Thought of the Week Archives

Thought of the Week: Harsh Words on Gold, 04.22.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

As a graduate trainee in a London accepting house in the fall of 1981, I was given the tour and history of my new, 130 year old bank. It was one of the banks that set the daily gold price and had large bullion deposits somewhere under its location at 114 Old Broad Street. But the tour stopped at the vault door. No one went further (probably someone did but it was beyond my pay grade) and further discussion discouraged. Such was the mystery of gold.

Gold always struck us as a very weird investment. Sure it has this allure (it’s finite, durable, inflation hedge, the more ominous the world, the better for gold and so on) which can attract aficionados. Part of its reputation as a hard money tool is bunk. The Gold Standard that became the stuff of legend, from around 1870 to 1914, proved to be a very painful way to correct current account imbalances and led to several prolonged depressions and panics in any number of countries.

The recent obsession with gold had three phases: i) the 1970s rush when a production shortage (think Apartheid sanctions) led to a speculative bubble which took 20 years to clear and paved the way for ii) a Yale study in how, from 1959 to 2004, the risk premium for commodities was essentially the same as stocks but they were negatively correlated so you should jump in with new exciting vehicles in the form of iii) ETFs which quickly accumulated 84m oz of gold or about twice the entire circulation of Krugerrands. They also have a very weird third-hand claim on the gold if you care to read the prospectus. Short version: you don’t own gold when you own an ETF.

And that set the stage for a speculative blow out. Gold’s utility as an inflation hedge is useless. Here's one chart where the best you can say is that gold beats inflation sometimes but in a highly volatile way:

Or here where we divide gold by the CPI to get...well call it what you want but a hedge would be a straight line and this one ain’t. And it’s the same chart whether you price in Swiss francs, yen or pounds.

We think two things happened. One is that the low or negative correlation of commodities disappeared once the same buyers appeared. In other words, low correlations can happen if commodity buyers exhibit inherently differing behaviors to investors, (for example, they buy for industrial needs, inventory and fabrication) but these correlations narrow considerably once buyers are pursuing the same end. Put another way, correlations are as much buyer dependant as they are intrinsically dependant. With gold, the correlation with stocks used to be negative but for the last five years and one year have been 0.22 and 0.66. Two. Gold and its derivative markets have de minimis hedge loads, i.e. it no longer serves any utility as a hedge and so becomes just another financial asset. Risk on or risk off. Take your choice.

So what now? People will make money from gold but it will be increasingly speculators and timers. Not investors. We probably wouldn’t touch it.

Big HT to my colleague Jason Doiron on this...

¹Yale? Yes, well look at the recent debate on the data veracity of the Reinhart-Rogoff study to see how easily beguiled investors can be by oh so serious papers.

Sources: Bloomberg; Capital Economics; Credit Suisse; “Facts and Fantasies about Commodity Futures,” Gary Gorton and K. Geert Rouwenhorst (National Bureau of Economic Research); Federal Reserve Bank of St. Louis; Sentinel Asset Management, Inc.

Thought of the Week: Morning in Japan, 04.08.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

There were two very important central bank meetings last week, one from the Bank of Japan the other the ECB. Bank of Japan press conferences have been soporific affairs for years with a few QE programs not leading to much and no changes to inflation targets. Deflation, a declining workforce and falling aggregate demand have been pretty much the unbroken story for the best part of two decades. Enter Abenomics last December, which promised higher inflation, active fiscal policy and more intrusive monetary policy. That’s when the stock market started a quick 10% rally for the last few weeks of the year. The one remaining piece for it all to work was whether the new Bank of Japan governor, Kuroda, could activate the rest of the central bank to start a new program. The dilemma was, would reactionary forces trump political intent?

We got our answer last week. The bank announced a radical program that includes: i) a doubling of the monetary base from now until the end of 2014 ii) maturity extension of bonds from less than 3 years to up to 40 years iii) JGB purchases of around $56bn a month for the next 20 months…that’s 65% of the amount purchased by the Fed in an economy less than one third in size iv) purchases of more risk assets, including corporate bonds, ETFs and REITs...can you imagine if the Fed announced they were buying $2bn of ETFs every month? v) scrapping the banknote rule which prevented JGB purchases from exceeding notes in circulation...in the US they do already and by a factor of around 1.5:1.0 and finally vi) a more strident form of communication that intends to "drastically change the expectations of markets and economic entities."

Will it work? In the short term, we saw what you would expect from a QE launch. The yen weakened by 3%. It is now 20% devalued against last September’s level. Bonds rallied 1.5% as yields fell 12bps and stocks ripped by over 2%. In the longer term, Japan has a deflationary bias: a smaller workforce, with more, low spending retirees, and productivity gains. This combination usually leads to lower prices. The average CPI over the last 20 years has been 0% and core CPI -0.1%. So the QE program will hit asset prices more quickly than broader economic prices. And hopefully domestic asset prices rather than a transfer through to overseas buying. We have seen Japanese initiatives come and go over the years. The stock market is still roughly 70% below its peak. But the combination of fiscal, monetary and inflation targeting has not been tried before. This is a critical juncture and so far so good.

ECB
The meeting at the ECB was the first since the Cypriot blow up where the central bank played a distinctly subsidiary role to the rest of the Troika. So the question was what would the bank do in the face of a flash CPI falling to 1.7%, unemployment rising to 12.0% and big declines in the national PMIs? The forecasts were also pretty dim. Here are the official 2013 forecasts compared to a year ago:

So in every case, severe downward revisions. The ECB had plenty of options: i) start using Structural Operations (HT to Lorcan Kelly at TrendMacro), which have vastly more flexibility than standard repurchase agreements and can include buying credit claims on non-financial companies and so bypass the banks ii) a rate cut iii) OMT expansion iv) changes in collateral policies to encourage more bank lending. But while acknowledging problems in the economy, including the access to funding which is seriously impeding the liquidity transmission mechanism, Draghi offered no new solutions. All in all a quiet affair and the ECB did not even bother to post the transcript of the Q&A section on its Web site until the next day.

Fed Speak
There were a number of Federal Reserve governors on point this week. We didn’t read all of them but we started with Kocherlakota of the Minneapolis Fed, certainly one of the more thoughtful of the regionals, expressing real concern about unemployment. His position is the unemployment rate will be 7% until the end of 2014, that a more accommodative policy is required and the threshold unemployment target, the target required before any policy change, should be 5.5% not 6.5%. He also directly linked inflation to wage growth pressures and saw no real upside in the PCE from 1.6%.

John Williams, over at the San Francisco Fed, stated that “substantial improvement” in unemployment was needed before any changes but that he saw the possibility of tapering purchases some time in the second half of the year. That seems a little optimistic given the level of claims and economic activity more in line with a 2.5% to 3.0% growth for the year. Still, at least he’s consistent on what would trigger changes in policy.

Janet Yellen pulled no punches. She thinks unemployment is far above what it should be and that it should be “center stage” for everything the FOMC discusses. There's no doubt that she feels that there will be no let up in purchases until the “substantial improvement” threshold is met and she also gave a preview on the exit strategy: taper, stop, reduce and raise. And that will be a very long trip.

This year’s serial dissenter, Esther George in Kansas, flat out thinks policy is too accommodative and that asset prices in farmland, high yield and leveraged loans could be a real concern. She is also concerned, not unfairly, that it’s not realistic to ask bank regulators to identify all the risks of accommodative policy. Put these four speeches together and we can see the frustration the Fed is facing on managing growth and employment with only monetary tools. Our own view is that we’re in for many more months of accommodative policy and that it will take several 200,000 plus NFP reports to affect any tightening. Last week’s bond market strongly suggests they see it the same way.

US Economy
The worry for the US is that for the last three years, spring has brought a weakening in the broad economy and set back for stocks. The average correction for spring corrections has been around 7% to 17%. Is this going to happen again? The first signal of weaker activity came last week with the ISM Manufacturing and Non-Manufacturing indexes. Both track large employers which is where most of the action in employment and production is centered given the tender state of the NFIB hiring intentions. Here's a quick GDP-weighted look at the two ISMs together with the March downturn painfully evident:

It was discouraging to see that both new orders and employment were down in both series. The claims number was also weaker at 385,000 after being in the 340,000 to 350,000 range for most of the last month. Here's the four week moving average against the S&P[1]:

The NFPs on Friday were a clunker. While the headline unemployment rate fell, the number of new NFPs fell to 88,000, the lowest level since last June. The participation rate fell again and the labor force shrank. It’s now half a million smaller than the level of last December. Here's the unemployment rate and hourly earnings. As expected the increase from last month has reversed.

We would be wary of another few weeks of disappointing numbers given the stock market’s affinity for good jobs numbers.

