Category: Chart of the Week

The State of U.S. Manufacturing

Generally speaking, the new orders component serves as an indicator of future demand, while the inventories component serves as an indicator of current supply. Comparing new orders to inventories helps to illustrate the supply/demand dynamic within the manufacturing sector, which in turn can help provide insight into future economic activity. When demand (i.e. new orders) is greater than supply (i.e. inventories), it’s a sign of future economic growth. When demand is less than supply, it’s a sign of future economic weakness.

The Institute for Supply Management (ISM) Manufacturing Index (also referred to as the ISM Purchasing Managers’ Index, or PMI) is the most commonly used leading indicator of economic activity within the United States manufacturing sector. It is a monthly index based on a survey of more than 300 manufacturing firms across the country. The ISM Manufacturing Index is composed of five equally weighted subcomponents: new orders, production, employment, supplier deliveries, and inventories. The index is an important leading indicator insomuch as it serves as a snapshot of the overall trend in manufacturing. Readings above 50 indicate that manufacturing is generally expanding, while readings below 50 indicate that manufacturing is generally declining.

In the September ISM report, the Manufacturing Index posted a reading of 51.6 (up from 50.6 in August). This was the 26th consecutive month the index posted a reading above 50, indicating that manufacturing in the U.S. has been expanding for more than two years. However, a deeper look at some of its subcomponents (specifically new orders and inventories) paints a different picture.

Generally speaking, the new orders component serves as an indicator of future demand, while the inventories component serves as an indicator of current supply. Comparing new orders to inventories helps to illustrate the supply/demand dynamic within the manufacturing sector, which in turn can help provide insight into future economic activity. When demand (i.e. new orders) is greater than supply (i.e. inventories), it’s a sign of future economic growth. When demand is less than supply, it’s a sign of future economic weakness.

In the September ISM report, the difference between the new orders component and the inventories component (New Orders Minus Inventories Index in the chart above) posted a reading of -2.4. This was the fourth consecutive month when the difference between new orders and inventories has been negative (a negative value in this index indicates that inventories are greater than new orders). As the chart indicates, since 1970, any time there has been a negative reading in the New Orders Minus Inventories Index for at least three consecutive months, the economy was either about to enter a recession or was in the midst of a recession. Although the current string of negative readings may be a temporary phenomenon caused in part by supply chain disruptions due to the earthquake in Japan, it is certainly not a sign of a strengthening economy.

Buying Opportunity for European Stocks?

Developed Europe has some tough economic challenges ahead. Italy and Spain just had their credit ratings downgraded putting further pressure on banks holding sovereign debt from the PIIGS nations. While Greece may not be saved from default, European leaders have indicated their commitment to not let its major institutions fail without a fight.

Developed Europe has some tough economic challenges ahead. Italy and Spain just had their credit ratings downgraded putting further pressure on banks holding sovereign debt from the PIIGS nations. While Greece may not be saved from default, European leaders have indicated their commitment to not let its major institutions fail without a fight. Talks surrounding the establishment of a fund to stabilize European banks began to materialize when Belgo-French bank Dexia, crumbling under the weight of its exposure to sovereign debt and toxic assets, was guaranteed a 90 billion euro bailout by Belgium, France, and Luxembourg. For those who believe that the Eurozone will weather the storm, the good news is that stocks are quite cheap for the major European nations as measured by P/E ratios. For example, Germany’s major stock index has a P/E ratio of 9.8 vs. its 15.8 historical median. Compare that to the S&P 500 at 12.4, and you are still looking at some intriguing bargains if you believe that not all of Europe is as weak as its weakest links. Germany’s seasonally adjusted unemployment rate at just 6.9% vs. 9.1% in the U.S. seems to suggest just that. While risks abound, the U.S. stock market is not free of exposure to Europe and Germany and France have shown resolve to keep the Eurozone intact, so maybe it’s time to consider cheaper European stocks once again.

The Euronext 100 Index is comprised of the largest and most liquid stocks traded on the exchange, encompassing French, Dutch, Belgian, and Portugese stocks. The FTSE 100 Index tracks the largest UK companies on the London Stock Exchange. The DAX Index measures the performance of the largest German companies on the Frankfurt Stock Exchange. P/E ratios are sourced from Bloomberg. Historical medians are calculated from the maximum number of data periods available for each respective index

Greek Debt Claims by Nationality of Bank

With the global equity markets moving every day on the latest news of the European debt crisis – specifically the Euro-zone’s handling of the Greek crisis – it is important to understand banks’ actual exposure levels (direct and indirect) to Greek debt. Direct exposure entails the outright holding of Greek promissory notes, while indirect exposure comprises derivative contracts, extended guarantees, and credit commitments.

