Catalpa Capital Advisors
Macro Insight: One-Way Ben

The history books might call him “One-Way Ben.” After finishing off his predecessor’s tightening cycle in the early months of 2006, Ben Bernanke shifted into easing mode even before the global financial crisis erupted and then became the first chief of the US central bank to slash the federal funds rate all the way to zero. The Fed now says rates will stay there until unemployment drops below 6.5%, which they don’t expect to happen until Bernanke is long gone.

Most central banks have a mandate to keep inflation low and many have adopted a specific inflation target. Under Ben Bernanke, the US central bank set a target of 2.0% in early 2012 and had committed to keep rates low into 2015, provided inflation also remained muted.

Unlike many central banks, however, the Fed has an additional mandate to keep unemployment low as well, currently running at 7.7% (the blue line in the chart). In a major policy shift at their last meeting, the Fed set a hard target for unemployment of 6.5% (the dashed line). For investors, the change from the calendar to the economic data now means that the best single indicator of Fed policy is the labor market, as measured by the unemployment rate.

The Fed’s singular focus on the unemployment rate might be misplaced. The job openings rate, an alternative measure of the health of the labor market, just returned to its cycle high (the red line in the chart, inverted on the right axis). Whereas the unemployment rate comes from a survey of households and simply measures how many people say they are out of work but looking, the job openings rate comes directly from businesses who report how many jobs they have available. Because of the added time needed to crunch the numbers, it comes out a month later. It also has a shorter history.

In earlier years, the current job opening rate of 2.7% would translate into an unemployment rate of around 6.0%, well below its current level and also below the Fed’s new threshold for monetary tightening. Insights explored the break in the relationship in July 2010 and economists still debate whether the shift reflects a skills shortage (unemployed people lack the experience businesses need) or simply a reluctance of businesses to fill the job openings they have (because of their cautious economic outlook, for instance). While both indicators show a similar pace of recovery, the gap has held constant.

If it turns out that businesses are providing a better measure of the labor market than the household surveys, the Fed risks misreading the health of the economy and might need to raise rates at a faster clip down the road. In the meantime, the ongoing flow of easy money could be like adrenaline for an otherwise reasonably healthy economy … and like steroids for the stock market.

Ben Bernanke has said he plans to step down when his current term comes to an end in January 2014, well before the Fed forecasts the unemployment rate to be low enough for rates to rise. While it is too early to know who will be the new chair, one thing is for certain. With US interest rates at zero thanks to One-Way Ben, his successor will have only one way to go: up.

Macro Insight: One-Way Ben

The history books might call him “One-Way Ben.” After finishing off his predecessor’s tightening cycle in the early months of 2006, Ben Bernanke shifted into easing mode even before the global financial crisis erupted and then became the first chief of the US central bank to slash the federal funds rate all the way to zero. The Fed now says rates will stay there until unemployment drops below 6.5%, which they don’t expect to happen until Bernanke is long gone.

Most central banks have a mandate to keep inflation low and many have adopted a specific inflation target. Under Ben Bernanke, the US central bank set a target of 2.0% in early 2012 and had committed to keep rates low into 2015, provided inflation also remained muted.

Unlike many central banks, however, the Fed has an additional mandate to keep unemployment low as well, currently running at 7.7% (the blue line in the chart). In a major policy shift at their last meeting, the Fed set a hard target for unemployment of 6.5% (the dashed line). For investors, the change from the calendar to the economic data now means that the best single indicator of Fed policy is the labor market, as measured by the unemployment rate.

The Fed’s singular focus on the unemployment rate might be misplaced. The job openings rate, an alternative measure of the health of the labor market, just returned to its cycle high (the red line in the chart, inverted on the right axis). Whereas the unemployment rate comes from a survey of households and simply measures how many people say they are out of work but looking, the job openings rate comes directly from businesses who report how many jobs they have available. Because of the added time needed to crunch the numbers, it comes out a month later. It also has a shorter history.

In earlier years, the current job opening rate of 2.7% would translate into an unemployment rate of around 6.0%, well below its current level and also below the Fed’s new threshold for monetary tightening. Insights explored the break in the relationship in July 2010 and economists still debate whether the shift reflects a skills shortage (unemployed people lack the experience businesses need) or simply a reluctance of businesses to fill the job openings they have (because of their cautious economic outlook, for instance). While both indicators show a similar pace of recovery, the gap has held constant.

If it turns out that businesses are providing a better measure of the labor market than the household surveys, the Fed risks misreading the health of the economy and might need to raise rates at a faster clip down the road. In the meantime, the ongoing flow of easy money could be like adrenaline for an otherwise reasonably healthy economy … and like steroids for the stock market.

Ben Bernanke has said he plans to step down when his current term comes to an end in January 2014, well before the Fed forecasts the unemployment rate to be low enough for rates to rise. While it is too early to know who will be the new chair, one thing is for certain. With US interest rates at zero thanks to One-Way Ben, his successor will have only one way to go: up.

Macro Insight: The Mean Reversion of US Residential InvestmentMaking the case for a recovery in US housing used to be pretty lonely. As the data steadily builds, the question has now shifted to how far the recovery can go. As impressive as the turn in residential investment has been, when viewed over the longer term it is just getting started.Household formation surged in the decade after World War II, as soldiers returned home and the boomers were born. In those post-war years, housing’s share of real GDP averaged 7.4%. After 1960, housing’s share settled into a lower equilibrium and has since averaged 5.6%, a more conservative reference point for assessing where the housing market could be heading today.During the recent boom, residential investment’s share of GDP peaked at 6.2% in 2005 and then began a lengthy and painful descent. Housing contracted for a record 14 straight quarters, on average slicing a full percentage point from the economy’s annualized growth rate. By the time the housing sector finally hit bottom in early 2011, its share of GDP had been cut by more than half to just 2.4%.Housing cycles tend to be symmetrical: the steepness of the decline is typically mirrored by the slope of the recovery, a pattern that economists call the “Zarnowitz Rule,” after the pioneering business-cycle economist Victor Zarnowitz. The recent housing downturn was particularly fierce and, now that the recovery is here, the upturn could be equally robust.Projecting out a recovery over the same time frame as the bust, housing could approach its average share of GDP sometime in the next three years or so. Residential investment has already been adding about a quarter of a percentage point to annualized GDP growth over the past six quarters. As the housing recovery gains steam, residential investment could directly contribute up to a percentage point to the economy’s growth rate. Some sectors of the economy are already picking up strength, from homebuilders to mortgage financing. A few industries shut down so much of their production during the bust that they are having a hard time keeping up with the recovery: building materials such as plywood and drywall are reportedly in short supply.In past business cycles, residential investment was typically an early mover, as homebuilders took advantage of low interest rates for new construction before the Fed tightened rates. In this cycle, housing is arriving late, pent-up demand is high, and the Fed says interest rates will stay low through 2015. The mean reversion of residential investment could propel the economy’s growth well into the late stages of this cycle.

Macro Insight: The Mean Reversion of US Residential Investment

Making the case for a recovery in US housing used to be pretty lonely. As the data steadily builds, the question has now shifted to how far the recovery can go. As impressive as the turn in residential investment has been, when viewed over the longer term it is just getting started.

Household formation surged in the decade after World War II, as soldiers returned home and the boomers were born. In those post-war years, housing’s share of real GDP averaged 7.4%. After 1960, housing’s share settled into a lower equilibrium and has since averaged 5.6%, a more conservative reference point for assessing where the housing market could be heading today.

During the recent boom, residential investment’s share of GDP peaked at 6.2% in 2005 and then began a lengthy and painful descent. Housing contracted for a record 14 straight quarters, on average slicing a full percentage point from the economy’s annualized growth rate. By the time the housing sector finally hit bottom in early 2011, its share of GDP had been cut by more than half to just 2.4%.

Housing cycles tend to be symmetrical: the steepness of the decline is typically mirrored by the slope of the recovery, a pattern that economists call the “Zarnowitz Rule,” after the pioneering business-cycle economist Victor Zarnowitz. The recent housing downturn was particularly fierce and, now that the recovery is here, the upturn could be equally robust.