Bonds
The GT10 has now backfilled its entire move from December 31st. We saw another point in return over the week as yields dropped 20bp. As of Friday mid session, the 10-year touched 1.69%. Over the last few weeks the 10-year returned 2.8% while equities ran flat. Investment grades, MBS and high yield were also mostly flat. This is not a robust, across the board bond rally. But the bull case for bonds is a combination of eurozone problems, weaker US stats, capital flows into the US dollar, many accounts simply underweight duration and the street generally short of inventory. The quality rally is evident too in i) the rally in JGB 10s, up 3.7% in two months and with the 10-year coupon dropping from 0.8% to 0.45%, and ii) Bunds up by the same amount with yields close to all-time lows at 1.21%. Looking at the US Treasury market from a world view, then, yields at 1.75% look very attractive! From a technical point, 1.70% on the GT10 looks like a bottom. But any more slack in the economic reports, yet alone a geopolitical scare, and we could see more bond upside.

Equities
For the last two months the market has settled into equilibrium of around 1500 to 1570 with the bias very much to the upside. It has been one of the most robust markets in the world with a near straight line up and YTD performance of +9%. Other markets have outperformed, particularly Japan which is up 21% in local terms but only 10% after adjusting for the weaker yen. The US market near term performance has been remarkable but remember we’re only just over the level of several years ago.

The difference between now and 2007 is that profits are higher, yields up and most of the market is cheaper. Investors seem to be in two camps: 1) the can't quite believe it but don’t want to miss it and 2) the it’s fine and use any dips to add exposure. We’re in the latter and have been for some months. There's very little bearish sentiment and none of the innate nervousness we’re picking up from the bond market. The upcoming earnings season will be a test. No one wants to sell ahead but if some of the estimates are revised as a result of the recent weaker economic news, we will see a correction opportunity.

Bottom Line: We peeled some of our equity exposure back mid-week and spent some money on bonds and duration assets. We also traded treasuries during the week. But we’re still over weight in equities.

Sources: Bloomberg, Capital Economics, CRT Ader, Economist Free Exchange, Federal Reserve Bank of St. Louis, IMF Fiscal Monitor, Federal Reserve Bank of Kansas, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Federal Reserve Board, Bureau of Labor Statistics, Bureau of Economic Analysis, US Department of Commerce, ISI, J.P. Morgan Market Intelligence, High Frequency Economics, Pantheon MacroEconomic Advisors, ISM Chicago, TrendMacro, Tim Duy’s Fed Watch, Bank of America, Merrill Lynch, Federal Reserve Bank of Minneapolis, Bank of Japan, CLSA, European Central Bank, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Minor crisis...not too many hurt, 04.01.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Cyprus proved, over the last two weeks, that markets often overlook the small stuff. Very few commentators we follow saw any of it coming and the theories that sprang up in the interim (Cyprus as vassal state to Russia, return to the Cypriot pound, imminent EU break up, twin euros in circulation, utter disaster for the economy, German intransigence and Schrecklichkeit) were absurd.

Here's what happened and, then, more important, we’ll look at what it means. 1) Cyprus is a divided country and has had a UN force keeping two sides apart for most of the last 50 years. There are roughly 1,000 UN troops maintaining a buffer zone equivalent to 3% of the country, including some of its richest arable land. 2) It joined the EU in 2004 and the euro in 2008. So we have a small country, now playing in the big league, with an overvalued currency and low rates. Cue the next stage: fast catch up, real estate boom and rocket growth in banking.

And dead on cue 3) Cypriot bank assets quickly became over 700% of GDP, compared to 350% for the EU and 90% in the US. Much of the liability growth came from depositors. There were virtually no bond creditors and the equity ratio for its largest bank never fell much below 20:1, compared, say, to US banks at 10:1. Customer deposits were around 80% of liabilities, again compared to around 33% in some of our best US banks. On the asset side, much of the sector was exposed to Greek private loans and sovereign bonds.

So the tie in with the bad part of the EU, plus the razor thin equity buffer, plus the reliance on demand deposits, plus the size of the two main banks, led to a collapse in banking profitability, bad loans and an ECB lifeline. At its peak, the largest bank was worth €17bn. You can have it now for €374m. 4) The ECB lifeline, in the form of emergency liquidity, was meant to be temporary. The Cyprus government asked for a more stable solution and got it, in the form of €5.8bn injection, but under conditions imposing losses on all creditors. With the equity tranche already wiped out, that only left the depositors. The agreements that the Cypriot negotiators agreed to was a 7% to 10% levy/haircut/wealth tax on all bank depositors, including small account holders who are usually insured.

Nearly there. The rest happens quickly. 5) Parliament rejects the deal. A new deal focused on just the two banks with the problem, not all banks. Insured depositors get 100c on the euro. Other depositors get large haircuts and an equity kicker (which is pretty worthless). The banks continue with their emergency liquidity. But, capital controls come into place and there are limits on cash withdrawals, check amounts and transfers aboard.

A final twist was that a hitherto anonymous bureaucrat said that the deal may well represent a template for future bank bailouts and that, yes, that included going after depositors. This was fully in line with an European Commission directive from a few months ago which said there must be "better protection [for] tax payers...[we may have to] interfere with creditors' rights...and [that the only protected liabilities were going to be] secured liabilities [and]...deposits...of less than one month." No fair complaining you couldn't find it on the Web site. So his comments were perhaps bad timing but otherwise pretty much on the money. The markets didn't like that one bit and hence the stories on two euros (one in Cyprus, one everywhere else), little guy depositors triggering bank runs and the contagion fear that all weaker banks would get the Troika hammer treatment.

With the picture a little calmer on Good Friday, we think the assessment goes like this.

1. Capital controls are not great but they happen all the time and the world's second largest economy uses them with impunity. So why not the 95^th? Article 65 of the EU Treaty explicitly allows exceptions to the free movement of capital when members need to undertake "prudential supervision of financial institutions."
2. The two-euro story doesn't work. There's no black market for Cypriot euros and a Cypriot euro in Austria will still buy you a bite or two of Wiener Schnitzel. The US has a currency used almost exclusively by about ten other countries. In any of those the dollar is worth exactly…a dollar. Regardless of capital restrictions.
3. This is not prelude to currency break up. It is prelude to tougher deals if you need a bank bail out and European banks certainly traded lower over the week. But funding stresses, such as the LOIS EUR, which measures the spread between interbank rates official rates, barely moved and remain well below the one year mean.
4. Other stresses in the week included a rally in Bunds and German T-Bills going a bit more negative. But Spanish bonds held value and remain well above what they were at the beginning of the year. The euro fell but rallied. Equities fell around 3% but also recovered.

Put all this together, and, yes, we have a miserable outlook for the Cypriot economy. It could decline by as much as 16% and sets back growth for years. It’s part, then, of this bigger picture of really awful nominal growth in Europe. Here's the nominal growth of the EU and the US with the blue line of the EU falling again and again. (HT Economist Free Exchange)

Growth is a huge problem as is attendant demand and unemployment. But perhaps we have slightly more certainty over how banks will be treated and another example, muddled maybe, of how the euro is determined to stay together. And that in turn makes us pretty confident about our European equity holdings, many of which are world class multinationals trading at very reasonable multiples.

FOMC
We stupidly scheduled a vacation when the FOMC met. These are just such bundles of fun that reading up on them after the event is a real downer. Like watching Valentino Rossi pull a last corner overtake when you already know the result because Speed schedules GP races at ungodly hours after the event is long over. I digress. The Fed committed to unchecked purchases. Their 2013 projections now look like this:

This means that, again, the collective estimates overstate growth, understate inflation and get employment about right. There was of course one dissenter, Esther George of Kansas with the familiar monster-in-the-closet inflation fears. Let's go hunting the snark inflation. Is it here in the GDP price deflator?

No.

Is it here in the Fed's favorite measure of inflation, PCE core that came out on Friday?

Why, no. Is it in the broad CPI and does the TIPS market care?

No and no. So the only explanation must be that the size of the Fed’s balance sheet is an inflationary time bomb and that it must come through to the real economy at some time. Any day now. And therefore the money story is the thing to look at...so here it is:

Not there either. Is it coming through in wages and a tight labor market?

No. That little tick on the right side of the hourly wages measure is still pretty meager and has a way to go before it disrupts the improvement in the unemployment rate. So it was nice, in the absence of any indicators that price or wages are affecting inflation, to hear Dudley of the New York Fed confirm that he would look for a real “substantial” improvement in the labor market before making any changes and that the Fed is falling short of the inflation target. And this was reinforced by recent hawk Kocherlakota from Minneapolis who stated that while he was all in favor of the 2.5%/6.5% inflation and unemployment target, he actually would like to see more “monetary accommodation” and that they should change the unemployment target to 5.5%. This is the same Kocherlakota who last May expressed concern about inflation at 2% and hypothesized that the then current labor market performance of 8.2% was close to “maximum” levels. It sounds like he stared into the abyss and didn’t like what he saw.

Again, what all this means is that despite gradual progress on the economic front, the Fed will look for more consistent signs of improvement before letting off the current asset repurchase program.

And in the economy?
Generally the week had very disappointing consumer confidence numbers (surely the sequester plus delayed reaction to the payroll tax), Richmond Fed Manufacturing, where orders and delivery times fell and the Chicago PMI, where production, new orders and backlogs all took small hits. The big reports for the week were the revised third estimate GDP numbers for Q4, which came in at 0.4%, up a bit from the original 0.1% but still very weak in the government sector. Without that, GDP would have been around 1.8%. We also saw the first glimpse of corporate profits (they're not in the first and second estimates). Here they are as percent of GDP, their second highest read in twelve years.

