"Kee" Points with Jim Kee, Ph.D.

World: There were two big headline events from last week. The first was Spanish bank problems (Spanish government bond yields have risen above 6%). The second was the release of China’s first quarter GDP growth rate, which came in at 8.1% annualized. That was above the official target of 7.5% but below the fourth quarter’s 8.9%. I find it implausible that any of this – China’s growth or the condition of Spanish banks - was new news; but markets sold off nonetheless. Interestingly, Moody’s has decided to delay until May its decision of whether or not to downgrade the credit ratings of 114 banks in 16 European countries (WSJ). Expectations are for most of these larger banks to have their ratings cut a notch or two. That should be priced into stocks right now, so it will be interesting to see the market’s reaction to European debt downgrades in early May.


Otherwise, it looks like the global economy is improving, or at least ceasing to deteriorate. Global manufacturing PMIs (Purchasing Managers’ Indices) suggest “stabilizing” (rather than contracting) economic activity (Wells Fargo). PMIs from Europe suggest less contraction in the first quarter of this year than the 1.3% annualized rate of contraction reported for the fourth quarter of 2010. That would be consistent with the mild recession scenario for Europe. And the Chinese manufacturing PMI for March came in at close to a twelve-month high. This mirrors manufacturing PMIs in other Asian economies, which have registered expansion (>50) over the past few months. Hong Kong-based Gavekal asserts that most Chinese indicators, including the Chinese property market, have probably already troughed or will in Q2, so they forecast stronger Chinese growth in the second half of 2012. Finally, retail sales in the United States grew by .8% in March, which was more than double the .3% consensus estimates.


Earnings note: Companies are reporting their earnings or profits for the first quarter. The month following a quarter, when companies report, is known as “earnings season” (January, April, July, and October). Wall Street analysts typically forecast company earnings, with some companies having no analysts cover them while others are covered by over 20 analysts. The combined estimates of Street analysts are known as consensus estimates. The current line, which we think is accurate, is that the fairly strong macro data we are seeing, along with prior earnings estimate “downgrades” (when analysts lower their forecasted earnings estimates, or “revise downward”), should make it easier for companies to “beat” the consensus when they report. If they do, it is called a “positive earnings surprise.” If they fall short, it is called a “negative earnings surprise.” As an aside, I spent several years in my research career with very talented quantitative analysts trying to build models that used things like “upgrade/downgrade” ratios and positive/negative earnings surprises in order to forecast aggregates like industries, large versus small caps, and even relative country performance. It didn’t work. Even peer-reviewed papers that suggested that upgrade/downgrade ratios could be used to build international asset allocation models couldn’t be replicated by us. So company earnings are very important to stay on top of, but they are not as prescient as you would think for forecasting broad asset class performance.


Chinese Renminbi: China has agreed to “loosen” the band around which their currency (the Renminbi) trades. It can now rise or fall by 1% each day relative to the dollar versus the previous .5% band. China wisely gained instant currency credibility by linking its currency to the U.S. dollar back in 1994. Today, there is widespread conviction here in the U.S. that China has been keeping its currency or exchange rate too low (a belief I don’t share). Since China exports a lot to the U.S., it is believed that a floating rate would see the Renminbi bid up or appreciate. That’s because buyers of Chinese goods ultimately have to exchange their dollars for Chinese currency. Buying more Chinese goods leads to a flow of dollars into China, which would bid up the Renminbi relative to the dollar in a floating rate regime.  And in general, when the Chinese have loosened the peg (since 2005) it has appreciated. But allowing it to float freely, that is, completely severing its link to the U.S. dollar, is another thing entirely! As Nobel Laureate Robert Mundell, who advises the Chinese government, pointed out in 2005, a new, freely floating paper fiat (not backed by anything) currency issued by a communist country could very well fall like a rock if severed from the dollar. I think that has a lot to do with the Chinese government’s hesitancy to allow the currency to freely float.


Inflation: Finally, U.S. consumer price indices were also released last week by the BLS (Bureau of Labor Statistics). Here’s what I wrote for the press. Some of this is redundant for Kee Points readers, so I put it at the end!


Today’s Consumer Price Index (CPI) release for March is good news, as it shows continued, modest increases in both the CPI and the core index, or all items less food and energy. Believe me, what you don’t want to see after three years of Fed credit easing is falling indices, or disinflation threatening to turn to deflation. That would tell you that something is seriously wrong or broken here in the U.S. But today’s numbers are consistent with continued, modest expansion in the U.S. economy. Interestingly, housing (shelter) and cars and trucks drove about half of the 0.2 percent increase in the core rate. That’s a good sign too…housing and autos typically lead economic recoveries, but they have largely been on their back during this one. I hope this indicates that the trough in housing and autos is behind us. As for the Fed’s room to maneuver, there is nothing really that implies restriction in this month’s releases. Prices in the underlying goods and services that make up price indices ebb and flow, and the Fed knows that. Most increases and decreases in the indices are transient as these underlying prices run their course. Think of the CPI numbers along the lines of a statistical process control chart. The Fed’s long-run inflation target is about 2% for the core rate, and I’d say they allow variability of plus or minus two percent. So anything in the 0% to 4% range is roughly “in control” and anything out of that range implies a “breakout” that constrains policy. So every tick up isn’t an inflation break-out, and every tick down isn’t a deflation signal. That’s the way I think about it, and that’s how I feel investors should think about it.