Projecting out a recovery over the same time frame as the bust, housing could approach its average share of GDP sometime in the next three years or so. Residential investment has already been adding about a quarter of a percentage point to annualized GDP growth over the past six quarters. As the housing recovery gains steam, residential investment could directly contribute up to a percentage point to the economy’s growth rate.

Some sectors of the economy are already picking up strength, from homebuilders to mortgage financing. A few industries shut down so much of their production during the bust that they are having a hard time keeping up with the recovery: building materials such as plywood and drywall are reportedly in short supply.

In past business cycles, residential investment was typically an early mover, as homebuilders took advantage of low interest rates for new construction before the Fed tightened rates. In this cycle, housing is arriving late, pent-up demand is high, and the Fed says interest rates will stay low through 2015. The mean reversion of residential investment could propel the economy’s growth well into the late stages of this cycle.

Macro Insight: When Incumbents Win
The drop in the US unemployment rate to 7.8% in September extends the downward trend that’s been unfolding for the past three years. While the overall pace might be slow, the decline in the unemployment rate from its peak is unmistakable. For incumbent US presidents seeking reelection to a second full term, that’s all that matters.
Insights last examined the relationship between incumbents and unemployment in May 2011, showing how post-war US presidents won a second full term if the unemployment rate went down during the election year, and vice versa. Since World War II, ten prior US presidents have run for reelection. Three of them inherited their offices but didn’t run for second full terms. Ford succeeded Nixon but failed to win on his own. Truman and Johnson won their own first terms but dropped out for the second.
Seven presidents ran for a second full term. Five of them won with clear margins of victory in the popular vote when unemployment was falling (the green dots in the chart). In 2004, for instance, the unemployment rate averaged 5.5% for the full year, a decline from an average of 6.0% the year before, and George W. Bush duly won reelection with a 2.5% margin of victory in the popular vote. In contrast, the other two incumbents lost when the unemployment rate was rising (the orange dots).
There’s now enough data to see how the current incumbent might fare this election year. The light green line shows the change in the unemployment rate in 2012 to date: Last year the unemployment rate averaged 9.0% and it’s averaged 8.2% so far this year, an improvement of 0.8 percentage points, suggesting high odds of reelection. If the trend continues, the full year improvement will go up, as does the likely margin of victory.
Notably, the directional change in the unemployment rate matters more than the level. In 1980, for instance, the unemployment rate was 7.2%, up considerably from the prior year and Carter lost his reelection. In 1984, the unemployment rate was even higher at 7.5%, but it was falling from the year before and Reagan won reelection in a landslide. The trend is the key.
Political scientists have written many papers exploring the relationship between the economy and elections, offering as many theories as there are academics. Narrowing the question to just incumbents and the unemployment rate helps cut through the thickets: A run for a second full term inevitably becomes a referendum on the first. No matter how the incumbent or the challenger might try to position the race, so far the electorate has consistently given a thumbs up to the incumbent when unemployment is going down.

Macro Insight: When Incumbents Win

The drop in the US unemployment rate to 7.8% in September extends the downward trend that’s been unfolding for the past three years. While the overall pace might be slow, the decline in the unemployment rate from its peak is unmistakable. For incumbent US presidents seeking reelection to a second full term, that’s all that matters.

Insights last examined the relationship between incumbents and unemployment in May 2011, showing how post-war US presidents won a second full term if the unemployment rate went down during the election year, and vice versa. Since World War II, ten prior US presidents have run for reelection. Three of them inherited their offices but didn’t run for second full terms. Ford succeeded Nixon but failed to win on his own. Truman and Johnson won their own first terms but dropped out for the second.

Seven presidents ran for a second full term. Five of them won with clear margins of victory in the popular vote when unemployment was falling (the green dots in the chart). In 2004, for instance, the unemployment rate averaged 5.5% for the full year, a decline from an average of 6.0% the year before, and George W. Bush duly won reelection with a 2.5% margin of victory in the popular vote. In contrast, the other two incumbents lost when the unemployment rate was rising (the orange dots).

There’s now enough data to see how the current incumbent might fare this election year. The light green line shows the change in the unemployment rate in 2012 to date: Last year the unemployment rate averaged 9.0% and it’s averaged 8.2% so far this year, an improvement of 0.8 percentage points, suggesting high odds of reelection. If the trend continues, the full year improvement will go up, as does the likely margin of victory.

Notably, the directional change in the unemployment rate matters more than the level. In 1980, for instance, the unemployment rate was 7.2%, up considerably from the prior year and Carter lost his reelection. In 1984, the unemployment rate was even higher at 7.5%, but it was falling from the year before and Reagan won reelection in a landslide. The trend is the key.

Political scientists have written many papers exploring the relationship between the economy and elections, offering as many theories as there are academics. Narrowing the question to just incumbents and the unemployment rate helps cut through the thickets: A run for a second full term inevitably becomes a referendum on the first. No matter how the incumbent or the challenger might try to position the race, so far the electorate has consistently given a thumbs up to the incumbent when unemployment is going down.

Macro Insight: US Housing Heals

After a few fitful starts, the US housing recovery is gathering momentum. New and existing home sales are up. Homebuilder confidence is stronger. Perhaps most important of all, house prices throughout the country are rising.

All 20 cities in the S&P Case-Shiller Home Price Index have now put in a bottom. Some cities have been healing for quite some time: in San Francisco, home prices stopped falling in March 2009 and are already up 18.1% (the dark bars in the chart). At the other end of the spectrum, New York reached its low earlier this year and home prices are now up 3.7%. Overall, the 20-City Home Price Index is up 6.0% (the dark orange bar).

A few cities are posting record-breaking monthly gains. Although the data only goes back two decades, home prices in Detroit were up 6.0% in June, the strongest ever. Atlanta and Chicago also posted record gains. Since the Case-Shiller data is not seasonally adjusted, the pace of gains will be tempered in coming months. But the trajectory is clearly up.

As broad as the recovery in home prices has been, there is still a long way to go. In order to return to peak levels, the overall home price index needs to gain a total of 54.0% from the trough; so far, it is just over a tenth of the way. Dallas is the most advanced: its decline of 11.2% was the smallest during the bust and it is already more than halfway back. Meanwhile in Las Vegas, the city where the biggest bubble popped, home prices plunged 61.7% and are up a modest 4.5% from the trough; it could be many, many years before house prices fully recover.

If sustained, rising home prices will do a world of good for the US economy. A large share of homeowners with negative equity will find themselves back above water. The legions of banks that had written down their real estate assets will need to write them back up. As higher prices feed into appraisals, cash-strapped local and state governments will be lifted out of the red as property tax revenues rise. The Federal Reserve, for its part, will finally allow their myriad alternative stimulus measures to expire and return to traditional monetary policy.

Home prices in the US might be approaching an important tipping point. Many potential homeowners stayed on the sidelines when prices were falling, waiting for the bargains to get even better. With incomes strong and mortgage rates at record lows, housing affordability might be as good as it will ever get. As pent-up demand enters the market, house prices will receive further support in a self-reinforcing cycle that accelerates the healing process in housing.

Macro Insight: US Housing Heals

After a few fitful starts, the US housing recovery is gathering momentum. New and existing home sales are up. Homebuilder confidence is stronger. Perhaps most important of all, house prices throughout the country are rising.

All 20 cities in the S&P Case-Shiller Home Price Index have now put in a bottom. Some cities have been healing for quite some time: in San Francisco, home prices stopped falling in March 2009 and are already up 18.1% (the dark bars in the chart). At the other end of the spectrum, New York reached its low earlier this year and home prices are now up 3.7%. Overall, the 20-City Home Price Index is up 6.0% (the dark orange bar).

A few cities are posting record-breaking monthly gains. Although the data only goes back two decades, home prices in Detroit were up 6.0% in June, the strongest ever. Atlanta and Chicago also posted record gains. Since the Case-Shiller data is not seasonally adjusted, the pace of gains will be tempered in coming months. But the trajectory is clearly up.