Some of that is due to lower taxes but a lot is the continuing story of a strong corporate sector that goes some way to justify the run up we have seen in stocks.

The other big number was personal income which rose 0.7% after the 4.0% decline last month which was, in turn, highly distorted by the run up in dividend income in the fourth quarter. It’s not a strong number and spending was probably propped up by another low savings ratio. Also compensation grew at about half the rate of personal income. The latter number was helped by income receipts on assets and rental income.

Bonds
The story for most of the week was a good old fashion flight to quality. The GT10 came in by around 10bps to finish at 1.84%, for a total return of 1.2%. As we’ve said before, these are markets where the coupon can be won or lost in an instant given duration and rate levels. The same story for Bunds which had a similar 1 point gain as investors sought safety. The Fed doves were out in force and the weaker numbers mentioned above let the market drift stronger. The new range for treasuries might well settle into a lower band of 1.75% to 1.85%...at least that’s what the technicals suggest. Throw in some quarter-end positioning, a long weekend, index rebalancing and the market was pretty quiet in other areas. The New Issue Market was quiet too with none of the big corporate names coming with new deals.

Equities
The new money into equities continues. It’s not a rotation. There's no big flood from fixed income money coming. But there has been a roughly $100bn run down in money market mutual funds that may well have found its way into equities. Mind you, that happened last year too and fizzled out by June. The market is holding up well. As we’ve mentioned before, the 1570 level is supported by $111 in earnings. Back when the market was at the same level in 2007, it was $89. So a fourteen multiple feels sound. Also if the S&P 500[1] had just kept up with inflation from 2000, it would be 2056 today, not 25% lower. We’ll certainly keep any eye on multiples.

Bottom Line: Using cash to trade treasuries. Over weight equities but not increasing.

Sources: Bloomberg, Capital Economics, CRT Ader, Economist Free Exchange, Federal Reserve Bank of St. Louis, IMF Fiscal Monitor, Federal Reserve Bank of Kansas, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Federal Reserve Board, Bureau of Labor Statistics, Bureau of Economic Analysis, US Department of Commerce, US Dept of Housing & Urban Development, ISI, J.P. Morgan Market Intelligence, High Frequency Economics, Pantheon MacroEconomic Advisors, ISM Chicago, TrendMacro, Tim Duy’s Fed Watch, Bank of America, Merril Lynch, Federal Reserve Bank of Minneapolis, ECB Bank Structural Reform, European Commission, “Directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions”; United Nations; Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Things could get bumpy but hang in there?, 03.18.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

What America does with its money.
The quality of the Fed’s Flow of Funds data is about as comprehensive a balance sheet assessment of corporate and private America as you could wish for. It’s also great for looking at trends rather than the hot spots over which the market frets. Here are some of the findings:

US: no push but some pull through
The four fiscal threats are winding their way through the system. These were i) increase in taxes for January 1st, ii) sequester, iii) continuing resolution, and iv) debt ceiling. We’re still awaiting the effect of the first two on the economy. So far things have been muted but they may not remain so. Starting with the fiscal drag, this is what growth in government spending looks like in the post recession period compared to the first eight years of the decade.

That blue line is the slower rate of all government expenditures which has happened pretty much relentlessly since 2010. The red line is the 20% increase in government spending in the…well you know. This month’s budget statement can be broken into the following (the numbers are for five months into the fiscal year starting October):

Now, the fiscal year is not over and there are seasonalities which make the straight line extrapolation a little simplistic. But the core story is that fiscal consolidation is going on and at quite a pace. The deficit is falling rapidly. It’s certainly helped by double-digit growth in revenues which supports the truism that the cleanest and quickest way to improve the deficit is to get people back to work. The so-called entitlement programs are growing but so too are the hypothecated taxes, especially the social retirement tax. At the rate of the current shortfall, and assuming modest growth in the $2.6tr Social Security trust fund, Social Security will drop scheduled benefits down to payable benefits in about 22 years. We do not currently see a scenario where Social Security stops paying!

The deficit meanwhile continues to shrink. The latest CBO estimate is for a deficit of 5.3% for this year and leveling out at around 3% for the next 10 years. Whatever problem we’re trying to solve, discretionary non-entitlement programs isn’t one of them. And the entitlement programs really revolve around an aging population and medical costs. But they’re certainly not big enough to crowd out the private sector.

On the jobs side, we saw the JOLTS report which should be a lot stronger given the employment gains. There does not seem to be enough in the way of job openings. The latest number show around 3.6m up from lows of 2.4m but the relevant number is openings per person unemployed and it looks like this:

So that’s way above what we would expect. Here the normal cue is “aha...see it’s structural unemployment” and there're some points to that argument. The NFIB came out last week and, again, 34% of companies reported few or no qualified applicants for job openings. Similarly, the participation rate is coming down steadily (here the blue line) while earnings (red line) hooked up in the last report.

But against this, we should acknowledge that the small companies in the NFIB survey always report difficulties in hiring and even at the worst unemployment rate levels in 2009, well over a quarter reported difficulty in finding applicants. On the earnings side, we would rather see a few months of higher earnings increases before claiming a tightening labor supply. The latest number may be no more than employers willing to provide overtime and more pay rather than hire. So it’s way too soon to think of the labor market as constrained or in some way structurally changed from prior years.

Bonds
We had 3/10/30 auctions last week. The 3-years are rarely eventful. The 10-year had been traded weakly in the first half of the week, disturbed, probably, by the strongish NFPs. Going into the auction the 10-year was trading weakly in the repo market which tells us that there was a big short ahead of the auction. But the auction was successful and the 10-year yield ended up some 5bp lower by week’s end. The 30-year auction was a little weaker with a lower bid/cover ratio and the indirect bidders taking 42% compared to a norm of 34%. By the end of the week there was very little net move in bonds.

Overall, the tone seems to be firming. We have digested the supply. Mortgages remain under pressure…we think it’s mainly hedge fund selling. High yield continues to outperform IGs YTD by about 180bp. Put that down to equity strength.

Equities
All roads lead to a 1600 level. The consolidation around the 1560 level is very welcome. The market has two forces at work: those who want a pull back and those who don’t want to fight the tape. One adage works for us right now: don’t short a bull market. Consensus estimates are for a $110 EPS coming into earnings season. The valuation strikes us as very reasonable.

Bottom Line: On any small set back we will up our equity exposure.

Bottom, bottom line: Two members of Sentinel’s extended family passed away last week. Our deepest sympathies go to the families.

Sources: Bloomberg, Capital Economics, CRT Ader, Economist Free Exchange, Federal Reserve Bank of St. Louis, IMF Fiscal Monitor, Federal Reserve Bank of Kansas, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Federal Reserve Board, Bureau of Labor Statistics, Bureau of Economic Analysis, Congressional Budget Office, US Dept of the Treasury, ISI, J.P. Morgan Market Intelligence, High Frequency Economics, Pantheon MacroEconomic Advisors, TrendMacro, Tim Duy’s Fed Watch, Bank of America, Merrill Lynch, National Federation of Independent Business, Sentinel Asset Management, Inc.

Thought of the Week: We made it. Now what?, 03.11.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Imagine you are in a boat about the size of a car. The waves coming at you are equivalent to a twelve story building. Your boat is leaking badly and you're about to head into the Roaring Forties, some of the most ill-tempered seas in the world. What do you do? Well, Donald Crowhurst faced this in 1968 in an attempt to be the first to sail solo round the world. The stark choices were to continue, and meet almost certain disaster, or turn around and face bankruptcy. Then a third option came to him. Stay still, wait for other racers to pass him by, slip into their wake and return home the short way. Survive with a simple deception. No harm done. It turned out very badly and if you want to know the ending, watch a tremendous documentary called Deep Water. But for today, the “staying where you are and waiting it out option” is what is happening in Europe. What looks like a fairly settled policy is fast becoming a very dangerous situation. The outlook for the world’s second largest economic block is pretty awful.

On we stumble
The ECB is a curious animal. Its only mandate is price stability and to do it with very few tools. QE? Nope. Asset purchase? Not really. Buyers of sovereign debt in the primary market? Definitely not. Foreign exchange intervention? No. Reserve management? No.

This week the bank kept interest rates unchanged even as unemployment hit the 19m mark. Mario Draghi warned that in a bank-based economy, i.e. where capital markets play little part in the financing of enterprises and nearly all expansion and growth must be financed with loans, the transmission mechanism was still very weak. In simple terms, this means that credit does not flow and that banks’ poor asset quality and risk aversion prevents liquidity flowing to where it’s needed most. So we have a situation where i) inflation is at or below the forecast rate ii) the flow of money is seized and iii) the OMTs are a solution that, as yet, no one wants to engage . So what we face is very limited ECB support to the wider economy in Europe.

