My afternoon train reading:
• Surprise is the only constant in the markets this year. (WSJ)
• ETF Model Portfolios Change Advisory Biz (ETF.com)
• Where in the world is the Kuwait Investment Authority? (AI-CIO)
• Death of the Time Stamp: Medium, Slingshot & the Movement Away from RIGHT NOW (Hunter Walk)
• Active management is alive and kicking (FT)
• He’s allocated money to victims of 9/11 and the BP oil spill. Can Ken Feinberg handle GM? (WonkBlog)
• Is Work Killing You? In China, Workers Die at Their Desks (Bloomberg)
• Tax cuts in Kansas have cost the state money — and job creation’s been terrible (WonkBlog) see also Kansas Tax Cut Leaves Brownback With Less Money (The Upshot)
• Inside the Google World Cup War Room (Re/Code)
• Digitally restored ‘Hard Day’s Night’ revives Beatlemania 50 years later (WSJ)
What are you reading?
Stock Pickers Have Tough Time in 2014
Weekly Update: Housing Tracker Existing Home Inventory up 14.0% YoY on June 30th, Above June 30, 2012 Level
There is a clear seasonal pattern for inventory, with the low point for inventory in late December or early January, and then usually peaking in mid-to-late summer.
The Realtor (NAR) data is monthly and released with a lag (the most recent data released was for May). However Ben at Housing Tracker (Department of Numbers) has provided me some weekly inventory data for the last several years.
Click on graph for larger image.
This graph shows the Housing Tracker reported weekly inventory for the 54 metro areas for 2010, 2011, 2012, 2013 and 2014.
In 2011 and 2012, inventory only increased slightly early in the year and then declined significantly through the end of each year.
In 2013 (Blue), inventory increased for most of the year before declining seasonally during the holidays. Inventory in 2013 finished up 2.7% YoY compared to 2012.
Inventory in 2014 (Red) is now 14.0% above the same week in 2013. (Note: There are differences in how the data is collected between Housing Tracker and the NAR).
Also inventory is now above the same week in 2012. This increase in inventory should slow price increases, and might lead to price declines in some areas.
Note: One of the key questions for 2014 will be: How much will inventory increase? My guess was inventory would be up 10% to 15% year-over-year at the end of 2014 based on the NAR report. Right now it looks like inventory might increase more than I expected.
The Fannie Mae serious delinquency rate peaked in February 2010 at 5.59%.
Last week, Freddie Mac reported that the Single-Family serious delinquency rate declined in May to 2.10% from 2.15% in April. Freddie's rate is down from 2.85% in May 2013, and is at the lowest level since January 2009. Freddie's serious delinquency rate peaked in February 2010 at 4.20%.
Note: These are mortgage loans that are "three monthly payments or more past due or in foreclosure".
Click on graph for larger image
The Fannie Mae serious delinquency rate has fallen 0.75 percentage points over the last year, and at that pace the serious delinquency rate will be under 1% in late 2015.
Note: The "normal" serious delinquency rate is under 1%.
Maybe serious delinquencies will be back to normal in late 2015 or 2016.
For starters, the EU wants Russia to halt the flow of weapons into Eastern Ukraine, and it wants that process verified. That appears to be a reasonable demand.
Secondly, the EU demands pro-Russia militants return control of Izvarino, Dolzhanskiy and Krasnopartizansk (three border checkpoints) to Ukraine. The militants refuse to surrender, arguing that theirs is now a sovereign state.
Returning control of three Ukrainian checkpoints is an unreasonable, if not idiotic demand on Russia. Short of invading Ukraine and taking over the checkpoints, there is absolutely no way for Russia to comply with the resolution.
Finally, the EU demands “launch of substantial negotiations on the implementation of President Poroshenko’s peace plan”. Once again, Russia is not in control of militants who may or may not wish to negotiate anything.
Of the three demands, the Financial Times reports the first has been met as Moscow Makes Last-Minute Concession to Ukraine on Border Controls.
“President Vladimir Putin has proposed that Ukrainian border guards be granted access to those crossing points from the Russian side as observers for joint control of the border, and that observers from the [Organisation for Security and Co-operation in Europe] also be admitted to those crossing points from the Russian side,” said Russian foreign minister Sergei Lavrov.Russia agreed to the first demand after "Vladimir Putin discussed the crisis by telephone with Germany’s Chancellor Angela Merkel and President François Hollande of France and Petro Poroshenko, their Ukrainian counterpart."
“We hope that this initiative of the Russian president will allow all responsible parties to take a decision to extend the ceasefire, to extend the truce,” Mr Lavrov said.
At this point, there is little else Russia can do, and it would be very unreasonable to impose more sanctions on Russia for a situation in Ukraine that Russia has no fundamental control over.
Anyone but a bureaucrat under heavy influence of US meddling would rapidly come to that conclusion, but don't count on it.
