Home arrow Financial Commentary arrow 2006 Quarterly Text arrow Ben Bernanke is an Economist?
Ben Bernanke is an Economist? Print E-mail

The Economy

Of all the data we money managers review for signs of economic vigor, none surpasses the employment report in importance. It is our portal to the future performance of the economy. We place great stake in this report as it provides a window into the minds of corporate leaders regarding economic expansion. It hints at the working man and woman’s future spending and borrowing plans. We catch a whiff of inflation expectations, the direction of the stock and bond markets, Fed Policy and who will win the World Series. It’s all in how you read the tea leaves. It’s the economist’s favored indicator because it provides an opportunity to show the world the value of a hard-earned and over-priced degree. All of the economist’s accumulated knowledge comes to bear on this once monthly data release. For money managers, the anticipation is palpable, as we sit before our Bloomberg screens with economists’ predictions clutched in our sweaty hands, knowing the future value of our client’s investment portfolios may well hang in the balance. The June Employment Report, released July 7th, enjoyed more than the usual hype. Economists from many of the major firms made sudden, sharp upward revisions in their payroll predictions, all in the eleventh hour. The numbers were crunched and re-crunched, as only expert economists can crunch them. The buzz on the street was that this report could be a Blockbuster! A hush fell over the world’s financial markets. And the number is . . .I rose from my seat as the payroll numbers tumbled across my flat panels. I gazed into the mirror and asked, “Are all economists spineless creatures bending to the wind, lacking in both conviction and conscience? Are they practitioners of a dark and false science trained in meaningless platitudes and wholly conditional laws?” The handsome devil in the mirror replied, “Perhaps, but my opinion may be misguided and is therefore subject to revision,” thus confirming my membership in this dubious club. Why am I upset with my brethren, those over-paid pinheads toiling in expensive suites in the bowels of banks, brokerages and consulting firms? I’ll tell you why. Following years of study at prestigious universities, deciphering economic theory and emerging as self-declared Keynesians, Supply-Siders, Monetarists or neo-classical devotee’s, they flopped at crunch time like the ‘62 Mets. What might cause an educated professional to discard the teachings that cost a small fortune and guide a lucrative career? The pied piper in this instance was someone at Automatic Data Processing. Yup, the guys at ADP, who may be processing your employee payroll and benefits, or mine, proved to be the market movers who rocked the very foundation of modern economic analysis. ADP warned that, in their opinion, the US economy was roaring ahead at a breakneck pace, about to break a six year record by adding 368,000 private sector jobs in June. The whisper on the street, passed by email, voice line and financial reporter was, “Hey, these guys at ADP are sharp, they’re onto something.” Despite anecdotal evidence to the contrary, and years of book learnin’, the economist community (think herd) raced to up their predictions. Goldman Sachs hedged the ADP opinion by boosting their published estimate by 100,000 jobs to 250,000. Not to be outdone, other firms jumped to 300,000 new non-farm jobs. The bond market braced for a major sell-off. A number like this could keep the Fed in a tightening mode for the rest of the year. The number, give me the number . . . . Oops! Ouch! Wow! The US Economy added a mere 121,000 jobs with a quarter of those coming from local and state government hiring. About 75,000 new hires were concentrated in restaurants, bars, and health care. Restaurants, bars and hospitals, there must be a connection. The average monthly employment gain dropped to only 108,000 for the second quarter of 2006, below the first quarter’s 176,000 and the long term average of 235,000 new jobs per month. Construction, retail, and manufacturing employment were essentially flat, reflecting a slowing economy. It is clear that rising interest rates and energy costs coupled with a weakening housing market are slowing consumption and hiring. The largest threat to US growth, cited in a Wall Street Journal poll of, dare I say it, economists, is that the Fed (also economists) will overshoot, raising borrowing costs to a level that may cause a recession in 2007. If I have learned anything in the “professional seasoning process,” it is to be consistent, avoid changing horses at every loggerhead and to take a deep cleansing breath and a healthy serving of my favorite beverage before swallowing what is often served up as “professional opinion.” At ICM, we see the economy slowing the second half of 2006. Inflation will be sticky at 2.5% to 3% on an annual basis. Many of the forces depressing prices are being stretched. Productivity gains are harder to come by late in economic expansions. And while there are billions of workers waiting in the wings to take high paying jobs at half the going wage, the pool of sufficiently skilled workers is slow to match corporate demand. China’s appetite for raw material will keep pressure on industrial and building commodity prices. The Chinese economy will grow along with its trade surplus by 10% or more in 2006. Oil is a depleting commodity. The fact is not on those  with the stuff beneath their soil. Geo-political threats to supply abound. Bullets fly and bombs explode and nukes proliferate in an around much of the world’s oil supply. Russia, Venezuela and the Middle East all have love/hate relationships with their largest consumer, America. Our best guess is that gasoline prices with likely stay high, above $2.50 per gallon, with crude around $70 per barrel, for the remainder of the year. An energy shock in the form of supply disruption could send prices even higher. It is hurricane season once again and little has been done to protect or improve our domestic refinery capacity in the Gulf of Mexico. Flat to lower housing prices will slow the velocity of the real estate ATM and drain liquidity from the discretionary spending reservoir. Those adjustable rate mortgages that looked so good just a year ago are ratcheting upward. Minimum credit card payments have also risen this year. In short, the average consumer is carrying a heavier debt burden than at any time since the economic expansion began some five years ago. Our message has remained constant regarding the state of the economy. We take the long term macro view that economic and interest rate cycles play out over the course of several years. At ICM, we stand by our predictions and convictions. Hmm, I wonder who does our payroll?