As broad as the recovery in home prices has been, there is still a long way to go. In order to return to peak levels, the overall home price index needs to gain a total of 54.0% from the trough; so far, it is just over a tenth of the way. Dallas is the most advanced: its decline of 11.2% was the smallest during the bust and it is already more than halfway back. Meanwhile in Las Vegas, the city where the biggest bubble popped, home prices plunged 61.7% and are up a modest 4.5% from the trough; it could be many, many years before house prices fully recover.

If sustained, rising home prices will do a world of good for the US economy. A large share of homeowners with negative equity will find themselves back above water. The legions of banks that had written down their real estate assets will need to write them back up. As higher prices feed into appraisals, cash-strapped local and state governments will be lifted out of the red as property tax revenues rise. The Federal Reserve, for its part, will finally allow their myriad alternative stimulus measures to expire and return to traditional monetary policy.

Home prices in the US might be approaching an important tipping point. Many potential homeowners stayed on the sidelines when prices were falling, waiting for the bargains to get even better. With incomes strong and mortgage rates at record lows, housing affordability might be as good as it will ever get. As pent-up demand enters the market, house prices will receive further support in a self-reinforcing cycle that accelerates the healing process in housing.

Macro Insight: Drought Fallout
Hungry people standing in bread lines start revolutions: France in 1789, Russia in 1917, Egypt in 2011. That fact must make certain regimes around the world uneasy as the global drought now unfolding causes crops to fail and grain prices to surge. For everyone else, higher food prices are in store and a return to global inflation looms.
In the United States, the world’s largest grain exporter, a warm spring encouraged early planting and predictions of record crops. Instead, the hot summer is now scorching the country’s farmland. The last 12 months have been the hottest since the US started keeping records in 1895. According to the US Drought Monitor, 53% of the country is experiencing drought conditions, the most since 1956. The US Department of Agriculture has already cut its corn crop forecast by 12%.
Globally, land temperatures are now the highest on record. According to the Global Drought Monitor, severe conditions extend from the US and into Canada; reach across much of central Africa, India, Europe, and central Asia; and affect parts of Australia and South America. The International Grains Council recently cut its global forecast, particularly for wheat.
The worldwide drought has already pushed corn futures up 56% since the start of June. Wheat is close behind, jumping nearly 40%. Soybeans recently hit a new record high. Barley, rice, rapeseed, and other grain prices are also up.
The spike in grain prices is beginning to spill over into the broader economy. US ranchers are reducing their cattle herds because of the higher feed costs, which eventually will mean higher meat prices. Restaurants and food packaging companies could see their thin margins squeezed even tighter. If sustained, the pass-through of higher food prices will also show up in the general price level, complicating policy options for central bankers currently accustomed to benign inflation.
The implications are especially challenging for emerging markets, where food has a larger weight in consumer prices indexes. Low inflation has provided room for interest rate cuts to spur growth in many countries. Higher prices could take away that room for maneuver and even force a policy reversal. China, in particular, could be in for a rude shock in the months ahead, just in time for their leadership transition in the fall.
This is now the third surge in grain prices in five years. In 2007-08, food riots broke out in more than thirty countries. In 2010, many governments began to restrict exports. When Russia suspended supplies to Egypt, soaring food costs subsequently helped set the stage for what turned into the Arab Spring. So far, global inventories are holding up, but the year is barely half over and no one knows just when the drought will end. Higher grain prices can cause inflation. Food shortages cause regime change.

Macro Insight: Drought Fallout

Hungry people standing in bread lines start revolutions: France in 1789, Russia in 1917, Egypt in 2011. That fact must make certain regimes around the world uneasy as the global drought now unfolding causes crops to fail and grain prices to surge. For everyone else, higher food prices are in store and a return to global inflation looms.

In the United States, the world’s largest grain exporter, a warm spring encouraged early planting and predictions of record crops. Instead, the hot summer is now scorching the country’s farmland. The last 12 months have been the hottest since the US started keeping records in 1895. According to the US Drought Monitor, 53% of the country is experiencing drought conditions, the most since 1956. The US Department of Agriculture has already cut its corn crop forecast by 12%.

Globally, land temperatures are now the highest on record. According to the Global Drought Monitor, severe conditions extend from the US and into Canada; reach across much of central Africa, India, Europe, and central Asia; and affect parts of Australia and South America. The International Grains Council recently cut its global forecast, particularly for wheat.

The worldwide drought has already pushed corn futures up 56% since the start of June. Wheat is close behind, jumping nearly 40%. Soybeans recently hit a new record high. Barley, rice, rapeseed, and other grain prices are also up.

The spike in grain prices is beginning to spill over into the broader economy. US ranchers are reducing their cattle herds because of the higher feed costs, which eventually will mean higher meat prices. Restaurants and food packaging companies could see their thin margins squeezed even tighter. If sustained, the pass-through of higher food prices will also show up in the general price level, complicating policy options for central bankers currently accustomed to benign inflation.

The implications are especially challenging for emerging markets, where food has a larger weight in consumer prices indexes. Low inflation has provided room for interest rate cuts to spur growth in many countries. Higher prices could take away that room for maneuver and even force a policy reversal. China, in particular, could be in for a rude shock in the months ahead, just in time for their leadership transition in the fall.

This is now the third surge in grain prices in five years. In 2007-08, food riots broke out in more than thirty countries. In 2010, many governments began to restrict exports. When Russia suspended supplies to Egypt, soaring food costs subsequently helped set the stage for what turned into the Arab Spring. So far, global inventories are holding up, but the year is barely half over and no one knows just when the drought will end. Higher grain prices can cause inflation. Food shortages cause regime change.

Macro Insight: The Saudi Sanction
Normally losing Iran’s 2.5 million barrels of oil a day would be a huge problem for the global economy. But Saudi Arabia appears to be sustaining net output levels as they quietly lead the effort to deny Iran the bomb.
Sanctions against Iran have been building up for some time but now the vice is getting really tight. The US is about to implement a law that cuts off countries from the US banking system if they import oil from Iran. With a few exceptions, many countries are already reducing their imports, including China, Japan, and India. For its part, the EU will soon impose a ban on insuring any tanker that carries Iranian oil. Since 95% of the maritime insurance industry goes through Europe, the ban will effectively shut down most of Iran’s exports by sea.
The IMF calculates a “fiscal breakeven” price of oil for the countries in the Middle East and North Africa. The calculation starts with the cost of production, including equipment and labor, with the big swing factor being accessibility: oil is cheaper to drill in Saudi Arabia than in Iran. Both are more accessible than oil shale in the US or Brazil’s deep sea reserves. Additionally, the breakeven price includes taxes and other government claims on oil. Many oil-producing countries finance their social programs with oil revenues; those outlays surged when popular unrest swept the region.
In 2010, Iran’s breakeven price of oil was $68 (the blue bar). By early 2012 it had gone up $49 (the orange bar) to reach $117 (the blue dot), well above the current price of $96 for Brent (the black line). At OPEC’s recent meeting, Iran led the countries with high breakeven costs who wanted to reduce quotas and push prices higher. On the other side of the breakeven divide, Saudi Arabia sought to increase production, ostensibly to support flagging global growth. Officially, both sides agreed to leave the quotas unchanged. Unofficially, OPEC oil production remains 10% above quota, buffering Iran’s reduced exports.
Since the start of 2012, sanctions have already shut down 40% of Iran’s oil exports, pushing its effective breakeven oil cost to $195 (the red dot). With outlays vastly surpassing revenues, Iran’s foreign exchange reserves are being depleted. Meanwhile, Iran shows little inclination to yield on the core issue of uranium enrichment as the full force of sanctions loom.
Not that long ago, the loss of Iran’s oil might have caused oil prices to spike and tipped the global economy into recession. However, the world is united in thwarting Iran’s nuclear ambitions and Saudi Arabia is taking the lead to keep oil supplies higher than demand, one of several forces keeping a lid on global energy prices. And unlike other major producers that are already pumping at full tilt, Saudi Arabia still has spare capacity to tap. Saudi Arabia is the central bank of oil: it is the supplier of last resort.