Some commentators suggest the ECB has failed. In fact, it has done a lot given the very limited arsenal at its disposal. Draghi managed to talk away the risk of a break up last summer and the all important spread differential of Italian and Spanish debt to Bunds has held up. But we’re now entering a phase where the low rates simply forecast low growth, low demand and inertia. Not any broad confidence in growth. The ECB is not to blame. It has all the tools of a Swiss penknife in a world which needs backhoes. Meanwhile the real economy stats look pretty sad: 4Q GDP in the eurozone fell 0.6%, and nearly every component fell in unison. Exports were down 0.9% and consumption fell again. It has not registered positive growth since mid 2011. The French economy is feeling the pinch. Government is pulling back, the relatively strong euro hurts French exports, and its decade long history of increasing labor costs at twice the rate of Germany means that large parts of the economy are very uncompetitive. The overall risk, of course, is that if France begins to hurt, the core cohesion of the EU will come under increasing duress.

There are few hints that the road of “growth through austerity” will change in Europe. But there are more voices calling out. Last week the boss of Fiat said “I understand austerity, but we can lose weight until we die.” Or, another way, just staying put and trying to sit it out is highly dangerous. By any normal standard, Europe should be pursuing easier monetary conditions immediately and governments should be on a course of gradual fiscal growth. The fact that it is not happening means more woe.

The Fed by contrast...
Two more speeches last week from the Fed heavyweights (so that’s Bernanke and Yellen) which reinforced that any tussle between Camp One of “ease up soon, we don’t know what effects Fed policy is doing to financial markets” and Camp Two of “we know exactly what we want monetary policy to do and we won't ease up until we get there” is one sided. Camp Two is winning. Bernanke was up first where he answered the question of why rates are low. The answer was flatly that inflation is low and is expected to remain so, the recovery weak and that term premiums, or the extra return expected from holding long-term bonds, were low because of the safe haven demand for safe assets. He does not think that any assets are mispriced to any real level and that, anyway, the Fed has better oversight, supervision and understanding of the financial sector than they did. This is probably very true as last week’s stress tests on 18 of the large bank holding companies showed that under even severe conditions, Tier 1 capital would fall from around 11% to 8% or about what they were four years ago. In other words, there should not be any major financial fall out from the banks. Famous last words perhaps, but it does mean that there's unlikely to be any monetary easing caused by worries from asset prices.

Over at Janet Yellen’s speech we got some strong indications of what would change Fed policy. For a start, there's unlikely to be any change until we see a substantial improvement in unemployment. That means not just the 6.5% level, but things like hirings and total employment. Are we any where near? Well no, not even with the strong 236,000 increase in new jobs last week and a nice reduction in the unemployment rate to 7.7%. Here's the trend in new jobs. We’ve seen strong +230,000 numbers before in this recovery and they haven’t held.

Here's the hires-less-separations, which hit lows of -800,000 in 2008 and 2009 and should be closer to 350,000 in a robust labor market.

And here's all personal consumption expenditures which are not in any danger of hitting the Fed’s 2% target yet alone the newly revised one of 2.5%.

The recent personal income report held little to suggest any upward momentum to employment and growth. Disposable income fell 4%, interest payments as a total of compensation fell again (all part of household delivering) and DPI per capita, one of our favorite indicators of how much is being earned, fell YOY to $32,483. It hasn’t changed since 2006.

A final point in the speech was what the Fed may do with the $3.1tr in assets on the balance sheet, of which 88% are treasuries and MBS and 74% are securities of over five years’ maturity. We’ve thought for a while that the answer may be “nothing” and that the book may just roll off. In this case, the Fed can always use the overhang as a powerful tool to curb inflation because it could push the securities out quickly to raise rates if needed. This idea is getting more currency and could remove the risk of market destabilization. It would be a neat trick if we could get all the benefits of lower rates from asset purchases without concerns of a major put back. It would not be the first time this Fed has used untried policy to help the demand economy every way it can.

Bonds
Last week the market sold off around a point as it first saw better ISM numbers. The non-manufacturing index hitting a twelve-month high and both indices showed good gains in orders and employment. The strong employment gains on Friday were enough for 10-year treasuries to stay above 2%. But there was noise in the numbers to suggest (as above) that QE will remain. The labor force contracted by 130,000, participation dipped (it’s now half a point lower than a year ago) and even at the 200,000 of new jobs, we don’t hit the Evans-rule of 6.5% for well over a year. We continue to look at parts of the credit market where the “story”, or management, products and margins, are drivers of return, not just rates, duration and spreads. This is leading us into non-index names, which feels like a very good strategy in light of how hard some index constituent bonds might be hit in any ETF sell-off.

Equities
We made it. Records on the leading indexes. Although not in real terms and with some very painful corrections along the way. We don’t buy the “rotation” story and anyway “weight of money” arguments for stock gains are well worn and vacuous. Fund flows are simply less important these days. Hedge funds, institutional, corporate and retail demand have been growing, largely at the expense of funds. One good sign of confidence has been more announcements of share buy-backs. These aren’t always good for a few reasons. One, companies tend to buy less than they announce, two they nearly always buy near the top and three they can waste a lot of money doing it (one reason why they should run the purchases through the P&L account but that’s a diatribe for another day). But we have had a near 20 year record month for buy-backs in February and the market likes that. So do we.

Bottom Line: We remain overweight equities and have been for a while. On any pull-back we would add more. We are keeping a strong watch on valuations. Anything more than a forward multiple of 15 on the market would concern us.

Sources: Bloomberg, Capital Economics, CRT Ader, Economist Free Exchange, Federal Reserve Bank of St. Louis, IMF Fiscal Monitor, Federal Reserve Bank of Kansas, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Federal Reserve Board, Bureau of Labor Statistics, Bureau of Economic Analysis, US Department of Commerce, US Census Bureau, US Dept of Housing & Urban Development, ISI, J.P. Morgan Market Intelligence, High Frequency Economics, Pantheon MacroEconomic Advisors, ISM Chicago, Sentinel Asset Management, Inc.

Thought of the Week: Weave a circle round us thrice, 03.04.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

There was plenty of news to threaten the recent market rallies but, as of writing, we're within a whisper of all time highs in US stocks and managing to have a very orderly consolidation in bonds. This is surprising because the political process has once again taken careful aim and shot itself in the foot. The sequester has become the dumb answer to difficult questions and will initiate, mostly indiscriminate, across-the-board cuts. The markets have done mostly what they did with the fiscal cliff: wonder, shrug, announce a plague on both houses and kept moving. Here's the run down on three things that came at us:

1. Sequester
The headline total is about $110bn over two years and comes from the Budget Control Act of 2011. It is a straight cut to budget expenditures and meant to be equally painful to all discretionary spending...so it does not touch Medicaid or Social Security. It was effective January 1st 2013 but postponed until March 1st. Some $88bn of the cuts fall in 2013, the rest next year. About half is defense spending but excludes uniformed military personnel. Depending on timing, it's a hit to GDP of about 0.5% this year and 0.1% next year.

There are two effects of the sequestration. One, that if there's no middle ground on a relatively small issue, then what are the hopes of something bigger like the budget, continuing resolution and debt ceiling? Two, that GDP can ill afford more contraction in fiscal policy. In the latest GDP revisions for Q4 2012, we went from -0.1% to 0.1% or, put another way, we increased the economy by an annual rate of $4bn. Government expenditures contributed -1.38% to growth. Here's the year over year growth in government expenditures.

Now, while there may be a bounce in Q1 2013 spending to adjust for the shift in defense spending that was brought forward from Q4 to Q3 (thus over stating the decline in Q4), this is a real dampener to confidence when the economy is already facing weak export growth, slow inventory building and consumer spending. So lump on the sequester and we are really playing with fire.

2. Italy
Italy itself is not that important. Its markets are not big enough to sway flows or sentiment. But it is very emblematic of EU collaboration and unity. Quite simply, the market was complacent over these elections and underestimated the byzantine world of Italian politics.

Yes, yes, but what does it mean?
The election was a rejection of some of the austerity measures but not a rejection of the EU or its policies. It postpones labor and product markets reform but it's emphatically not a precursor to any rise of extremist parties (e.g. Catalonia secession in Spain or le Pen in France) or return to the bad old days of lira inflation. While we have to wait to see who takes up the PM role and we have more weeks of uncertainty, this is not prelude to dismantlement or crisis.

Markets were pricing in a benign outcome but were also looking for a reason to sell off after a 22% rise in the Italian stock market over six weeks. So we saw an 8% correction in equities and a 3 point correction in bonds. The bond market, which is the true fear barometer, took things well. An auction of 10-year bonds mid- week came in at 4.8% with a stronger bid/cover than the January auction. As of the end of the week, the rates were holding and the debate is on the composition of what will likely be an interim government. Unless yields hit the 5.5% level, Italy will not need ECB support and so will not have to sign on to a formal OMT and austerity program. We continue to hold Italian equities.