In politics, stupidity frequently trumps common sense.
Mike "Mish" Shedlock
With half of the year behind us, the S&P 500 finished off the first half with one of its largest margins of outperformance over the Dow Jones Industrial Average (DJIA) on record. Through Monday's close, the S&P 500 finished the first half up 6.05%, which was more than 450 basis points (bps) ahead of the 1.51% return for the DJIA. Going back to 1929, there have only been five other years where the DJIA performed worse relative to the S&P 500. The widest margin of outperformance was in 2000, when the DJIA was down over 9% in the first half of the year while the S&P 500 was down just 1.0%. The most recent period where the S&P 500 outperformed the DJIA by a wider margin was in 2009, so there's something for both bears (2000) and the bulls (2009) in terms of similar periods.
Earlier today we sent out a report to Bespoke Premium and Institutional clients discussing some of the potential implications for the market in the second half. Clients that wish to view the report can click on the link below. If you are not yet a client, sign up today for our free 5-day trial and take advantage of our July 4th special!
Yifan Cao and Adam Shapiro:
Will Inflation Remain Low?, by Yifan Cao and Adam Shapiro, FRBSF Economic Letter: Over the past two years, inflation has remained persistently low. As measured by the core personal consumption expenditures price index (core PCEPI), which excludes volatile energy and food prices, annual inflation has been below the Federal Reserve’s 2% target since April 2012. Given the recent path of inflation, a natural question to consider is how likely it is to remain low in the future. Recent research using financial market forecasts (Bauer and Christensen 2014) shows that inflation will remain low going forward. In this Economic Letter, we examine the outlook for inflation using model-based forecasts.
We rely on the well-known Phillips curve model and examine its implications for inflation over the next two years. In its most basic form, this model posits that inflation depends on past inflation and a measure of slack in the overall economy. We show that a basic Phillips curve implies that inflation is likely to remain low over the next two years.
As with any forecasting model, the basic Phillips curve is sensitive to the assumptions inherent in its underlying structure. The basic model has very few components and leaves out several potentially important determinants of inflation. Indeed, over the years, numerous extensions to the basic Phillips curve framework have incorporated additional factors that are likely to affect the dynamics of inflation. In this Economic Letter, we focus on two simple extensions that are potentially important to the current inflation outlook.
The first extension incorporates anchored inflation expectations with the constraint that long-run inflation eventually returns to the Fed’s inflation target of 2% (see Williams 2006, Stock and Watson 2010, and Cogley, Primiceri, and Sargent 2010). The second extension uses an alternative measure of economic slack that excludes the long-term unemployed and focuses on the short-term unemployed (see Gordon 2013, Rudebusch and Williams 2014, and Watson 2014). A Phillips curve model that incorporates these two extensions predicts a path for inflation that is still low but is higher than implied by the basic model.
The basic Phillips curve model
The Phillips curve framework is based on the premise that, during times of economic prosperity when overall demand rises higher than overall supply in the economy, there will be increasing pressure to push prices up. By contrast, during times of economic distress when demand falls relative to supply, there is a downward pressure on prices. The model therefore suggests that inflation depends on some indicator of unused productive capacity in the economy, or “slack.” While there are numerous measures of slack, a popular choice among economists is a measure referred to as the unemployment gap. This gap is defined as the difference between the level of the current unemployment rate and what the unemployment rate should be if the economy were operating at its full capacity. This latter measure is referred to as NAIRU, or the non-accelerating inflation rate of unemployment, and an estimate of it is produced by the Congressional Budget Office. The underlying intuition is that, when the economy is in distress, the unemployment rate will lie above NAIRU.
The basic Phillips curve describes the behavior of current inflation as a function of the past unemployment gap and past inflation. We estimate this model using data going back to 1985. We then use the parameters from our estimates to project future inflation, assuming that the unemployment gap follows some specified future path. We assume that the unemployment rate for the second quarter of 2014 will be 6.3%, as measured in May 2014, and thereafter it will move at a steady pace toward 5.55% by the end of 2015, which is the average unemployment rate projection from the Fed’s most recent Summary of Economic Projections (Board of Governors 2014).
Projected PCEPI inflation: Basic Phillips curve model
Sources: Bureau of Economic Analysis (BEA) and
Board of Governors, Summary of Economic Projections.
Figure 1 depicts actual inflation, measured by the annualized quarterly change in core PCEPI and the projection for inflation using the basic Phillips curve model. The basic model implies inflation is very persistent and projects core PCEPI inflation will remain below 2% through the end of 2015.
Extensions to the basic model
The basic Phillips curve is a parsimonious model and therefore leaves out a myriad of different variables that may affect the path of inflation. Indeed, throughout the past few decades, economists have extended the basic Phillips curve in a host of different ways. Looking at these variations can help give some insights into how certain components can change the outlook for future inflation. For this Economic Letter, we consider two simple extensions of the model that are particularly relevant given the current situation.