Macro Insight: The Saudi Sanction

Normally losing Iran’s 2.5 million barrels of oil a day would be a huge problem for the global economy. But Saudi Arabia appears to be sustaining net output levels as they quietly lead the effort to deny Iran the bomb.

Sanctions against Iran have been building up for some time but now the vice is getting really tight. The US is about to implement a law that cuts off countries from the US banking system if they import oil from Iran. With a few exceptions, many countries are already reducing their imports, including China, Japan, and India. For its part, the EU will soon impose a ban on insuring any tanker that carries Iranian oil. Since 95% of the maritime insurance industry goes through Europe, the ban will effectively shut down most of Iran’s exports by sea.

The IMF calculates a “fiscal breakeven” price of oil for the countries in the Middle East and North Africa. The calculation starts with the cost of production, including equipment and labor, with the big swing factor being accessibility: oil is cheaper to drill in Saudi Arabia than in Iran. Both are more accessible than oil shale in the US or Brazil’s deep sea reserves. Additionally, the breakeven price includes taxes and other government claims on oil. Many oil-producing countries finance their social programs with oil revenues; those outlays surged when popular unrest swept the region.

In 2010, Iran’s breakeven price of oil was $68 (the blue bar). By early 2012 it had gone up $49 (the orange bar) to reach $117 (the blue dot), well above the current price of $96 for Brent (the black line). At OPEC’s recent meeting, Iran led the countries with high breakeven costs who wanted to reduce quotas and push prices higher. On the other side of the breakeven divide, Saudi Arabia sought to increase production, ostensibly to support flagging global growth. Officially, both sides agreed to leave the quotas unchanged. Unofficially, OPEC oil production remains 10% above quota, buffering Iran’s reduced exports.

Since the start of 2012, sanctions have already shut down 40% of Iran’s oil exports, pushing its effective breakeven oil cost to $195 (the red dot). With outlays vastly surpassing revenues, Iran’s foreign exchange reserves are being depleted. Meanwhile, Iran shows little inclination to yield on the core issue of uranium enrichment as the full force of sanctions loom.

Not that long ago, the loss of Iran’s oil might have caused oil prices to spike and tipped the global economy into recession. However, the world is united in thwarting Iran’s nuclear ambitions and Saudi Arabia is taking the lead to keep oil supplies higher than demand, one of several forces keeping a lid on global energy prices. And unlike other major producers that are already pumping at full tilt, Saudi Arabia still has spare capacity to tap. Saudi Arabia is the central bank of oil: it is the supplier of last resort.

Macro Insight: The Fracking Revolution
Back in the 1950s, Texan geologist M. King Hubbert predicted that US oil production would reach a peak by 1970, which it did. His successors predicted that global oil production would peak sometime in the mid-2000s, which it almost did. But they might end up all being wrong, thanks to hydraulic fracturing, or “fracking,” which uses pressurized fluids to release energy supplies embedded in shale and other rock formations. Combined with horizontal drilling, fracking is revolutionizing the energy business with global implications that will take decades to play out.
Drill operators in the US have been at the vanguard of the fracking revolution, starting with natural gas. In the early 1990s, the overall rig count held stable, with roughly half drilling for oil and half for natural gas. A decade later, the rig business boomed and accelerated through the 2000s, with the vast majority drilling for natural gas (the orange line in the chart) as fracking was first developed and then widely deployed. Natural gas prices duly plunged.
With US natural gas prices near historic lows, drill operators are moving their rigs to apply the same techniques to oil shale. The share of rigs drilling for oil (the blue line) started to shoot up in 2010, eclipsed natural gas rigs in 2011, and is now at a record high. The drilling boom could be a harbinger of lower oil prices, even as the shift in rigs helps natural gas prices finally find a floor.
Fracking prospectors are developing massive new oil deposits across the US. According to the Government Accountability Office, the Intermountain West’s Green River Formation alone has as much recoverable oil shale as all of the conventional oil reserves in the world put together. Add US shale to Canadian tar sands and North America is poised to be a major energy supplier in the decades ahead.
Cheap and plentiful natural gas is already transforming some industries. The production costs for fertilizer and chemical companies have plunged. Trucking fleets are converting to natural gas for fuel. Electric utilities are swapping from coal to natural gas, which is both cheaper and burns cleaner: in the EIA’s global recent scorecard of developed economies, carbon dioxide emissions have fallen the most in the US because of the shift from coal to gas. A few years ago, the US began building facilities to import liquefied natural gas; the spigots are now being turned the other way. Taken all together, for the first time since President Truman, the United States is now a net energy exporter.
Fracking is going global. Natural gas projects are underway around the world, from Argentina to Poland to China. As environmental and regulatory issues get ironed out, oil projects will undoubtedly follow and add to traditional energy sources like the Middle East and new supplies from deep-sea drilling off the coasts of Brazil and East Africa. Global oil supply is already higher than demand for the first time since 2006.
The global energy markets have long been dominated by a small number of oligarchic countries supplying oil to everyone else. As the rest of the world joins the fracking revolution, energy production will be democratized. So much for peak oil.

Macro Insight: The Fracking Revolution

Back in the 1950s, Texan geologist M. King Hubbert predicted that US oil production would reach a peak by 1970, which it did. His successors predicted that global oil production would peak sometime in the mid-2000s, which it almost did. But they might end up all being wrong, thanks to hydraulic fracturing, or “fracking,” which uses pressurized fluids to release energy supplies embedded in shale and other rock formations. Combined with horizontal drilling, fracking is revolutionizing the energy business with global implications that will take decades to play out.

Drill operators in the US have been at the vanguard of the fracking revolution, starting with natural gas. In the early 1990s, the overall rig count held stable, with roughly half drilling for oil and half for natural gas. A decade later, the rig business boomed and accelerated through the 2000s, with the vast majority drilling for natural gas (the orange line in the chart) as fracking was first developed and then widely deployed. Natural gas prices duly plunged.

With US natural gas prices near historic lows, drill operators are moving their rigs to apply the same techniques to oil shale. The share of rigs drilling for oil (the blue line) started to shoot up in 2010, eclipsed natural gas rigs in 2011, and is now at a record high. The drilling boom could be a harbinger of lower oil prices, even as the shift in rigs helps natural gas prices finally find a floor.

Fracking prospectors are developing massive new oil deposits across the US. According to the Government Accountability Office, the Intermountain West’s Green River Formation alone has as much recoverable oil shale as all of the conventional oil reserves in the world put together. Add US shale to Canadian tar sands and North America is poised to be a major energy supplier in the decades ahead.

Cheap and plentiful natural gas is already transforming some industries. The production costs for fertilizer and chemical companies have plunged. Trucking fleets are converting to natural gas for fuel. Electric utilities are swapping from coal to natural gas, which is both cheaper and burns cleaner: in the EIA’s global recent scorecard of developed economies, carbon dioxide emissions have fallen the most in the US because of the shift from coal to gas. A few years ago, the US began building facilities to import liquefied natural gas; the spigots are now being turned the other way. Taken all together, for the first time since President Truman, the United States is now a net energy exporter.

Fracking is going global. Natural gas projects are underway around the world, from Argentina to Poland to China. As environmental and regulatory issues get ironed out, oil projects will undoubtedly follow and add to traditional energy sources like the Middle East and new supplies from deep-sea drilling off the coasts of Brazil and East Africa. Global oil supply is already higher than demand for the first time since 2006.

The global energy markets have long been dominated by a small number of oligarchic countries supplying oil to everyone else. As the rest of the world joins the fracking revolution, energy production will be democratized. So much for peak oil.