3. Bernanke in Testimony
The Fed is outwardly arguing its dual mandate. The hawks are i) pressing on asset price inflation ii) extremely uncomfortable with both the unemployment mandate and iii) QE buying. But these are Fed "participants" not FOMC "members". The only people that count are Bernanke, Yellen and Dudley. They (and Bernanke's testimony) are not giving one inch of ground to the hawks. QE will continue until they see "substantial improvement: in the labor market". The GDP numbers, weaker than any of the estimates, give them no reason to have any optimism that we're on a strong path.

The general tone of economic reports last week was steady and up. So we had a better report on durable goods once the erratic aircraft order series was excluded. This is what it looks like using year over year numbers.

But the core new orders numbers looked a lot stronger, at +1.9% over the month grew for the fifth straight month.

Finally, claims are trending better with a print below 350,000 and 4-week moving average of 355,000:

One nice update from the testimony was that the chairman brought up other "tools" that would normalize policy. First among these was the ability to retain assets and increase IOER. We think the Fed will never sell from its balance sheet. In other words the "exit strategy" riddle has the simplest answer: run off until maturity. This clearly underpins the market and means that large overseas holders (so China and Japan) need not worry about a disorderly exit and upset of the bond market.

Bonds
We are at around 1.87% on the 10-year which is exactly where we were in mid-January. In other words, GTs weakened as the market thought that Q4 GDP was not as bad as the print but strengthened as the risks of:

1. payroll tax turning into a bigger deal than expected;
2. higher gas prices (+15% YTD) biting into consumer spending;
3. sequester going ahead followed by continuing resolution and debt ceiling; and
4. indicators like NFIB, personal income and Philly Fed looking weak

...all came to the fore. In other words, we're in the 2% GDP world again with a soft Q1.

Also, we had a break down in the GT10 range. We had 22 straight trading sessions between 1.95% and 2.05%. Every time we got to 2.05% the tone would change and we would rally. The recent move below 1.90% changes the range a bit and if we get a decisive break to the 1.80% level, we would put on the shorts.

We have to be careful in these markets because people are used to buying the dips. Last week the GT10 was at par and 3/4, then ran to 101 1/2 then back to 101 1/4. We had a good 7-year auction and an index extension later in the week. Both helped the buying.

Elsewhere, in credit spreads are narrow, the New Issue Market is well bid but secondaries weaker. We had some very tight spreads on news issues. The high yield market looks vulnerable.

Equities
Stocks are on a breather. As long as the 1450 level holds, there's not likely to be a correction of any size. We're buyers at these levels and below.

Why are we buyers?

1. Housing indicators (so starts, pending sales, final sales, Case-Schiller, HD[1], mortgage rates) are all helping the wealth affect along. Nothing like 2006 crazy but at the margin. And that's what counts.
2. Easy money in US and now Japan. That helps rates, which helps interest costs, which helps sales growth which helps stocks.
3. More dividend stories to support the market.
4. Also good capital management announcements.
5. Here's how you can get to a decent outlook (not a prediction) on stocks in the S&P 500[2]:
   • i. start with a dividend of 2.3%, add in gross share,
   • ii. plus gross share buy backs of 4.8% (which is annualized rate YTD),
   • iii. plus M&A for public companies at 1% of S&P,
   • iv. less stock issuance for options at 1%,
   • v. equals 7.1% effective return

...and forward earnings on the market are in the $110 range so 13.5x, which has a lot of support.

Bottom Line: So, stay calm. The more headline drama, the more the market will trade en bloc or beta if Greek is your thing. That's not good for alpha generation in the short-term but allows for great buying. We're overweight equities with our own and client money and will stay that way.

Sources: Bloomberg, Capital Economics, CRT Ader, Economist Free Exchange, Federal Reserve Bank of St. Louis, IMF Fiscal Monitor, Federal Reserve Bank of Kansas, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Federal Reserve Board, Bureau of Labor Statistics, Bureau of Economic Analysis, US Department of Commerce, US Census Bureau, US Dept of Housing & Urban Development, ISI, J.P. Morgan Market Intelligence, High Frequency Economics, Pantheon MacroEconomic Advisors, Sentinel Asset Management, Inc.

[1] There was a position in Home Depot (HD) as of March 1, 2013. To see Sentinel Investments' Top 10 Holdings for all funds, please click here.

[2] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Looking for a Reason to Sell Off, 02.25.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Markets were looking for a reason to correct. Risk assets had outpaced themselves since mid November and in the first seven weeks the S&P[1] had outperformed the US Treasury 10-year note by 12% and the 30-year bond by 15%. There was no major event to the week. Just fatigue rollover and a mildly negative spin on the FOMC minutes. The markets will lumber through the sequester and face the next test on the debt ceiling and first quarter results. Below the surface, the outlook is mildly optimistic. Why the qualifier? Because everything, in Europe, US and Japan, must be set in the context of the asset deflation and deleveraging going on and that will go on for some years. In all this, the US is best placed to continue to outperform but it will remain subdued by any past measure.

Let's take as our start of the modern economic era Tawney's definition of the Reformation as the "rise of capitalism." So 500 years. Plot this on a calendar of January to February. Our first meaningful record of any national accounts came in 1665, so late April, from William Petty in the form of an income, expenditure and physical assets count. Adam Smith came along in mid-July and global value added measures came with Michael Mulhall in early September. The first measure of GNP came in October (Meade and Stone). Post-war data improved steadily in mid-October and everything we use as historical precedent dates pretty much from then on. Sure, there's some strong inferred data and extrapolation from the Depression era from October 1st to October 8th and we can use those. But heavy real time data only started to improve around December 10th and in some cases, like integrated EC data, it starts around December 20th. The Great Recession started December 26th and the latest round of QE started around 10.00pm on December 31st.

Apologies to Carl Sagan for all this. But the point is that we're flying sight-impaired on much of the economic issues we face today. Our national economic databases, everything in the FRED series, would likely fit onto an iPhone. We just don't have that much information. And that's why we have little consensus on what we face and what to do about it. So economists and politicians rage. The economic torpor sludges on.

We were reminded of this last year when the IMF came out with a very big "whoops" on fiscal multipliers saying that they were around 1.7 not 0.5. And this meant that a fiscal austerity cut of €1.00 would not contract the economy by €0.5 but €1.7. And again last week when a 500 page report thumped on our desk from the European Commission that made some startling points: i) that fiscal consolidation killed aggregate demand when it was meant to inspire confidence ii) that a new divide of falling output and massive unemployment has risen within the EU iii) that larger welfare states have tended to higher employment rates iv) that of 23m unemployed, 10m are long-term unemployed (which in the EU is defined as one year, not the US definition of 27 weeks) and one in five of those have never had a job v) that raising minimum wages improves the fiscal outlook and v) automatic stabilizers, which are merely counter cyclical expenses, worked.

Stay with me. We're nearly done. Another report tracing the banking crisis also made some counter intuitive conclusions: i) that risk averse economies are more prone to crisis, because savers want safe and liquid assets which means banks can't take on longer term assets and spreads decline ii) labor market flexibility increases the probability and severity of a crisis because workers over produce and then cut production more quickly iii) high uncertainty leads to crises and the higher savings, lower loan supply and financial sector fragility cycle starts anew.

So what? Well, this stirs up the economic debate quite a bit, even if we brush this off with "well, that's Europe; the US is different...and in a good way." It suggests strongly that our policy and debates hold no adamantine rules. And that the slow income growth, high savings, slow output and high unemployment have no easy solution of "spend more or cut more but for goodness sake, decide which." With apologies to Donald Byrd who died two weeks ago, it is a slow drag.

FOMC
We had a run of Fed regional presidents speak recently and it's no surprise that the last two sets of minutes implied a healthy divide. For the voting members, the hawks are mostly Esther George of Kansas who is worried about rising farm land, bond prices and high yield loans. She barely mentions unemployment. Janet Yellen, the Vice Chair, and one to watch for if Bernanke decides to step down next year, is all about employment growth and low participation...here you can see the 2000 peak and quick decline:

As well as the growth in earnings which has pushed along at levels way below inflation, see here:

And finally the imprecise but still relevant output gap which can't seem to trend up to its potential, see here:

Ever read IKEA instructions? They start in Swedish, translate to Chinese and then to English. With English not being anyone's first language. Fed minutes have about the same level of readability. There's always some rune reading going on when interpreting Fed minutes, especially when it comes to defining "few...some...many." We don't think it matters too much because Bernanke is firmly in charge and probably has all the permanent members with him. The dissenters can use speeches to make different points but rarely carry the day for policy changes. There's no uncertainty about the zero rate. That stays until they reach the 2.5/6.5 (rates for inflation and unemployment) threshold.

What is less certain is how long they maintain the $85bn asset purchase program and if they vary the mix and rate. That seems entirely appropriate because we would concede that the Fed balance sheet is getting a little weird: $3.2 trillion, of which $1.7tr is in government debt, which is about 15% of all public debt, and of that, $1.3tr in maturities over five years or about 26% of the total. Some members express concern and may want to "vary" or "taper" the pace of purchases as economic conditions change.