With the global equity markets moving every day on the latest news of the European debt crisis – specifically the Euro-zone’s handling of the Greek crisis – it is important to understand banks’ actual exposure levels (direct and indirect) to Greek debt. Direct exposure entails the outright holding of Greek promissory notes, while indirect exposure comprises derivative contracts, extended guarantees, and credit commitments.

French banking institutions have the largest amount of direct exposure at $56.9B, followed by German ($23.8B), British ($14.7B), American ($8.9B), Italian ($4.5B), Swiss ($3.1B), Japanese ($1.3B), and Spanish ($1.1B) firms. On a direct basis, American banks appear somewhat secure relative to their French, German, and British counterparts. However, U.S. banking institutions by far have the most indirect (possibly construed as riskier) exposure at $38.4B, followed by French ($8.4B), German ($5.2B), British ($4.6B), Italian ($1.7B), Swiss ($1.4B), Spanish ($0.4B), and Japanese ($0.06B) banks.

Any default or writedown of Greek debt will greatly affect the financial systems of all countries with repercussions likely to spread throughout the global stock market. Per SEC filings, JPMorgan, Citibank, Bank of America, Goldman Sachs, and HSBC collectively have $52.4B of exposure to the PIIGS nations. While a bailout is likely for the troubled European nations in some way, no clear resolution has been reached. Unfortunately, global equity markets can be expected to feature elevated volatility until the debt problems of Greece and its fellow European countries are completely resolved.

Where’s the Yield?

Wild uncertainty in the equity markets coupled with European debt concerns have driven U.S. Treasury yields to all-time lows, and left income-driven investors searching for alternative sources of yield. While bonds will always serve as major component of an income-driven portfolio, the overarching low yield environment has led investors to look beyond the traditional sources of return.

Wild uncertainty in the equity markets coupled with European debt concerns have driven U.S. Treasury yields to all-time lows, and left income-driven investors searching for alternative sources of yield. While bonds will always serve as a major component of an income-driven portfolio, the overarching low yield environment has led investors to look beyond the traditional sources of return. This week’s Chart of the Week examines the potential of other asset classes to provide the income streams that have historically been provided by bonds.

As shown above, dividend yields for U.S. large cap equities now exceed that of the 10-year Treasury, and the MSCI EAFE and EAFE Value indices have attractive yields as well, exceeding those of the BarCap Global Bond Index and the BarCap U.S. Corporate Bond Index. The NCREIF Property Index has generated an annual income return of 6.44% as of June, 30, 2011, which provides an opportunity for greater portfolio diversification with minimal correlation. These asset classes are more volatile than traditional bond portfolios in regards to capital appreciation, but the income generation has become favorable to many options in fixed income. While it would be premature to label these trends as a new regime, it will not be surprising to see income-driven investors tilt their portfolios to include greater allocations of higher yielding (and traditionally more volatile) asset classes.

Profits, Compensation, and Unemployment: A New Pattern?

Corporate profits as a percentage of employee compensation reflect the after tax profits of companies compared to the total compensation provided to American workers.  As this percentage increases, corporate profits are increasing relative to employee compensation.

In the above chart, corporate profits as a percentage of employee compensation reflect the after tax profits of companies compared to the total compensation provided to American workers. As this percentage increases, corporate profits are increasing relative to employee compensation. Historically, corporate profits as a percentage of employee compensation and the unemployment rate have moved in opposite directions: in the past, both employees (through lower unemployment rates) and employers (through higher profits relative to employee compensation) have benefitted together during periods of prosperity and both have suffered together through difficult periods.

The historical pattern mentioned above holds for the period 1968 – 2008 when the unemployment rate and corporate profits as a % of employee compensation move in opposite directions: high relative profits for employers have historically coincided with low levels of unemployment. However, beginning in 2009 both the unemployment rate and corporate profits relative to employee compensation began to move sharply higher. This appears to be the first time in recent history that they have moved in tandem to such a dramatic degree and shows that corporate profits relative to employee compensation are at historical highs given the current unemployment rate. Intuitively, this makes sense, given that economic growth has been slow: companies have achieved profits through cost-cutting and efficiencies, which unfortunately comes at the expense of jobs. If previous patterns repeat themselves, either corporate profits relative to employee compensation will decline or the unemployment rate will begin to recede noticeably as companies begin to hire.

New Sources of a Recession?