In our first exercise, we examine how much a credible Fed inflation target would affect the inflation forecast generated by the Phillips curve. Specifically, we impose a restriction that steady-state core PCEPI inflation lies at the Fed’s perceived inflation target, currently 2%. This is equivalent to assuming that, on average, consumers and firms believe that future inflation is “well anchored” around the Fed’s inflation target level (see Williams 2006). The assumption is reasonable if firms are forward-looking, setting prices based on expectations of future demand and cost, and incorporating the Fed’s explicit inflation target.
Projected inflation: Basic vs. anchored expectations
Sources: BEA and Board of Governors, Summary of Economic Projections.
Figure 2 depicts this Phillips curve model that imposes inflation expectations anchored at the Fed’s target, alongside the basic model projection. The modified projection is slightly higher, but still lies below 2% by the end of 2015. This slow movement of inflation from its current level, even assuming anchored expectations at 2%, highlights the strong persistence of inflation implied by the data and the model. Generally, most models of inflation dynamics agree on this key trait, that is, inflation moves sluggishly over time.
Breakdown of unemployment: Short-term vs. long-term
Source: Bureau of Labor Statistics.
In our second exercise, we alter the measure of slack used in the Phillips curve inflation forecast. The years since the most recent recession have been marked not just by higher overall unemployment, but also by different durations of unemployment taking divergent paths. As Figure 3 shows, the short-term unemployment rate, defined as the number of people out of work for less than 27 weeks divided by the labor force, has dropped precipitously since the most recent recession ended. In terms of the short-term unemployed, the economy is back to its historical average. By contrast, the long-term unemployment rate has remained elevated. As Robert Gordon (2013) and Mark Watson (2014) recently pointed out, these long-term unemployed may be exerting less upward pressure on wages and prices than the short-term unemployed. For instance, this may be the case if firms compete more for potential employees who have only recently become unemployed than for those whose skills may have eroded or who may otherwise be scarred by prolonged unemployment.
For this exercise, we alter our measure of economic slack to account for this dichotomy. Rather than using overall unemployment, we focus on the short-term unemployed. Specifically, we create a short-term unemployment gap measure by gauging how monthly rates over the 1985 to 2014 sample period deviate from the average short-term unemployment rate.
Projected inflation: Short-term unemployment as slack
Sources: BEA and Board of Governors, Summary of Economic Projections.
Figure 4 shows that the projections for inflation using the short-term unemployment gap exceed the projections of the basic model using the overall unemployment gap. If we also impose well-anchored inflation expectations, inflation rises at a relatively fast pace, surpassing 2% by the end of 2015. The reason for the higher inflation projection is that, in terms of the short-term unemployment rate, there is currently little economic slack. In fact, the short-term unemployment rate projects excess demand over the next two years, which implies strong upward pressure on prices.
Inflation, as measured by the core PCEPI, currently stands below the Fed’s 2% target. A simple empirical Phillips curve implies that inflation will remain relatively low in the near future. Estimating just how low depends a great deal on the assumptions in the model. We test two specific variations to the basic model, altering the measure of slack and the assumptions about inflation expectations. We find that these variations produce some higher projections for future inflation. However, it is difficult to prove that any one specification of the model is the true one. Instead, examining the effects of various specifications can be instructive in exploring how various factors affect forecasts of inflation.
Bauer, Michael D., and Jens H.E. Christensen. 2014. “Financial Market Outlook for Inflation.” FRBSF Economic Letter 2014-14 (May 12).
Board of Governors of the Federal Reserve System. 2014. “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, June 2014.” Table 1, Summary of Economic Projections.
Cogley, Timothy, Giorgio E. Primiceri, and Thomas J. Sargent. 2010. “Inflation-Gap Persistence in the U.S.” American Economic Journal: Macroeconomics 2(1), pp. 43–69.
Gordon, Robert. 2013. “The Phillips Curve Is Alive and Well: Inflation and the NAIRU during the Slow Recovery.” NBER Working Paper 19390.
Rudebusch, Glenn, and John Williams. 2014. “A Wedge in the Dual Mandate: Monetary Policy and Long-Term Unemployment.” FRB San Francisco Working Paper 2014-14 (May).
Stock, James, and Mark Watson. 2010. “Modeling Inflation after the Crisis.” NBER Working Paper 16488.
Watson, Mark. 2014. “Inflation Persistence, the NAIRU, and the Great Recession.” American Economic Review 104(5, May), pp. 31–36.
Williams, John. 2006. “Inflation Persistence in an Era of Well-Anchored Inflation Expectations.” FRBSF Economic Letter 2006-27 (October 13).
Jim Rogers is a legendary investor that co-founded the Quantum Fund and retired at age thirty-seven. He is the author of several books and also a financial commentator worldwide.