Macro Insight: The Government is a Drag
The US economy posted a slower growth rate in the first quarter of 2.2%, disappointing expectations of 2.5%. The culprit wasn’t households or businesses, both of which made positive contributions. It was the government. In fact, the economy would have beat expectations if the government drag hadn’t sliced off 0.6 percentage points. 
The Bureau of Economic Analysis tracks the US economy in four major categories; three of them have been adding to growth since the end of the recession in 2009. Personal consumption is the largest category, now accounting for 70% of GDP; it has already surpassed pre-recession levels in inflation-adjusted dollars and contributed to growth in all eleven quarters of the new expansion. Private domestic investment has yet to fully recover but is well above the lows, adding to GDP in all but one quarter of the expansion. Net exports, the third category, was slower to turn but has been more supportive of growth over the last year. 
In stark contrast to the rest of the economy, government expenditures continue to contract and have now subtracted from real US GDP growth for six straight quarters, the longest such stretch since Eisenhower. The government, in other words, is still in recession. 
About half the government drag comes from reduced military outlays, which are down 7% from the peak in September 2010 and might continue to edge down as overseas commitments are further curtailed. State and local government spending accounts for the other half; this part of the drag is beginning to stabilize and was almost flat in the first quarter. 
The government’s contribution to economic growth can come directly from its expenditures and investment or indirectly through stimulus and other fiscal and monetary policies. In past business cycles since 1960,  the government itself was usually an early source of growth in a new expansion. On average, government spending directly added about half a percentage point to the growth rate through this point of an expansion, as opposed to an average quarter point reduction in this cycle. 
The government’s indirect contribution has been far more robust, although the longer-term implications have yet to be seen. There has been record-setting deficit spending at the national level and the Fed continues to hold interest rates at historic lows, together boosting personal consumption and private investment. A new study from Fitch Ratings and Oxford Economics estimates that US fiscal and monetary policies added more than 4% to overall GDP over the past two years. Some of that impact could be reversed when all the stimulus ends, particularly the scheduled expiration of the Bush/Obama tax cuts at the end of 2012. And the Fed’s eventual return to tight monetary policy looms heavily on the distant horizon. 
For now, the economy has been firing on three pistons: consumption, investment, and exports. Government, the fourth piston, has been seriously misfiring. The headline GDP numbers could therefore be understating the health of the US recovery. At this point, the private sector has plenty of steam, softer payrolls notwithstanding, and so the government itself doesn’t need to be an engine of growth. It might be enough if the government just weren’t such a drag.

Macro Insight: The Government is a Drag

The US economy posted a slower growth rate in the first quarter of 2.2%, disappointing expectations of 2.5%. The culprit wasn’t households or businesses, both of which made positive contributions. It was the government. In fact, the economy would have beat expectations if the government drag hadn’t sliced off 0.6 percentage points.

The Bureau of Economic Analysis tracks the US economy in four major categories; three of them have been adding to growth since the end of the recession in 2009. Personal consumption is the largest category, now accounting for 70% of GDP; it has already surpassed pre-recession levels in inflation-adjusted dollars and contributed to growth in all eleven quarters of the new expansion. Private domestic investment has yet to fully recover but is well above the lows, adding to GDP in all but one quarter of the expansion. Net exports, the third category, was slower to turn but has been more supportive of growth over the last year.

In stark contrast to the rest of the economy, government expenditures continue to contract and have now subtracted from real US GDP growth for six straight quarters, the longest such stretch since Eisenhower. The government, in other words, is still in recession.

About half the government drag comes from reduced military outlays, which are down 7% from the peak in September 2010 and might continue to edge down as overseas commitments are further curtailed. State and local government spending accounts for the other half; this part of the drag is beginning to stabilize and was almost flat in the first quarter.

The government’s contribution to economic growth can come directly from its expenditures and investment or indirectly through stimulus and other fiscal and monetary policies. In past business cycles since 1960,  the government itself was usually an early source of growth in a new expansion. On average, government spending directly added about half a percentage point to the growth rate through this point of an expansion, as opposed to an average quarter point reduction in this cycle.

The government’s indirect contribution has been far more robust, although the longer-term implications have yet to be seen. There has been record-setting deficit spending at the national level and the Fed continues to hold interest rates at historic lows, together boosting personal consumption and private investment. A new study from Fitch Ratings and Oxford Economics estimates that US fiscal and monetary policies added more than 4% to overall GDP over the past two years. Some of that impact could be reversed when all the stimulus ends, particularly the scheduled expiration of the Bush/Obama tax cuts at the end of 2012. And the Fed’s eventual return to tight monetary policy looms heavily on the distant horizon.

For now, the economy has been firing on three pistons: consumption, investment, and exports. Government, the fourth piston, has been seriously misfiring. The headline GDP numbers could therefore be understating the health of the US recovery. At this point, the private sector has plenty of steam, softer payrolls notwithstanding, and so the government itself doesn’t need to be an engine of growth. It might be enough if the government just weren’t such a drag.

Macro Insight: US Housing is Shovel-Ready
In past US economic cycles residential investment gave a big boost to the early stages of recovery. Not this time. Nearly three years into the expansion, the net contribution of the housing sector to real GDP is exactly zero. However, the data is beginning to stir and, critically, homebuilders could be starting to build.
Each month, the National Association of Homebuilders surveys its members about current housing conditions. The responses are then tallied into an index that is published jointly with Wells Fargo. A reading above 50 indicates that homebuilders report current conditions as being good or fair. The Housing Market Index has been below 50 for nearly six years, a record stretch of homebuilder pessimism.
The bleak outlook that homebuilders have reported in recent years is mirrored in the data. Housing starts have a strong correlation with sentiment of 0.7, according to the NAHB, and have been languishing at multi-decade lows. The stock of new houses has correspondingly plunged to the lowest in history. With supply so low, even a modest pick up in sales activity could translate in shortages of new houses in at least parts of the country. Homebuilders appear to see that turn in the data beginning to unfold.
According to the NAHB, homebuilder sentiment can lead major turning points in housing starts by four to six months. For instance, sentiment peaked during the boom in June 2005 and starts rolled over exactly six months later. During the bust, homebuilder sentiment had bottomed by January 2009 but bounced along the bottom for the next two years.
At long last, however, homebuilder sentiment is turning up, with the index doubling in just the last six months. There have been periodic upticks in this series ever since the bubble burst but nothing of the magnitude now seen in the data. Two of the line items within the survey are just as striking: “traffic of prospective homebuyers” and “expectations of sales in six months” have also doubled. The surge in homebuilder sentiment could be a harbinger of a similar acceleration in housing starts that begins to unfold through the rest of this year.
Economists predict the US economy will grow 2.4% in 2012, according to a recent survey by the Wall Street Journal, which is about the same as the 2.3% they were expecting six months ago just before the renewed strength in the housing data. They might need to start upgrading their forecasts. Residential investment usually marks the start of an economic cycle, on average accounting for one eighth of real GDP growth in the first ten quarters of post-war expansions. By coming late this time, residential investment could mean that the later stages of this cycle last longer and are stronger than the consensus expects.

Macro Insight: US Housing is Shovel-Ready

In past US economic cycles residential investment gave a big boost to the early stages of recovery. Not this time. Nearly three years into the expansion, the net contribution of the housing sector to real GDP is exactly zero. However, the data is beginning to stir and, critically, homebuilders could be starting to build.

Each month, the National Association of Homebuilders surveys its members about current housing conditions. The responses are then tallied into an index that is published jointly with Wells Fargo. A reading above 50 indicates that homebuilders report current conditions as being good or fair. The Housing Market Index has been below 50 for nearly six years, a record stretch of homebuilder pessimism.

The bleak outlook that homebuilders have reported in recent years is mirrored in the data. Housing starts have a strong correlation with sentiment of 0.7, according to the NAHB, and have been languishing at multi-decade lows. The stock of new houses has correspondingly plunged to the lowest in history. With supply so low, even a modest pick up in sales activity could translate in shortages of new houses in at least parts of the country. Homebuilders appear to see that turn in the data beginning to unfold.