Since 1980 the three most volatile cyclical components of GDP have been “change in private inventories”, “fixed investment in non residential structures”, and “fixed investment in residential structures”. While these three categories make up only 8% of GDP, they have historically accounted for almost 60% of any negative change in GDP during a recession.

Since 1980 the three most volatile cyclical components of GDP have been “change in private inventories”, “fixed investment in non residential structures”, and “fixed investment in residential structures”. While these three categories make up only 8% of GDP, they have historically accounted for almost 60% of any negative change in GDP during a recession.

Recent economic data indicate that the risk of recession in the U.S. has increased substantially over the last three months. However, one major difference as the chart shows, is that these components of GDP (“change in private inventories”, “fixed investment in non residential structures”, and “fixed investment in residential structures”), which typically are the key drivers of a cyclical downturn, are not anywhere close to the peak levels that are often seen leading up to a recession. In fact, “fixed investment in nonresidential structures” is almost one standard deviation below normal, “fixed investment in residential structures” is more than two standard deviations below normal, and “change in private inventories” is roughly in line with historic norms.

While this does not mean that the US cannot slide into recession in the coming months, it does mean that any recession is likely to look very different from the prior recessions the US has experienced since 1980. Since any recession is usually positive for net exports (as we saw in 2008), and given that the normal drivers of recession discussed above are already unusually low, a recession is likely to be driven by a drop in Government Consumption Expenditure or Personal Consumption Expenditure. These two components made up 91.4% of GDP in 2Q2011, but have historically been two of the most stable components of GDP.

As a result it seems likely that if a recession occurs over the next 12 months, it will be driven by lower consumer or government spending. However, since these components tend to be very stable, both a deep recession or a rapid recovery seem unlikely.

Labor Share and Corporate Profits

Since the 1980’s until the most recent recession, the U.S. maintained relatively stable GDP growth.  However, this growth was not evenly apportioned.  During this time, income inequality increased, and labor’s share of output declined.

The chart above shows labor share on the left axis, and corporate profits as a percentage of GDP on the right axis. Labor share is calculated by the U.S. Bureau of Labor Statistics, and measures the percentage of output that employers pay in employee compensation. Corporate profits as a percentage of GDP is calculated based on the U.S. Bureau of Economic Analysis (BEA). It includes income earned abroad by corporations.

Since the 1980’s until the most recent recession, the U.S. maintained relatively stable GDP growth. However, this growth was not evenly apportioned. During this time, income inequality increased, and labor’s share of output declined. Over the past decade this loss in income was supplemented with an increase in leverage, including mortgage debt. The subsequent consumer deleveraging has led to weak aggregate demand and tepid GDP growth out of the recession. With lower wage costs and new sources of global demand, corporate profits soared.

In the near term, these imbalances still seem firmly in place. Aggregate demand, and thus economic growth, is weak. Earnings growth remains comparatively strong. In the long-term, what may be good for the economy may or may not be good for corporations and the stock market. Wage inflation would improve household balance sheets by both increasing income and decreasing nominal debt burdens. However, higher costs would lead to declining corporate profits.

A Wild Summer for VIX and the Stock Market

This week’s COW takes a look at the Volatility Index (“VIX”), defined by the CBOE as the measure of short-term stock market volatility conveyed by S&P 500 option prices. It is also known as the “markets fear index”, as VIX tends to rise when markets are falling. Although the VIX has been extremely volatile since the Financial Crisis of 2008, we chronicle the events of the last two months in an effort to further illustrate the dramatic equity market movements of summer 2011.

This week’s COW takes a look at the Volatility Index (“VIX”), defined by the CBOE as the measure of short-term stock market volatility conveyed by S&P 500 option prices. It is also known as the “markets fear index”, as VIX tends to rise when markets are falling. Although the VIX has been extremely volatile since the Financial Crisis of 2008, we chronicle the events of the last two months in an effort to further illustrate the dramatic equity market movements of summer 2011.

Looking at the chart, we first notice the overall inverse relationship between the S&P 500 index (red line) and VIX (gray line); when one index is falling, the other is rising – not surprising, since we would expect market fear (as measured by the VIX) to increase when the equity market (S&P 500) is falling. Second, the month of July was relatively quiet, as neither index showed much movement over the course of the month. However, as August arrived, several events triggered substantial movements in the two indices. We focus on three of the most notable:

  • On Monday, August 8th, S&P downgraded the United States’ credit rating from AAA to AA+; VIX saw a 50% intraday gain from 32 to 48.
  • On Thursday, August 18th, VIX closed 35% higher than the previous day in the wake of more rumored problems for European banks, settling at 42.67 by end of day.
  • Finally, August 24th featured another large movement in the VIX index when it was announced that the CEO of Apple, Steve Jobs, was resigning due to health concerns. VIX quickly subsided though as markets expressed confidence in his successor to maintain Apple’s impressive run.