What might those be? Well, Bullard of the St. Louis Fed, gave some indications when he said they would look at total employment, hours worked, JOLTS data and, we would guess, participation, inflation expectations and asset prices. This means to us that if the economy is good, they will pull back on asset purchases. But we're not there yet. Also buried in the minutes was a clue about the unwind. Again, several members said they would want to hold the securities for a "longer period." Our guess is that means until maturity. So on balance we had not great economic reports, added to a commitment to hold the current assets plus a possible change in buying if things get better. That seems a good enough mix even if the communication is a little opaque. The market initially fell a quarter point but rallied back by half a point over the next day which seems the right response.

Europe
The broad story remains that financial markets, spreads and banking are in a stable to mend phase but the real economy is in a bind. So Spanish spreads against Bunds have narrowed from 626bp last summer to 360bps, Italy from 520bp to 292bp and even Greece from 2900bps to 950bps. But the GDP figures for Q4 came in at -0.6% and most positive numbers, like better budget deficits, lower inflation, improved current accounts, are just as indicative of weakness as strength. Europe is thus working from a very low base and will take a while to return to positive rates of expansion.

There are a few options and questions: i) will Germany use some of its borrowing room to set up some expansion ahead of the November elections (maybe) ii) will the ECB give more guidance on monetary policy (probably) or iii) adopt programs for banks to lend (probably not) and iv) in light of recent euro strength, will they try to talk or intervene the currency down (just talking it down from €1.36 to €1.31 has been quite an achievement, so yes)? We think on the whole, Europe will have a slow mend and buying into equities is about buying into global growth and some exports.

US
Highlights of the week were a slight drop in housing starts but a revision up to the prior two months. Housing starts are 24% above those of a year ago, but as the following graph shows that's quite a way off the peak.

Housing is more of a wealth effect and consumer boost story. If people feel confident about jobs, they're willing to form households and follow through with all the expenditures. Housing by itself is not a big driver of growth. Here's private residential fixed investment as percent of nominal GDP. It's a big drop from the peaks and likely to stay that way.

We saw the same upward revision story in industrial production with the three month on three month increase now at 1.9% and the new orders index from the ISM and Empire Survey showing some solid increases. Inflation at the producer and consumer levels came in soft and below expectations. The core, ex-food and energy, had a slight rise but that was after two months of very slow growth. No inflation here.

Bonds
We don't see a lot of opportunity at these rates levels. The return spread of the S&P over the broad bond aggregates YTD is now about 5.82%. It was as high as 8.33%. The closer it moves to 5%, the more we're ready to take our cash holdings down and start buying more into equities.

The high yield spreads came in fast in the last half of 2012. Here's the yield less the yield on the 10-year note.

While there's still a healthy bid on new issues, we have seen some softening in the after markets. The opportunity in bonds is about "stories" meaning idiosyncratic risks of management, products, cover and margins. That's why we're buying away from the indices when we can.

Equities
Equities have had a strong run and especially small company stocks. Here's the ratio small company performance to the S&P. Every time the line slopes up, small cap outperforms:

Hopefully some of the new money hype is rolling over. A "weight of money" argument for stocks is one of the flimsiest reasons for a market rise and rarely has legs to it. It's up there with "there are more buyers than sellers." We thought the market needed a reason to sell off a bit and the FOMC minutes were the catalyst. Earnings growth this year may come in at around 10% but real operating earnings before share buy backs distort the story and will be about half that. And the real, not per share earnings, are what counts for GDP. For now, though, the risk assets have strong sentiment behind them.

Bottom Line: Increasing the equity exposure on any correction.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Sources: "Employment and Social Developments in Europe 2012", EC Publications; Contours of the World Economy 1-2030, Angus Maddison; Jonathan Portes, www.notthetreasuryview.blogspot.com; "Booms and Systemic Banking Crises", Frederic Boissay, Fabrice Collard, and Frank Smets; Frances Coppola Comment; Bloomberg; Capital Economics; CRT Ader; Economist Free Exchange; Federal Reserve Bank of St. Louis; IMF Fiscal Monitor; Federal Reserve Bank of Kansas; Federal Reserve Bank of New York; Federal Reserve Bank of Philadelphia; Federal Reserve Board; Bureau of Labor Statistics; Bureau of Economic Analysis; US Department of Commerce; US Census Bureau; US Dept of Housing & Urban Development; ISI; J.P. Morgan Market Intelligence; TrendMacro; University of Michigan; High Frequency Economics; Pantheon MacroEconomic Advisors; Sentinel Asset Management. Inc.

Thought of the Week: Currency Wars? What currency wars?, 02.11.2013

There's much talk of currency wars right now. We think they're way overblown. The source of the problem lies with Japan, which has made explicit a strategy to lower the yen, increase domestic demand and increase inflation. It needs to do all three. The twenty year old balance sheet recession and deflation in Japan has been a costly error in targeting inflation and not much else. Over this time, the Japanese yen appreciated by around 100% to a high of ¥77 against the dollar. The attraction of the yen was certainly not its thriving economy. It was a combination of a i) deflationary wage spiral ii) a savings glut that favored domestic government bonds iii) high real rates...even today, Japan is one of the few major economies to have a positive real rate of return on its 5-year government bonds which pay around 13bps but inflation has been below zero for most of the last four years and iv) demand for a safe asset when safe assets are in short supply.

Recently, the government announced Abenomics (meaning a lower yen, higher spending and inflation). The yen dove around 13% since and stocks jumped around 16%. Here's the yen/dollar cross rate:

The "currency wars" started to attract attention because if Japan is forcing a quick fix devaluation to make its goods more competitive, then someone on the other side is becoming less competitive. The first places to look were China and South Korea who complained but took little action. China pegs and protects its currency so instead made a few air space incursions over Japan to send a message. And the second place was the euro which saw a 4% appreciation in less than three weeks.

So is this a currency war? Not in the same way of the frequent competitive devaluations in the 1980s or central banks targeting a specific exchange rate and standing ready to defend it...the one exception being the Swiss National Bank but the Swiss have always been different in, well, a just different way. The move into the euro is partly an ongoing policy of diversification of reserves, increased confidence in the stability of the union and, lest we forget, eurozone trade and current account surpluses. The ECB is not taking any stand on the euro. Nor is the Fed. Nor is the Bank of England. And if there's no stand and no policy, then a war can't happen. What we're seeing is a last ditch effort by Japan to get its economy growing. It should work but the long term problems, such as a shrinking workforce, a declining capital stock, run down of its overseas assets, remain.

US Economy
We're a week late on the NFPs but would add three points to the commentary. Start with demographics. The nice thing about demography is that it's quite easy to forecast. A 20-year old now will be 30 in ten years, so we know where they will be. Mortality and life expectancy grows predictably. Births are easy enough to measure. The only big variable is immigration but there's litte appetite to change long standing policies of making it highly inconvenient. So the US population is growing around 0.9% a year, participation in the labor force is declining about 0.2% a year and the net increase in labor supply is about 0.6% a year. On a labor force of around 156m, an increase of 0.6% a year requires 930,000 new jobs a year or 78,000 per month to absorb new workers. All that does is stabilize unemployment. We need more to improve it.

Another way is to continue to drop the participation rate and here something is going on. Here is participation by women in the labor force. As steady decline from a peak twelve years ago.

What's going on? These are guesses but a few things come to mind: i) small company hiring is slower than large companies and women participate more in smaller enterprises ii) service sector jobs have not improved iii) slower hiring or part-time work given lack of demand and uncertainty over benefit costs. It's not at all clear but the point is that if participation increases, then the new jobs number is going to have to run faster to keep up. And if it doesn't we might see good-enough new job numbers (i.e. over 150,000) but little effect on the unemployment rate. Which then means the Fed will keep easy money in place because the target of 6.5% will prove very difficult to reach.

The second point about the employment numbers was the size of the revisions. These were up. In the final quarter the first print for NFPs was 472,000. They now stand at 603,000. The revisions for the year were quite remarkable. The first print NFPs, the ones we all react to, were 1.7m or 141,000 per month. The final numbers are 2.2m or 180,000 pm for 2012. Take the difference between the 2012 rate and the 78,000 required to absorb the growing labor force and the extra is 1.2m or 0.8% of the labor force. Which is how much the unemployment rate fell in the last twelve months. So by any measure it's a slow grind.

Finally, here's the increase in employment against GDP indexed back to the start of the recession.

What this suggests is that employment is growing slightly faster than the GDP rate would seem to allow. These are changing rules and dynamics in the economy and the growth/employment relationship (or Okun's Law) is by no means predictable. But the risk is that lower growth (the flat blue line) may not be able to support the ongoing (upward sloping red line) rise in employment.

Elsewhere, we had a slow week. The two ISM reports (manufacturing and services) showed little change. Here they are in a rough GDP weighted index:

The increase in capital spending in the manufacturing sector was offset by a bigger decrease in business activity in the non-manufacturing sector. Employment held up in both series.

The trade numbers came in on Friday. These are the ones estimated by the Bureau of Economic Analysis for the "flash" GDP report that came out ten days ago and showed a dismal 0.1% decrease with trade contributing a decline of 0.25% to GDP. The good news is that the trade deficit came in at (-$38bn) compared to (-$43bn) in the prior three months. That change alone is good for a 0.5% upward revision to GDP. It was a good month for exports for materials and a slow month for imports of oil.