According to the NAHB, homebuilder sentiment can lead major turning points in housing starts by four to six months. For instance, sentiment peaked during the boom in June 2005 and starts rolled over exactly six months later. During the bust, homebuilder sentiment had bottomed by January 2009 but bounced along the bottom for the next two years.

At long last, however, homebuilder sentiment is turning up, with the index doubling in just the last six months. There have been periodic upticks in this series ever since the bubble burst but nothing of the magnitude now seen in the data. Two of the line items within the survey are just as striking: “traffic of prospective homebuyers” and “expectations of sales in six months” have also doubled. The surge in homebuilder sentiment could be a harbinger of a similar acceleration in housing starts that begins to unfold through the rest of this year.

Economists predict the US economy will grow 2.4% in 2012, according to a recent survey by the Wall Street Journal, which is about the same as the 2.3% they were expecting six months ago just before the renewed strength in the housing data. They might need to start upgrading their forecasts. Residential investment usually marks the start of an economic cycle, on average accounting for one eighth of real GDP growth in the first ten quarters of post-war expansions. By coming late this time, residential investment could mean that the later stages of this cycle last longer and are stronger than the consensus expects.

Macro Insight: The Housing Hockey Stick Redux
During most of the last century, the Shiller Real Home Price Index was remarkably flat before surging into a dramatic hockey stick in the early 2000s. After the bubble burst, the index plunged and recently touched a new cycle low. Some experts argue that the index will revert to its long-term average and that home prices need to drop another 25%.
But investors should be aware that the Shiller Index itself is stitched together from several different sources; the data that is currently collected doesn’t really have a historical mean to revert to. Other data, meanwhile, suggests the worst of the bust is done.
To create a long-term real home price index (the long thick line in the chart) Yale economist Robert Shiller collected historical data back to the 1880s. As Shiller explains, the earliest segments in the index are based on surveys and newspaper ads, when hard data was scarce. Then in the 1950s the government began compiling a number of formal house price indexes, two of which are used in Shiller’s index. The Case-Shiller Home Price Index (which Robert Shiller co-created with Karl Case) takes over in 1987. The boom and bust in the overall index, therefore, is reflecting the swings in the short history of this last segment.
The apparent stability of the distant past might look different if a consistent data set were available. The Case-Shiller segment (the thin dark blue line) surged 85% during the boom and then plunged 34% during the bust. The preceding segment of the index uses data from the FHFA, formerly OFHEO (the orange line); it surged 50% during the boom and then plunged 23% during the bust. Another source altogether that is compiled by the US Census Bureau, the Quality-Adjusted New House Price Index (the green line), isolates the underlying new home price trends from quality improvements by explicitly adjusting for size, amenities, and location; it surged 25%, plunged 20%, and is now back to where it was.
Mean reversion, however, isn’t always a sure thing. During an earlier hockey stick in the late 1940s, the Shiller Real Home Price Index surged 60% and stayed there. Indeed, the index shows three distinct periods of sustained equilibrium: it held steady in its first few decades into the 1910s, dipped down to a lower level in the 1920s through World War II, then popped in the post-war surge to a higher level, holding steady for several decades until the hockey stick of the 2000s. Today’s home prices could settle into any one of those equilibrium levels … or perhaps a new and higher equilibrium altogether.

Macro Insight: The Housing Hockey Stick Redux

During most of the last century, the Shiller Real Home Price Index was remarkably flat before surging into a dramatic hockey stick in the early 2000s. After the bubble burst, the index plunged and recently touched a new cycle low. Some experts argue that the index will revert to its long-term average and that home prices need to drop another 25%.

But investors should be aware that the Shiller Index itself is stitched together from several different sources; the data that is currently collected doesn’t really have a historical mean to revert to. Other data, meanwhile, suggests the worst of the bust is done.

To create a long-term real home price index (the long thick line in the chart) Yale economist Robert Shiller collected historical data back to the 1880s. As Shiller explains, the earliest segments in the index are based on surveys and newspaper ads, when hard data was scarce. Then in the 1950s the government began compiling a number of formal house price indexes, two of which are used in Shiller’s index. The Case-Shiller Home Price Index (which Robert Shiller co-created with Karl Case) takes over in 1987. The boom and bust in the overall index, therefore, is reflecting the swings in the short history of this last segment.

The apparent stability of the distant past might look different if a consistent data set were available. The Case-Shiller segment (the thin dark blue line) surged 85% during the boom and then plunged 34% during the bust. The preceding segment of the index uses data from the FHFA, formerly OFHEO (the orange line); it surged 50% during the boom and then plunged 23% during the bust. Another source altogether that is compiled by the US Census Bureau, the Quality-Adjusted New House Price Index (the green line), isolates the underlying new home price trends from quality improvements by explicitly adjusting for size, amenities, and location; it surged 25%, plunged 20%, and is now back to where it was.

Mean reversion, however, isn’t always a sure thing. During an earlier hockey stick in the late 1940s, the Shiller Real Home Price Index surged 60% and stayed there. Indeed, the index shows three distinct periods of sustained equilibrium: it held steady in its first few decades into the 1910s, dipped down to a lower level in the 1920s through World War II, then popped in the post-war surge to a higher level, holding steady for several decades until the hockey stick of the 2000s. Today’s home prices could settle into any one of those equilibrium levels … or perhaps a new and higher equilibrium altogether.

Macro Insight: China’s Yuan-O-Matic
The US Treasury recently reaffirmed that China is not manipulating  its currency. Perhaps so. But over the past decade the yuan has moved  against the dollar with an algebraic precision that nevertheless betrays  a heavy hand by the central planners in its currency market.
Technically, China resumed a managed float in mid-2010 that allows  the yuan to move within a narrow range around a basket of currencies.  Chinese officials have indicated that the basket includes dollars,  euros, yen, won, and several other international currencies.
Since mid-2010, while there have been short lulls in the  strengthening and even a few modest reversals, the yuan’s revaluation  (the blue line in the chart) has been remarkably steady. On average, the  central planners have been increasing the yuan’s value nearly a tenth  of a fen each day (or 0.000887 yuan). The regression equation in the  chart (the pink band) has a near-perfect r-squared of 0.98. Unless  Beijing’s policymakers shift course, the currency will strengthen to 6  yuan to the dollar by next November, just in time for the US  presidential elections and stronger than currently priced into the  futures market.
The yuan has been just as predictable in earlier years too, it’s just  the equation that has changed. In 2009-10, China pegged the yuan firmly  to the dollar, as it had in the first part of the decade, leaving a  flat line. However, from 2005 until the financial crisis of 2008,  China’s revaluation policy had an extra dimension. While the daily  change was not constant, it steadily accelerated in clockwork fashion,  picking up the pace a little bit each day. In that period, the  polynomial regression yields a curve (the red band) with an r-squared of  0.99.
Just where the yuan should really be is anyone’s guess. Many  economists look to purchasing power parity and believe the yuan remains  deeply undervalued; others argue the opposite. Politically, many of  China’s trade partners contend that an undervalued yuan gives it an  unfair trade advantage; China says its trade surplus is already  shrinking and some officials are hinting that the yuan has strengthened  enough. Ultimately, at least for now, the value of the yuan is going to  be what the central planners say it is. While China has made great  strides toward the market in the last thirty years, unleashing powerful  engines of growth and prosperity, when it comes to the currency market  the best policy for investors remains: don’t fight the Red.

Macro Insight: China’s Yuan-O-Matic

The US Treasury recently reaffirmed that China is not manipulating its currency. Perhaps so. But over the past decade the yuan has moved against the dollar with an algebraic precision that nevertheless betrays a heavy hand by the central planners in its currency market.

Technically, China resumed a managed float in mid-2010 that allows the yuan to move within a narrow range around a basket of currencies. Chinese officials have indicated that the basket includes dollars, euros, yen, won, and several other international currencies.

