Monday, November 30, 2015

Fed's forward guidance may be responsible for more market volatility

The 2008 financial meltdown exposed a lack of transparency in the financial system. The U.S. Federal Reserve, in response, sought to provide more openness and fewer surprises with forward guidance -- early indications of changes in monetary policy to guide investors, businesses and households. The Fed's hope was that providing information about likely changes could reduce market disruptions. 

I have long been skeptical of the effectiveness of forward guidance because future changes in monetary policy are heavily dependent on data that are not yet known. Worse, the Fed has consistently been too optimistic about the economic recovery, making its forward guidance ineffective.

In 2012, the Fed forecast 3.4 percent growth for 2015, but gradually cranked that down to 2.1 percent, the average annual growth rate since the recovery started in mid-2009. It similarly cut to 2 percent from 4 percent its initial forecasts for 2012, 2013 and 2014. 

To assess whether forward guidance has been effective in preventing market disruptions, compare today's economy with the market conditions of the mid-1990s, prior to its use. Of course, there are significant differences in inflation, global growth and other measurements, yet the differences in volatility between then and now are stark. 

The Fed raised short-term interest rates in February 1994 without warning. It pushed rates up six more times by November 1994, doubling the federal funds rate to 6 percent. This caused Treasury yields to skyrocket in what became known as the great bond massacre of 1994.

Yields on 10-year Treasuries jumped 2.3 percentage points to 8.1 percent, for a price loss of 23 percent. The 30-year Treasury-bond yield leaped by 1.9 percentage points for a principal decline of 17 percent. The index that measures stock-market uncertainty reached a high of 23.9 in April, compared with a 10.8 level before the first rate increase.

Ditto for Treasury volatility, which is measured by taking the 20-day moving average of the daily percentage change in yield. For 10-year Treasuries in 1994, volatility rose from 0.5 percent at the start of the year to a peak of 1.2 percent, while volatility in the 30-year bond climbed from 0.4 percent to a peak of 1 percent.

If forward guidance worked, you’d expect less stock and bond volatility now -- even more so with all the Fed’s talk of raising rates. Nevertheless, forward guidance appears to be stirring up markets, not calming them down. Stock and bond market volatilities have jumped to levels vastly exceeding those of the mid-1990's.

The Fed indicated it might raise rates in June, September and now December. From their February lows, yields have risen 68 basis points (100 basis points equals one percentage point) on the 10-year Treasury note and 87 basis points on the 30-year Treasury bond.

The 1994 yield increases were higher. Still, the volatility index jumped to 40.7 in late August, almost twice the 23.9 high of 1994. Similarly, our index of Treasury volatility this year reached 2.9 percent for the 10-year and 2 percent for the 30-year -- more than double the 1994 levels. 

Why are stock and bond volatilities twice as high with forward guidance than without it? Anticipation of a Fed rate rise and China's economic slowdown have roiled stock markets. Also, I believe higher bank capital requirements have led to less liquidity, and therefore higher volatility, in Treasuries. 

But forward guidance is also a culprit due to the Fed’s chronic overoptimism about economic growth and its persistent warnings of an imminent rate increase.

The Fed isn't alone with its embarrassingly overoptimistic forecasts. The International Monetary Fund and the World Bank keep reducing their outlooks for global growth. Economists in the Wall Street Journal’s forecasting surveys have also persistently cut their growth forecasts. 

The Fed’s use of forward guidance has been ineffective due to its inability to correctly forecast economic conditions. And this probably led to more, not less, market volatility. Back when the Fed surprised investors, stock and bond market volatility was half of today’s levels. 

Instead of continuing to do the same thing repeatedly and expecting different results, why not just abandon forward guidance? 

Originally posted on

Sunday, November 22, 2015

Gary Shilling says China economy not headed to recession

As the leaders of 17 countries gathered in the Philippines Wednesday for the annual Asia-Pacific Economic Cooperation forum, Chinese President Xi Jinping stated the obvious. "The Chinese economy is a concern for everyone," he said. "We will work hard to shift our growth from just expanding scale to improving its structure." 

What he means is that China's economic deceleration -- the official growth rate of 6.9 percent is a six-year low -- is the sign of an economy in transition. It's moving from an over-reliance on exports and government-led investment to an economy that is more consumer-led. 

So how's that going? First the bad news: The industrial goods-producing sector of the Chinese economy is in recession and likely to remain there for at least another year. 

Now the good news: The domestic-oriented service sector is likely to keep growing at low, double-digit rates -- and that should result in real GDP growth of 4 percent to 5 percent.  

Until recently, China's economy grew rapidly, thanks to a booming manufacturing sector that imported raw materials and equipment to produce goods that were exported to North America and Europe. Slow growth in the developed world, however, put an end to that ploy. 

