INSIGHTS

On May 31, 2011

What to expect when you’re expecting….from an economic perspective.

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As most parents are aware, the book “What to Expect When You’re Expecting,” written by Heidi Murkoff and Sharon Mazel has become the Bible for new parents to-be. Though there may be little correlation between pregnancy and economics, the title is very poignant heading into the last month of the second quarter.


Most expectations are often led by recent experiences. As such, the timeline of one’s memories can lead them to a predisposition on what to look for. Here our a few perceptions about the current market that we see in our many discussions with clients:

• Interest Rates are headed higher.


• The fiscal discipline (or lack there of) of the United States and the many state governments is on a collision course with severe ramifications to the overall economic growth domestically and globally.


• The erosion of the U.S. dollar is imminent.


• Inflation is at the precipice of what has not been seen since late 1970s.

Our view points to the above baseline expectations have been laid out, but we think it is important to note that at some point every prediction will eventually prove the soothsayer correct, so even the most diametrically opposed viewpoints will eventually come to fruition. The question each money manager asks him/herself is when will these events occur and what is the expected timeline before they impact the markets? What many miss is that even when one is correct with their calls, they are wrong on the effects of the marketplace.


As an example, consider the significant event of Standard & Poor’s placing U.S. Treasuries on negative outlook. Most investors, institutional and retail, would argue that the negative outlook was long overdue. Some would say it should have happened in the late 1980s when debt exploded and others more recently as the deficit is running at nearly 10% of GDP. The timing of these negative outlooks often is influenced by one’s political affiliation.


The Treasury market’s reaction on the day of the announcement and movement since then reveals the point of our argument. The few days after the announcement by Standard & Poor’s (April 18th), the 10-year rose to 3.41% from a 3.37%. We currently sit at 3.08%, or an increase in bond prices of 2.76%, since the announcement a little over 6 weeks ago. So while the many calling for the accountability of the credit rating agencies to enforce their view that the United States is in trouble were right, the market’s moved in the opposite manner.


Interest rates will head higher…eventually. The important distinction, from our perspective, is what will drive these rates higher and when. Fundamental long-term increases in rates rely on fundamental economic growth outside the Fed’s comfort zone and/or fundamental inflation being passed through to consumers at a high rate. The Fed is more uncomfortable with the benign growth than the other, meaning a more accommodative Fed for some time. Secondly, inflation is continuing the pattern that started in 2003 where higher producer costs have had little luck in being passed on to the consumer. From 1976 – 2003 the Consumer Price Index (CPI) was on average 1.3% higher on a year-over-year basis versus the Producer Price Index (PPI). Since 2003, the opposite has happened. The PPI has been higher than the CPI by an average of 1.00%. Currently it’s a spread of 3.4%....that spells out a less than hospitable environment for intermediate inflation expectations.


One last thing on pass through is to review the unionization of employees. According to the Monthly Labor Review, January 2006, The United States has seen a steady drop in union enrollment since the late 1970s. In 1973 Union membership in the United States stood at 18,066,000 while at the end of 2006 we stood at 15,359,000. While dramatic in its drop, more dramatic is the percentage of total non-farm payrolls. Based on total non-farm payrolls in 1973 of 77,630, union enrollment was at 23.2%. If we update it to 2006 totals, we see that rate has been cut in half to 11.3%. Currently, the estimated total is heavily skewed by the public sector unions which total 36.8% while private sectors total 7.6% of workforce though current final numbers are not yet available from the Bureau of Labor Statistics, U.S. Department of Labor and National Labor Board. Though the math may be a bit broad, it points out a clear trend in a significant slow down in union memberships. This is important because the ability to negotiate higher wages based on costs of living adjustments from unions become much less impactful than that of the private market dictating wage increases based on competition and war for talent.


As a comparison, the European Union (EU) has seen enrollment increase from 1970 to 2003 by a total of 6.8%. In the wake of consumer inflation rising from its disinflationary marks of 2008 and 2009 and the higher level of unionized employees, one can see why the European Central Bank is concerned about inflation being passed through while the Federal Reserve is more concerned with sustaining economic growth. The European hawkishness toward inflation and the Japanese economy in a short-term retraction creates an environment where nearly 28% of global GDP is buffering the inflation move allowing the Federal Reserve to maintain their accommodative policy.


As evidenced by the U.S. Treasury market and the negative outlook from Standard & Poor’s, the expectations were right, but the reaction creates an even bigger conundrum in what to do about it. We often see these types of events in macro events and initial reactions. The market will ultimately price-in expectations and actual events in the long run, but in the short run, you may be right and wrong at the same time. On second thought, maybe it is a lot like parenting.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog. For additional commentary or financial resources, please visit www.aamlive.com.