The Fed

Did I mention that Ben Bernanke is an economist?  Mr. Bernanke was sworn in as the Chairman of the Board of Governors of the United States Federal Reserve on February 1st, 2006. Don’t get me wrong, Ben Bernanke is brilliant man, an intellectual of some accomplishment. He scored 1590 out of 1600 on his SAT. I wonder which question he missed. Ben graduated from Harvard summa cum laude in 1975 and earned his PhD at MIT in 1979. He taught economics at NYU and Stanford and is a tenured professor in the Department of Economics at Princeton University, a department he chaired from 1996 through 2002. Mr. Bernanke has been a member of the Fed Board of Governors and was Chairman of President Bush’s Council of Economic Advisors. At the time of his much anticipated appointment to the Chairmanship of the Fed critics noted that Ben had never had a real job. I’m not insulting teachers. If I were smart I’d be one now. But Ben has dwelled exclusively in either the ivory towers of higher learning or the marble monuments of the Federal Government. Searching his resume has turned up neither paper route nor lemonade stand. His decisions and actions will be based on economic theory without the benefit of having held a position in the corporate world. One of Mr. Bernanke’s first rubs with the real world came a few months into his new Fed gig. While having what he thought to be a private conversation with CNBC’s “Money Honey” Maria Bartiromo, Ben said in effect the markets had him all wrong and that he might delay further rate increases. As much a news shark as a money honey the lovely Ms Bartiromo made public the conversation in question the following day as the lead story on CNBC.  Ben is not the first man to disclose more information to a pretty girl than might, in hindsight, seem prudent. His detractors cut him little slack. There is more to Mr. Bernanke’s perceived image problem than the lack of experience as a capitalist or “the money honey incident” as it has come to be known. Ben is seen by inflation hawks and bond market vigilantes as a monetarist who is soft on inflation. To some in the markets and press that is akin to an alcoholic running a liquor store. Talk of Bernanke replacing Greenspan had already begun when the scent of Japanese style asset deflation hung in the air in the US. Mr. Bernanke was on the markets’ radar screens when he gave a number of speeches about how the Fed could battle the deflationary threat by firing up the printing presses at the US mint. Ben even appeared to be endorsing the virtues of a little inflation in the footnotes of a speech he delivered in 2002 where he wrote, “people know that inflation erodes the real value of the government’s debt and, therefore, that it is in the interest of the government to create some inflation.” The father of the monetarist theory of economics (to which Bernanke and Greenspan subscribe) is the Nobel Prize winner  Milton Friedman. Milton’s most famous quote is “inflation is always and everywhere a monetary phenomenon.” Monetarists believe the remedy for economic ills lies in proper manipulation of the supply and cost of money. Mr. Friedman wrote that a solution to deflation could be to use a helicopter to drop money on an economy.  Mr. Bernanke picked up the moniker “Helicopter Ben”, neither as catchy as the “Money Honey” nor as complimentary. Ben is trying to buff up his image as an inflation fighter and a communicator. But it seems the more he speaks to the media the muddier the financial waters become. A Bloomberg article written by John Fraher on July 9th said, “Bernanke and his colleagues have found it difficult to convey a consistent message. They first signaled in April that they might hold off additional rate increases , then ratcheted up their anti inflation rhetoric in May and June before returning to hints of a pause in the statement following the June 29 rate increase.” Former Fed Governor Larry Meyer complained recently, “The message has been shifting.” Meyer, a private sector consultant, no longer appreciates the obtuse nature of Fed-speak. Who cares if Ben is a bit unclear and inconsistent? The Dow climbed 195 points April 18th after Fed minutes suggested the end of rate hike was near. Three weeks later the bottom fell out of the Dow Industrial Average as it plunged 142 points when the Fed suggested increases might continue. Ben uttered the phrase “unwelcome inflation” in assessing the economy on June 5th and the Dow dumped 199 points. The DOW staged its biggest rally in three years following the June 29th Fed meeting when talk of a halt to rate increases trumped the 25 basis point hike in the Funds Rate. Confused? Did I mention that Ben Bernanke is an economist? We see the market’s confusion and the Fed’s lack of clarity and consistency as a function of a difficult set of choices. The choices are imbedded in the mission statement of the Federal Reserve, namely, balancing price stability with full employment and sustainable economic growth. The economy is slowing and we know that monetary policy works with a lag. We won’t know the full effect of this year’s rate hikes until next year. We do know that today’s inflation rate is accelerating in real time. Inflation may ebb along with the economy but there is no guarantee. Will the Fed choose to fight the inflation devil it can see and touch today or the recession devil that may be lurking around the corner tomorrow? The Fed and Bernanke in particular are feeling the pressure to reassert their inflation fighting credentials. They will be vigilant. But they do not want to preside over a recession so early in the Bernanke run. With global rates rising to cool growth and international tensions mounting by the day it stands to reason that the Fed will pause at 5.25% or 5.5%. The bear market for bonds is nearing its end.