Since mid-2010, while there have been short lulls in the strengthening and even a few modest reversals, the yuan’s revaluation (the blue line in the chart) has been remarkably steady. On average, the central planners have been increasing the yuan’s value nearly a tenth of a fen each day (or 0.000887 yuan). The regression equation in the chart (the pink band) has a near-perfect r-squared of 0.98. Unless Beijing’s policymakers shift course, the currency will strengthen to 6 yuan to the dollar by next November, just in time for the US presidential elections and stronger than currently priced into the futures market.

The yuan has been just as predictable in earlier years too, it’s just the equation that has changed. In 2009-10, China pegged the yuan firmly to the dollar, as it had in the first part of the decade, leaving a flat line. However, from 2005 until the financial crisis of 2008, China’s revaluation policy had an extra dimension. While the daily change was not constant, it steadily accelerated in clockwork fashion, picking up the pace a little bit each day. In that period, the polynomial regression yields a curve (the red band) with an r-squared of 0.99.

Just where the yuan should really be is anyone’s guess. Many economists look to purchasing power parity and believe the yuan remains deeply undervalued; others argue the opposite. Politically, many of China’s trade partners contend that an undervalued yuan gives it an unfair trade advantage; China says its trade surplus is already shrinking and some officials are hinting that the yuan has strengthened enough. Ultimately, at least for now, the value of the yuan is going to be what the central planners say it is. While China has made great strides toward the market in the last thirty years, unleashing powerful engines of growth and prosperity, when it comes to the currency market the best policy for investors remains: don’t fight the Red.

Macro Insight: Santa’s Empty Workshop
During last year’s holiday season, US retail sales returned to  pre-recession levels. This year they are surging to new highs. Skeptical  retail stores, however, are keeping inventories low. Maybe too low.
In earlier decades, inventory management used to be largely reactive  to the ebb and flow of the economy. When the economy slowed, inventories  built up and production was cut until the shelves were cleared, after  which production eventually resumed. During the inflation of the 1970s,  there was even an incentive to hold excess inventory: companies could  book profits merely by buying extra quantities of stock to sit in their  warehouses. Against that backdrop, the ratio of inventories to sales  climbed ever higher.
An inventory revolution finally hit in the late 1980s. Inflation  peaked and the cost of raw materials began a multi-decade decline,  reversing the incentive for companies to buy excess inventory.  Meanwhile, new thinking was gaining ground in Japan that recognized the  hidden costs of excess inventories: storage fees, misallocation of  resources, and the risk of holding outdated inventory, particularly in  technology and other fast-paced industries. Instead of stockpiling, the  new approach delivered supplies to the factory gates just in time for  production. After just-in-time techniques went global, inventory cycles  became less pronounced and the inventory-to-sales ratio plunged. The  question is just how low can it go.
Today, “just in time” can take too long. With inventories so lean,  the global  economy is increasingly vulnerable to supply chain  disruptions. In 2010, a volcano in Iceland interfered with the delivery  of machinery parts to Asia. In 2011, Japan’s earthquake disrupted auto  production all the way back to Europe. More recently, floods in Thailand  shut down the production lines of hard-drive manufacturers and  shortages loom throughout the computer industry.
Moreover, low inventories could reflect an overly pessimistic  assessment of the economy’s near-term prospects. Inventory-to-shipment  ratios are near cycle lows for US businesses broadly and are at all-time  lows at retail stores. Despite the glum forecasts, consumers continue  to spend and, to judge by the latest Gallup surveys, are planning on  spending even more this season. With global supply chains being  disrupted and inventory levels so low, the risk for holiday shoppers is  that the shelves are empty before the stockings are full. In that event,  the most popular present might turn out to be gift cards.

Macro Insight: Santa’s Empty Workshop

During last year’s holiday season, US retail sales returned to pre-recession levels. This year they are surging to new highs. Skeptical retail stores, however, are keeping inventories low. Maybe too low.

In earlier decades, inventory management used to be largely reactive to the ebb and flow of the economy. When the economy slowed, inventories built up and production was cut until the shelves were cleared, after which production eventually resumed. During the inflation of the 1970s, there was even an incentive to hold excess inventory: companies could book profits merely by buying extra quantities of stock to sit in their warehouses. Against that backdrop, the ratio of inventories to sales climbed ever higher.

An inventory revolution finally hit in the late 1980s. Inflation peaked and the cost of raw materials began a multi-decade decline, reversing the incentive for companies to buy excess inventory. Meanwhile, new thinking was gaining ground in Japan that recognized the hidden costs of excess inventories: storage fees, misallocation of resources, and the risk of holding outdated inventory, particularly in technology and other fast-paced industries. Instead of stockpiling, the new approach delivered supplies to the factory gates just in time for production. After just-in-time techniques went global, inventory cycles became less pronounced and the inventory-to-sales ratio plunged. The question is just how low can it go.

Today, “just in time” can take too long. With inventories so lean, the global economy is increasingly vulnerable to supply chain disruptions. In 2010, a volcano in Iceland interfered with the delivery of machinery parts to Asia. In 2011, Japan’s earthquake disrupted auto production all the way back to Europe. More recently, floods in Thailand shut down the production lines of hard-drive manufacturers and shortages loom throughout the computer industry.

Moreover, low inventories could reflect an overly pessimistic assessment of the economy’s near-term prospects. Inventory-to-shipment ratios are near cycle lows for US businesses broadly and are at all-time lows at retail stores. Despite the glum forecasts, consumers continue to spend and, to judge by the latest Gallup surveys, are planning on spending even more this season. With global supply chains being disrupted and inventory levels so low, the risk for holiday shoppers is that the shelves are empty before the stockings are full. In that event, the most popular present might turn out to be gift cards.

Macro Insight: The Looming US Housing Shortage
After 52 consecutive months of declining inventory, there were  163,000 new houses for sale on the US market in September, unchanged  from the month before. With new homes sales beginning to perk up from  multi-decade lows, demand could quickly outstrip supply. At least in  parts of the country, the next housing crisis could be a shortage of new  homes.
The stock of new homes for sale typically ebbs and flows with the  broader business cycle (the first chart with the blue line). When the  economy begins to slow, home sales drop off (the middle chart in brown)  and the supply of houses begins to increase. The supply of new homes in  months (the green line) indicates how long it would take for all the new  houses on the market to clear at the current pace of sales.  Historically, that ratio has averaged about 6 months.
At the height of the boom in the mid-2000s, demand vastly outstripped  supply even as homebuilders added to the supply at a furious pace. When  demand collapsed a few years later, homebuilders were slow to react,  resulting in a huge supply overhang. As the crisis worsened, the  inventory ratio eventually reached an all-time high of 12.4 months in  2009.
Today, the housing market is showing tentative signs of healing.  Existing home sales have stabilized, house prices have bottomed, the  homeownership rate has ticked up, and the threat of a massive shadow  inventory is fading. Economic growth is firming in parts of the country  that missed the worst of the bubble and new workers will need places to  live. Rental markets are getting tighter and new housing construction  could soon follow, perhaps reflected in the recent improvement in  homebuilder sentiment.
With the supply of new homes at such low levels, even a modest  pick-up in the pace of sales could have a dramatic impact. When the  housing recovery gains real traction, the current supply of new homes  could run out within a few months, leading to higher house prices, a  boom in residential construction, and an unexpectedly powerful lift to  the US economy.

Macro Insight: The Looming US Housing Shortage

After 52 consecutive months of declining inventory, there were 163,000 new houses for sale on the US market in September, unchanged from the month before. With new homes sales beginning to perk up from multi-decade lows, demand could quickly outstrip supply. At least in parts of the country, the next housing crisis could be a shortage of new homes.

The stock of new homes for sale typically ebbs and flows with the broader business cycle (the first chart with the blue line). When the economy begins to slow, home sales drop off (the middle chart in brown) and the supply of houses begins to increase. The supply of new homes in months (the green line) indicates how long it would take for all the new houses on the market to clear at the current pace of sales. Historically, that ratio has averaged about 6 months.

At the height of the boom in the mid-2000s, demand vastly outstripped supply even as homebuilders added to the supply at a furious pace. When demand collapsed a few years later, homebuilders were slow to react, resulting in a huge supply overhang. As the crisis worsened, the inventory ratio eventually reached an all-time high of 12.4 months in 2009.