For the sake of comparison, the five-year average of the VIX index is 24.32; thus these elevated figures in August certainly reflect a higher than normal volatility, which has indeed played out in the equity markets. Although the figures do not approach the all-time high of 96.4 when markets were collapsing in October of 2008, the elevated levels have made investors stand up and take notice. Unfortunately, the VIX will likely continue to be volatile, which is a direct reflection of expected choppiness in the equity markets.

Will Excess Reserves Lead to Inflation?

This week’s chart looks at the amount of excess reserves banks are holding at the Federal Reserve (orange line) along with the corresponding changes to the Federal Reserve’s balance sheet (black line). As of the end of July 2011, banks are holding over $1.6 trillion in excess reserves, which is notably higher than what historical averages would suggest. This has led some market commentators to worry about inflation escalating as banks begin to lend out those assets (note that overall loans and leases issued by commercial banks, as represented by the red line, have fallen since the Financial Crisis of 2008 – 2009).

This week’s chart looks at the amount of excess reserves banks are holding at the Federal Reserve (orange line) along with the corresponding changes to the Federal Reserve’s balance sheet (black line). As of the end of July 2011, banks are holding over $1.6 trillion in excess reserves, which is notably higher than what historical averages would suggest. This has led some market commentators to worry about inflation escalating as banks begin to lend out those assets (note that overall loans and leases issued by commercial banks, as represented by the red line, have fallen since the Financial Crisis of 2008 – 2009).

In the United States, all depository institutions (commercial banks, savings and loans, credit unions, etc.) are required by the Fed to satisfy a reserve requirement (or liquidity ratio): each bank must retain a certain amount of cash that cannot be used for loans to business or consumers. Any reserves held above the required amount are considered “excess reserves”.

Historically, institutions have minimized their excess reserves because it is generally more profitable to issue loans than to hold the cash (the banks can earn higher amounts of interest via loans). When money is lent by banks, it can have what is called a multiplier effect on money supply: because banks only have to hold a small percentage of assets to meet the reserve requirement, they are able to increase the money supply by lending. For instance, with a 10% reserve requirement, $100 could theoretically be turned into $1,000 through the multiplier effect.

As a result of this theory, many market commentators have expressed concern over the current large level of excess reserves held by banks. Based on this macroeconomic theory, even a relatively small decline in excess reserves of $100 billion could theoretically increase the money supply by $1 trillion (assuming a reserve requirement of 10%).

The Fed is confident that inflation is not a near term threat to the economy, and when (if) inflation does become a concern, it has the tools to control the growth of price levels. A large output gap in the U.S. economy, high levels of unemployment, and slow wage growth are the most commonly cited reasons for the expected low levels of future inflation. The Fed also has a few tools to help combat inflation from excess reserves, including selling large amounts of securities from its balance sheet (either outright sales or using reverse repurchase agreements) or increasing the interest rate it pays on excess reserves to incent banks to continue to hold excess reserves. The ability to pay interest on excess reserves is a new tool for the Fed and in its view alters the theory behind the multiplier effect.

The fact remains that the U.S. is in uncharted monetary policy territory, with little historical precedent to rely on. As Fed Vice Chairman Donald Kohn said, “the calibration of our exit from these policies is complicated by a paucity of evidence on how unconventional policies work. We will need to be flexible and adjust as we gain experience”.

Frequency and Magnitude of Stock Market Corrections

This week’s chart examines the frequency and magnitude of market corrections in the U.S. equity market, as measured by the S&P 500 Index. A market correction is defined as a decrease of 10% or more within one calendar year.

This week’s chart examines the frequency and magnitude of market corrections in the U.S. equity market, as measured by the S&P 500 Index. A market correction is defined as a decrease of 10% or more within one calendar year. Using data back to 1950, we found that every year featured at least one market drawdown, and over half of those years (35 of the 62 years, approximately 56%) were true market corrections. What is even more interesting is how large some of these corrections were, with 11 of those years seeing intra-year declines of over 20%. So while the steep drop over the last week has contributed to an 18% decline in the S&P 500 Index (through Monday’s close), perhaps investors can find some reassurance knowing that more severe market corrections have occurred in the past.