Market Recap

Our benchmark, the 2 Year Treasury Yield climbed during the second quarter of 2006 from 4.81% to 5.18%, an increase of 37 basis points. During the quarter the Federal Reserved upped the Funds rate from 4.75% to 5.25%.The slope of the yield curve changed from essentially flat from 6 months to 30 years to an inverted slope. See figure 1. The inversion placed the 6 Month Treasury Bill yield at the peak, 5.25% in line with the Funds Rate, and the 5 Year Treasury Note yield at the trough at 5.10%. The bond market is beginning to sense the end of the tightening cycle and a fairly constructive long term inflation outlook. The yield of the Two Year Treasury Note traded below the Funds Rate during parts of April, May and June, even as the futures markets guessed the Fed would continue to hike.  See figure 2. The slope of the curve has been inverted off and on over the past year and was the source of the “Greenspan Conundrum”. Mr. Greenspan’s conundrum centered around the fact that even as the Fed pushed short borrowing costs higher the yield of longer term investments like the 10 Year Treasury remained stubbornly low. Many reasons were provided from the inversion that had little to do with a slowing economy. Foreign savings poured into US bond markets, pension funds and insurance companies needed to extend investment durations to match future liabilities, corporations were investing in securities rather than infrastructure. In short there were a number of plausible explanations, none of which satisfied the out-going Chairman. It is our humble opinion that the scenario has shifted. In a world of rising interest rates and tightening monetary policy we will find that economies dependent upon a low cost of funds (debt) and asset appreciation (real estate) are more vulnerable than those based on income. Income growth in the US has stagnated on an inflation adjusted basis during this economic expansion. The US consumer has found wealth and spending money in the interest rate driven real estate market and has extracted equity largely tied to floating rate loans. The dynamics of this source of liquidity have changed. While Greenspan and now Bernanke enact a tightening rate policy to combat inflation the risk to economic growth increases. It is to that risk we attribute the inverted curve and Treasury Note yields dipping below Fed Funds. Another indicator of economic conditions can be found in the corporate bond market. The same issues pulling on consumer balance sheets are found in the business world. Borrowing costs, energy costs and rising foreign labor cost are weighing on profit margins. Corporate bonds from AAA rated General Electric to junk rated energy and auto bonds have put in their worst performance in years. It is our belief that corporate bonds will under perform government debt. Investors have pulled in their horns on risk assets in the emerging markets of Asia and the Americas too. Not to beat a dead horse but most of you received our opinion on FNMA on May 10th and know we have continued to avoid investing in the mortgage giant for obvious reasons.  The short duration in our client portfolios has protected market value and produced total returns in excess of the Merrill Lynch 1-3 Year index.

Market Outlook

We look for a further inversion of the yield curve if the Federal Reserve continues to raise the Fed Funds Rate. The Funds Rate currently stands at 5.25% and the Fed has hinted that it is nearing the end of the tightening cycle. Baring run away inflation monetary policy is set to pause at 5.25% or 5.50%. The Two Year Treasury yield should track the Funds Rate fairly closely and stabilize in the second half of 2006. Prices will firm and total returns will more closely approximate coupon interest payments. In this environment two and three year maturities will provide the best risk reward profiles. As always we will focus on safety of principle and will match the duration of investments to your liquidity needs. Portfolio interest income will increase as assets are reinvested in the 5.00% to 5.5% yields that should prevail through the second half of 2006.