Today, the housing market is showing tentative signs of healing. Existing home sales have stabilized, house prices have bottomed, the homeownership rate has ticked up, and the threat of a massive shadow inventory is fading. Economic growth is firming in parts of the country that missed the worst of the bubble and new workers will need places to live. Rental markets are getting tighter and new housing construction could soon follow, perhaps reflected in the recent improvement in homebuilder sentiment.

With the supply of new homes at such low levels, even a modest pick-up in the pace of sales could have a dramatic impact. When the housing recovery gains real traction, the current supply of new homes could run out within a few months, leading to higher house prices, a boom in residential construction, and an unexpectedly powerful lift to the US economy.

Pudd’nhead Wilson had it right: “October. This is one of the  peculiarly dangerous months to speculate in stocks. The others are July,  January, September, April, November, May, March, June, December,  August, and February.”  Even in Mark Twain’s day, it seems, October was a  notorious month for stocks.
Market historians refer to October’s tendency to coincide with  inflection points in stocks as the Mark Twain Effect. While it is too  soon to know whether October 3 will prove to be the low for 2011,  it  would fit comfortably with past market cycles.
Since 1928, the market was down for the year in October a total of 37 times,  but went up from there in all but 8. In those 37 years, stocks sold off  through the lows for October an average of -14.3% and then rallied  5.4%, ranging from a high of 28.1% (1998) to a low of -9.9% (1973).
Fourth quarter recovery rallies can be powerful. Even in 2008, when  the market plunged -42.2% by mid-October and the global economy was  sliding into recession, stocks posted a respectable gain of 6.4% through  the end of the year. Altogether, a third of the rallies more than wiped  out the year-to-date losses and pushed stocks into positive returns for  the full year. The record surge in 1998 occurred in an environment that  is strikingly familiar in shape if not intensity: default fallout in  Europe, central bank interventions, and pervasive but ultimately  misplaced fears of a global slowdown.
While the seasonals have yet to fully play out in 2011, the  persistence of the October recovery rally through all kinds of market  environments is striking. This year, the S&P was down -12.6% through  the October 3 low, right in line with history; by mid-month it was up  11.5%, already more than the average recovery rally but less than a  third of the way to the 1998 record. There is good reason to expect  more.
Although forecasts of another US recession are endemic, the hard data  generally shows that the recovery is fragile but intact, from payrolls  to purchasing manager surveys to retail sales. Global central banks are  easing policy, Europe is edging toward a solution of its sovereign debt  crisis, at least for now, and there are even early whiffs of a policy  shift in China. The pieces are in place for a powerful fourth quarter  rally.

Pudd’nhead Wilson had it right: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” Even in Mark Twain’s day, it seems, October was a notorious month for stocks.

Market historians refer to October’s tendency to coincide with inflection points in stocks as the Mark Twain Effect. While it is too soon to know whether October 3 will prove to be the low for 2011, it would fit comfortably with past market cycles.

Since 1928, the market was down for the year in October a total of 37 times, but went up from there in all but 8. In those 37 years, stocks sold off through the lows for October an average of -14.3% and then rallied 5.4%, ranging from a high of 28.1% (1998) to a low of -9.9% (1973).

Fourth quarter recovery rallies can be powerful. Even in 2008, when the market plunged -42.2% by mid-October and the global economy was sliding into recession, stocks posted a respectable gain of 6.4% through the end of the year. Altogether, a third of the rallies more than wiped out the year-to-date losses and pushed stocks into positive returns for the full year. The record surge in 1998 occurred in an environment that is strikingly familiar in shape if not intensity: default fallout in Europe, central bank interventions, and pervasive but ultimately misplaced fears of a global slowdown.

While the seasonals have yet to fully play out in 2011, the persistence of the October recovery rally through all kinds of market environments is striking. This year, the S&P was down -12.6% through the October 3 low, right in line with history; by mid-month it was up 11.5%, already more than the average recovery rally but less than a third of the way to the 1998 record. There is good reason to expect more.

Although forecasts of another US recession are endemic, the hard data generally shows that the recovery is fragile but intact, from payrolls to purchasing manager surveys to retail sales. Global central banks are easing policy, Europe is edging toward a solution of its sovereign debt crisis, at least for now, and there are even early whiffs of a policy shift in China. The pieces are in place for a powerful fourth quarter rally.

Less return for more risk. That’s what the US stock market has been  delivering lately. The S&P 500 has just posted its worst ten-year  performance in decades.  Meanwhile, volatility is its highest since the  1940s.
Since 1935, stocks have delivered an average annualized return of  11.3%, using daily data and not including dividends. During that time,  however, the market’s performance has alternated between stretches of  double-digit returns and periods of single-digit or even negative  returns. In 1939, for instance, the 10-year price return for the S&P  500 was at a historic low of -10.0%. Returns strengthened through the  1950s, faded into the stagflation years of the 1970s, and accelerated to  new highs through the tech boom of the 1990s before plunging back into  negative returns more recently.
Meanwhile, market volatility has followed a different pattern. As  seen in the S&P 500’s daily standard deviation and also annualized  over 10-year periods, the market’s volatility was as at post-Crash highs  in the 1930s, bottomed out in the early 1970s, but then began grinding  higher for the next few decades before spiking after the financial  crisis of 2008.
Across the grand sweep of history, the relationship between risk and  return has been loose and variable. The 1950s was a golden age of high  returns and low volatility. Today it is the exact reverse.
The secular rise in stock market volatility remains a mystery. Some  experts attribute it to the rise of the hedge fund industry, where  assets under management show a remarkable correlation. Others argue that  flash trading and other computerized financial innovations are the  cause. Perhaps the deeper source is technology itself, in which the  dissemination of new ideas has accelerated dramatically, leading to a  highly compressed life cycle for business innovation. If so, the waves  of stock market performance might also become more compressed going  forward.
The anemic performance of the S&P 500 over the past decade has  prompted some observers to argue that the market might be in a “new  normal” of low expected returns. However, few of even the most bearish  forecasters would make the case for negative returns to persist for  another decade. As things stand, returns can improve but the not-so-new  normal of higher volatility is here to stay.

Less return for more risk. That’s what the US stock market has been delivering lately. The S&P 500 has just posted its worst ten-year performance in decades. Meanwhile, volatility is its highest since the 1940s.

Since 1935, stocks have delivered an average annualized return of 11.3%, using daily data and not including dividends. During that time, however, the market’s performance has alternated between stretches of double-digit returns and periods of single-digit or even negative returns. In 1939, for instance, the 10-year price return for the S&P 500 was at a historic low of -10.0%. Returns strengthened through the 1950s, faded into the stagflation years of the 1970s, and accelerated to new highs through the tech boom of the 1990s before plunging back into negative returns more recently.

Meanwhile, market volatility has followed a different pattern. As seen in the S&P 500’s daily standard deviation and also annualized over 10-year periods, the market’s volatility was as at post-Crash highs in the 1930s, bottomed out in the early 1970s, but then began grinding higher for the next few decades before spiking after the financial crisis of 2008.

Across the grand sweep of history, the relationship between risk and return has been loose and variable. The 1950s was a golden age of high returns and low volatility. Today it is the exact reverse.

The secular rise in stock market volatility remains a mystery. Some experts attribute it to the rise of the hedge fund industry, where assets under management show a remarkable correlation. Others argue that flash trading and other computerized financial innovations are the cause. Perhaps the deeper source is technology itself, in which the dissemination of new ideas has accelerated dramatically, leading to a highly compressed life cycle for business innovation. If so, the waves of stock market performance might also become more compressed going forward.

The anemic performance of the S&P 500 over the past decade has prompted some observers to argue that the market might be in a “new normal” of low expected returns. However, few of even the most bearish forecasters would make the case for negative returns to persist for another decade. As things stand, returns can improve but the not-so-new normal of higher volatility is here to stay.