And one stat that looked less rosy was productivity and costs which decreased at a 2% annual rate for the fourth quarter with unit labor costs at 4.5%. In Q2, they were running at +2.2% and 1.5%. Given the upturn in employment in Q4 and the slow pace of GDP growth, these are perhaps not surprising. It may well bounce back as we see other Q4 revisions, but for now it puts a dampener on corporate profits.

ECB
A quiet EBC press conference is greatly to be desired. Rates held. Mario Draghi frowned at the rise in the euro and it corrected 2% while he spoke. Another good example of "verbal intervention." The ECB is the "tightest" central bank right now. There's no QE in effect and no growth or unemployment targets to steer policy. Success in measured not so much by improvement in the real economy but by peripheral bond yields (steady), banking reform, liquidity provisions and ongoing dovish talk. It's quite a balancing act.

Bonds
We're still at the narrow range of 1.96% to 2.00% on the 10-year. There's some evidence of strong foreign buying, but that would probably be part of the currency offset trades mentioned above. Volume seems light at 70% of the last ten days. High yield bonds are under pressure with the CDX high yield [1] spread widening from its February 1st lows. The broad narrative with bonds is the trade off returns of the 10-year treasury. We have been in a 1.40% to 2.00% range since last April. There's no real big move and the market continues to thrive on anecdotes.

Equities
Enough of the rotation argument already! Yes, there have been improving flows into equities. But this is down to 401(k) rebalances, asset allocation models and some good old diversification after a solid run in bonds. Our guess is that investors are not engaged in a big bond sell-off and remain cautious on reentering an equity market that has near ruined them twice in twelve years. The 127% rise in stocks since early 2009 has not been without pain. There have been twelve up phases of between 12% and 40% and 11 down phases of -8% to -19%. It has not been a clean ride. We would await at least another month before deciding if there's any sea change in investor behavior. Don't bet on it.

Bottom Line: Earnings season is providing little in the way of surprises. About 60% of the companies in the S&P[2] have reported with an average 5% earnings surprise to the upside. Prices are barely moving in reaction. We remain overweight.

Sources: Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics, Capital Economics, Federal Reserve Bank of St. Louis, European Central Bank, CRT Ader, FT Alphaville, FT Money Supply, ISM Chicago, US Census Bureau, US Bureau or Economic Analysis, Pantheon MacroEconomic Advisors, ISI, J.P. Morgan Market Intelligence, High Frequency Economics, Goldman Sachs, Sentinel Asset Management, Inc.

[1] The Markit CDX North American High Yield Index is a basket of 100 single name high yield credit default swaps. An investment cannot be made directly in an index.
[2] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Some Seasonal Blips, 02.01.2013

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

We had a week of big numbers last week of which GDP, Personal Income, Durable Goods, the Conference Board's Consumer Confidence, payrolls and the FOMC were the ones that had our attention. We went to print a little earlier this week, so missed the NFPs. But this is what came at us. First GDP. There's a spin to be told but here are the raw numbers with the center column the one that caught markets wrong-footed.

GDP: Not much change when you look through a longer lens

Component	Q3 2012	Q4 2012	2012
Consumption	1.12%	1.52%	1.34%
Government	0.75%	(1.33%)	(0.34%)
Investment	0.12%	1.19%	1.02%
Inventories	0.73%	(1.27%)	0.16%
Exports	0.27%	(0.81%)	0.44%
Imports	0.11%	0.56%	(0.44%)
GDP	3.1%	(0.1%)	2.2%

Source: Bureau of Economic Analysis

Most of the comments centered on five things: 1) it was a negative print and for the economy to slip into recession territory on the back of a flimsy recovery was, well, uneasy 2) but don't worry too much because consumption grew 2.2% from 1.6% 3) residential investment grew over 13% for the second quarter in a row 4) the volatile non-farm inventory series dropped $44bn to knock 1.3% off growth and, finally and especially, 5) defense spending dropped 22%. Here's what defense spending looks like as a proportion of GDP, dropping to below 5% for the first time since 2008 and the biggest plunge since 1972.

Some of the defense numbers were due to a simple reversal from the prior quarter. It's easy enough to bring forward expenditures and payments a month or two, especially with a looming cliff debate. The trend has been down for over two years and will stay that way. Another component that fits the "not as bad as it looks" scenario is that the trade numbers are an educated guess. Trade reports with a six week lag, so we won't see December's numbers for another week. It's also subject to big revisions.

And, of course the first report GDP numbers are subject to substantial revisions. In Q3 of 2012 we started with 2.0% and ended with 3.1%. In Q1 2011 we started with 1.8% and ended with 0.1% and, probably worst of all, in Q4 2008 we started with (3.8%) and ended with a startling (8.9%) which is the difference between a recession and depression.

A last point on these numbers is just how slow nominal GDP has been. Less than 0.5% in the fourth quarter compared to 5.9% in Q3 and 4.0% for the year, which was unchanged over 2011. As we've mentioned before, yes, real growth measures and adjusts for all the right things but companies and businesses need nominal growth for their top line. This is where the NGDP targeting argument comes in and opens a new can of worms of where you start and how to adjust for the lags in the transmission mechanism. But it's a real problem in the US right now that we have such moribund, nominal and real growth.

So with this report we must put some faith in the private sector and investment spending and that if we strip out the one-offs and volatility, then growth was around 2.5% which was in line with consensus. The bigger question is why GDP can't seem to shake off more than around 2% growth. We have pushed inflation down. Here's the latest PCE number from the Personal Income report.

It can't seem to break above 2% and is driving monetarist and fiscal hawks crazy as to why it's not twice as high (the quick answers are because of multipliers and private deleveraging but that's for another day). Looking into 2013, we're nervous about the effect of the payroll tax increase which will eat into disposable income growth.

On a related report, Personal Income, which comes out the day after GDP, showed robust 2.6% growth. Is this the "Hallelujah�here she comes" moment? Because this hasn't been much above 0.3% to 0.5% for years. Well, no. It was some crafty forward payment of dividends ahead of the January 1st tax rise. Of the $353bn increase in personal income, $268bn was the dividend increase. Here it is:

We thought that most of corporate America tried to look through the fiscal cliff debates, and indeed corporate fixed investment and durable goods orders did pretty well in the quarter. But bringing forward dividend payments was an obvious way to preempt tax rises and companies took full advantage. However, this isn't the type of income that gets spent quickly. Real spending rose only 0.2% and the savings rate nearly doubled from October levels. Looking forward, much of this increase will reverse as will this, the real disposable per capita income, which has hovered around $32,800 for years.

A final reason why we're tepid on the beginning of 2013 was the painful drop in consumer confidence from 66.7 to 58.6. This was taken around January 17th so late enough for the first of the payroll tax increases to take effect. Components of the index include business confidence, employment and family income and one area hit particularly hard was the gap between those who said jobs were hard to find less those who said they were plentiful, rose to 29 against 25. This is all consistent with a weak quarter and any uptick on consumer confidence may have to wait some months.

FOMC
The first meeting of 2013 and the language was tepid. Here's how the Fed described the economy in January, December and a year ago:

	One Year Ago	December 2012	January 2013
Economy	Moderate	Moderate	Paused
Employment	Improved	Declined	Moderate
Households	Advanced	Advanced	Advanced
Investment	Less rapid	Slowed	Advanced
Housing	Depressed	Improved	Improved
Inflation	Moderate	Below target	Below target
Inflation Outlook	Stable	Stable	Stable
Inflation Estimate	<2%	<2%	<2%

Score high for consistency and low for any real, substantive improvement. The good news is that the Fed kept in place the MBS and Treasury buying program and made no allusion to changing this unless there's a substantial improvement in the labor market. This Fed has a new roster of regional Fed presidents, generally taking a more dovish line. Still, there was one hawk from Kansas, Esther George, who seems set to play the perennial dissenter role vacated by Jeffrey Lacker of the Richmond Fed. Her reasoning was that monetary policy increases the risk of financial imbalances. This is in line with a speech she made recently where she talked about high yield bonds and land prices being at record levels and that those could cause a shift away from a "full employment level" and then stated for good measure that monetary policy could "aggravate" unemployment. Well, yes if we were anywhere near full employment. It seems to duck the Fed's dual mandate (luckily others take it more seriously) and to fear something vague happening way, way down the road. A bit like cancelling your 500 mile car trip because you're worried about wear on the tires.

Bonds
GTs peaked briefly at 2.03% but then rallied half a point. The market seems to be setting up for the NFP report which comes out after we print. But the weak data last week should keep QE alive and well for quite a bit longer. The bear market in bonds is not about to commence any time soon. The New Issue Market is light given earnings. An interesting crack in high yield occurred last week when two high profile names both saw keenly priced new issues widen out by around 25bp in two days of trading. So there's some latent nervousness and the broad high yield index fell around 1.5% in the week.