China's other stimulus, infrastructure investment, resulted in ghost cities and a pile of debt now totaling 208 percent of gross domestic product. Together, the debt overhang and excess capacity will limit future growth. 

Now, exports are declining after decades of 20 percent annual growth. An earlier housing boom, driven by aggressive bank lending in response to the 2007-2009 recession, has been followed by a decline in construction. Growth in capital investment continues to slow. The industrial sector’s growth rate plummeted from a 22 percent annual rate in the second quarter of 2007 to a mere 0.2 percent in the third quarter of this year. 

You might think all these weak numbers signal that the Chinese economy overall is headed toward recession. I don’t believe so, and here's why: 

Services (which includes consumer spending) grew at a healthy 12 percent annual clip in the third quarter from a year earlier. True, the stock market bubble and housing boom propelled that growth, which is falling back to earth now. 

Still, since the recession, the service sector's share of GDP has grown while the industrial sector's share retreats. Since the first quarter of 2007, services gained 8.2 percentage points of GDP, to 51 percent, while the industrial sector’s share dropped 5.8 points, to 40 percent. The remaining 9 percent is agriculture. Services’ share of GDP first topped that of industry in the second quarter of 2012. 

A major obstacle to consumer spending in China is its high -- and rising -- savings rate. It was 30 percent in the first quarter, compared with just 4.8 percent in the U.S. in September. Chinese households save huge portions of their limited incomes because of the obligation in a Confucian society to provide for one’s family, but also because pensions are limited and China lacks a social-safety net. 

There is evidence, however, that Chinese consumers are spending more. Passenger rail traffic continues to grow by a solid 10 percent. Interest in personal health and sports is growing, and the number of marathons and marathon participants doubled between 2011 and 2014. After a slump in sportswear sales following the 2008 Beijing Olympic games, sales are again jumping. Internet traffic through mobile devices has nearly doubled this year, and movie box-office revenue is up more than 50 percent. 

Sales for technology, alternative energy, education, media and entertainment companies are rising much faster than those in basic industries. Twenty newer Chinese stocks tracked by Goldman Sachs had 23 percent revenue growth in the first half of 2015 versus a year earlier, compared with 2 percent for older companies. 

Further evidence of the shift can be found in employment growth, which is increasing for the services sector and declining for heavy industry. Since 2007, the labor force in services rose 8.2 percent, but just 3.1 percent in heavy industry.  

On balance, then, China's heavy industry is retreating while services are rising. What will these trends mean for future growth?

Bear in mind that the service sector also is vulnerable. The earlier boost to financial services by the stock market and housing bubbles has been reversed. Also, laid-off workers from private heavy industry and state-owned enterprises have reduced purchasing power. 

Using regression analysis, my firm measured the effects on GDP of various combinations of growth in the manufacturing and industrial sector and the services sector. For the third quarter, the 0.2 percent growth in secondary industries (manufacturing, energy, construction and mining) combined with the 11.9 percent advance in the tertiary sector (services) results in a total GDP gain of 5.4 percent. 

Adding the 0.5 percent GDP contribution from the ever-shrinking primary sector (agriculture), the total comes to 5.9 percent -- still below the (likely overstated) official 6.9 percent growth rate, though not by much. 

Chinese statisticians have no doubt been inflating their GDP numbers since Mao's Great Leap Forward in the 1950s demanded big output gains -- or else. Overstatements are probably greater now that growth is slowing. 

Even if services rose at an optimistic 13 percent, when combined with flat manufacturing growth in future years, GDP would still rise only 6 percent annually. A more realistic flat manufacturing sector and 10 percent growth in services yields 4.3 percent overall GDP, but don’t count on the Chinese National Bureau of Statistics to report a number that low! 

So even Beijing’s newly reduced growth target of 6.5 percent is unrealistic. The 4 percent to 5 percent range is more likely -- and that’s based on clearly overinflated historical numbers.  Still, ongoing growth in the services and consumer sector should stave off recession in China and actual declines in GDP. 

As China shifts from an export- and infrastructure-led economy to one more domestically driven, its impact on other economies will drop. In particular, China’s role as the vacuum for the world’s commodities will continue to recede.

Look for the recent nosedive in commodity prices, be it copper and other nonferrous metals, iron ore, coal or other basic materials, to persist. On the other hand, Chinese food imports may gain as rising personal income levels result in diet upgrades. It takes more grain to turn pigs into pork than it takes to satisfy human nutrition needs directly with corn. 

China will no longer dazzle the world as it did in past decades by taking over global manufacturing and growing rapidly. But at least slower, domestic-led growth will be more sustainable. 


Monday, November 16, 2015