, the first co-branded index — S&P/TWSE Taiwan Low Volatility High Dividend Index, which measures the performance of 40 high-yielding Taiwan companies — was announced. This newest innovation in indexing should facilitate greater access to equity market intelligence on Taiwan companies for investors both inside and outside of Taiwan.

These initiatives highlight our accelerating efforts to strengthen ties with bourses in key emerging markets in Asia and Latin America. The focus on these regions is a result of stronger economic growth relative to mature markets along with the increasing size of the investing public that looks for new investment channels. While several countries in the two regions have established derivatives markets, the use of exchange-traded funds and index-based strategies is still nascent, indicating huge room for growth.

The International Monetary Fund (IMF) recently forecast 6.5 percent growth in gross domestic product in developing Asia and 3.1 percent increase in Latin America for 2014[1], both of which are several notches higher than the predicted growth in the developed world. The continuous momentum in these regions, coupled with an increasingly sophisticated investment community, should bring growing business opportunities to us and our partners.