Equities
We're more than comfortable with the earnings season and valuations on the market. About half the S&P[1] companies have reported with the average earnings surprise being around +3.7%. But the price reaction is far more muted with Financials, for example, showing a 13% earnings rise but no price reaction. It's still an unloved sector with investors placing a big discount on earnings. Meanwhile, retail inflows are some of the highest since early 2000 and the big question is whether these are an indicator of anything. Our feeling is that they are more of a coincident indicator this time especially given it's only January. A lot of the flows may be 401(k) and other platform rebalance programs.

Bottom Line: Remain long on equities. We're at a five-year high and approaching an all time high seen in 2007. But back then, the market was priced at 17x earnings. This time it's closer to 14x. There will be some correction but we remain fine for now.

Sources: Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics, Capital Economics, CRT Ader, Goldman Sachs, J.P. Morgan Market Intelligence, Federal Reserve Bank of Kansas, Federal Reserve Board, Federal Reserve Bank of St. Louis, US Census Bureau, US Dept of Commerce, High Frequency Economics, Pantheon MacroEconomic Advisors, TrendMacro, U2, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: What budget problems?, 01.28.2013

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

"Vickers falls on fear of peace." There's an apocryphal story of how on the day after D-Day, the stock of Vickers, a large defense contractor, abruptly fell. I can't find the source but it was a good story going around the City some, ahem, 30 years ago. Last week there was not a lot of price action in bonds until Friday when economic upticks replaced budgets as the main driver. We saw a one point correction in treasuries. The market is right to push budget concerns into the background for now. Between the American Taxpayer Relief Act (or ATRA, the one that raised regressive taxes but, hey, tough) and the Budget Control Act (BCA) of 2011, some $2.3 trillion of savings are programmed in for the next 10 years. Of that, two-thirds comes from spending cuts and one third from revenue increase. This is what it looks like:

$bn	Program Cuts	Revenue Increases and Interest Savings	Total
BCA of 2011	$1,465	$236	$1,701
ATRA of 2013	$3	$644	$647
Total	$1,468	$880	$2,348
Needed to stabilize deficit	TBD	TBD	$1,368
Grand Total			$3,716

Sources: Center on Budget and Policy Priorities

The Washington debate is entirely focused on the "Needed to stabilize..." line and the split between program cuts and revenues. It is not about whether the total makes any sense. The $1,368 is the magic number which stabilizes the deficit at around 2.5% of GDP and debt at around 72%. So that's $1,368tr over 10 years during which the US economy will probably grow at a nominal 4% from around $16,000bn to $24,000bn or a cumulative (which is the language of 10-year budget negotiations) of $224,000bn. That's a 0.6% of GDP problem. Greece in its worse days had a 10% problem, putting some of the hyperbole around the US's position into perspective.

US government spending has been falling for a while. Of the big five budget expenditures which account for 80% of the federal budget (so, defense, Social Security, Medicare, Medicaid and interest), two fell and overall spending grew 3.6% compared to receipts at 11%. Here's the YOY growth in government spending:

This is why GDP for 2013 will continued to show a net drag from the government sector, which is about 8% of GDP. Some commentators point to the non-sustainability of government debt. No. Net interest on debt is covered 10 times by receipts and 57 times by GDP. In Greece those numbers were closer to 5 and 15. This is not to promote non-cyclical deficit spending but to reason why bond markets are not spooked by the budget and why the postponement of the debt ceiling was a non-issue. There's plenty of domestic savings to fund budgets for, well, ever if deleveraging doesn't stop.

The fear of sequester (about $120bn on the line) and the continuing resolution, which would theoretically shut the government down, are likely flash points. All markets will recoil if there's a real impasse. So for now the bond market is about real economic data and political showdowns. Not about debt and budgets.

US Economy
It was a quiet week. This week hots up with ISM, employment and GDP data. But what was reported last week was encouraging starting with claims at 330,000, the lowest since January 2008. The stock market generally likes employment gains and this week was no exception. Here the four week moving average against the S&P[1]:

The claims performance may not last. First, there's a very large seasonal adjustment. The reported DOL unadjusted numbers were 436,766 compared to 416,880 this time last year. So this year's adjustment is down 106,766 and last year's was 44,880. There might well be a spring up in claims in coming weeks as adjustment factors come in to play.

In other areas, the Kansas City and Richmond Federal Reserve manufacturing surveys remained in very weak territory with order backlogs and number of employees down. One respondent summed it up in a neat reciprocity:

"Since Congress continued to delay making firm decisions...we are again delaying decisions [to expand]".

The Richmond service sectors were better with some revenues up (but not retail) and stable employment. Not surprisingly, given the opera of the first few weeks of the year, big ticket sales are off. Finally the Leading Economic Indicators was up but this likely overstates growth. The index has a 42% weighting to hours worked and consumer expectations (which are linked) and another 15% weight to the S&P and bond spreads, which may only have a weak wealth effect right now. None of these look robust enough to lead to the 4.5% increase in GDP, which is what the historical relationship would indicate. This week's GDP number will be a lot more sober.

What remains is still a very easy set of financial conditions. Here's the Chicago measure:

This is mostly based on Treasury, CP, debt and lending and, when showing negative values, indicates financial conditions looser than average. And that's where we are. This week saw the Fed's balance sheet breach $3tr for the first time. Exactly as the FOMC minutes indicated, we saw treasuries increase by $10.3bn over the week, in line with the $45bn monthly target and MBS by $33bn compared to a $40bn target. The MBS purchases are usually more sporadic because the Fed has to wait for origination issues. So here's MBS held by the Fed:

And here's MBS at the sellers, the commercial banks:

And finally here are the Fed's holdings of short paper:

This is making it difficult for us on the MBS side. Normally, we would get defensive by using higher coupon issues to bring in duration. But the Fed support program is distorting things right now. In the bigger picture, we continue to see enthusiastic TIPS buying. This week's 10-Year auction came at (0.63%) compared to an average for the last six auctions (there are about six a year) of (0.43%). We'll probably look back in years to come as to how the government could borrow at negative rates for so long and why it didn't load up on cheap debt...but for now, let's assume that the upcoming FOMC meeting will have precious little to worry about on the inflation side.

Equities
We touched the 1,500 level on the intraday. The last time we were at that level was in December 2007 when earnings were $89 heading to $61 a year later. This time earnings are about $100 with a forward estimate of $112. So a rough P/E comparison of 16x compared to 13x. As with all big market rallies several things are letting loose at the same time. First, here's the VIX[2] to S&P ratio.

In the high "risk-off" days of recent years this dropped to numbers in the mid-30s. At the current low levels of the VIX, it's at levels seen in late 2007. It's a rapid embrace of risk. Second, the flows from retail clients are coming on strong. Some of this is beginning of year rebalancing and new 401(k) flows. Some may be trying to catch up to the returns of 2012. Third, there's some short covering with the 50 most shorted companies up 8% YTD compared to the S&P of 5.3%. Fourth, a narrower list of leaders. There were 454 stocks, or 24%, making their all time highs on the NYSE in early January. By last week that number dropped to 354 or 19%.

The valuations, however, on top companies remain in the 12x to 13x range and that's not expensive. Another thing we hear is that dealers are short index calls that expire this week and that ETF desks continue to see real dollar demand in equities...buying liquid, passive vehicles is usually the first way to get equity exposure. This rally may stay a while.

Europe
There was some concern that recent gains (for example, Spanish yields well under 5%, most European stock markets up 6% to 10% YTD) would come under stress as the first of the LTROs came up for voluntary repayment. This €489bn facility greatly helped bank funding a year ago but carried some stigma as peripheral banks off-loaded bad collateral. On Friday, the ECB announced that about half the banks would repay €137bn of that. All things being equal, this reduces the ECB balance sheet. But this should not be viewed as tightening (H/T Lorcan Kelly at TrendMacro). The bank will keep open a 3-month option and maintain all its open refinancing operations. So there's no change to overall policy stance and certainly no change to rates. European banks have rallied 50% since May last year and while there are some loan quality issues for smaller banks, the ECB will keep them afloat. Initial market reactions were an uptick in the euro and bonds steady.

Bottom Line: We have been long equities and high yield and trading GTs for a while. We continue to use MBS for the income and some protection from duration volatility (hence the higher coupons). It's worked out well and the run up could continue. Equity investors are not about to play five years of catch up all at once but there's latent demand for equities out there for now.

Sources: "To Stabilize the Debt, Policymakers Should Seek Another $1.4 Trillion in Deficit Savings," Richard Kogan (1/9/2013), Center on Budget and Policy Priorities; TrendMacro; Federal Reserve Bank of Kansas; Federal Reserve Bank of Richmond; Federal Reserve Bank of St. Louis; Federal Reserve Bank of San Francisco; Capital Economics; Bureau of Labor Statistics; CRT Ader; J.P. Morgan Market Intelligence; Federal Reserve Board; ISI; Goldman Sachs; ConvergEx Group; Pantheon MacroEconomic Advisors; High Frequency Economics; Bloomberg; The Conference Board, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.
[2] Chicago Board Options Exchange Market Volatility Index is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. An investment cannot be made directly in an index.

Thought of the Week: Avoid Disappointment, Aim Low, 01.22.2013

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

No, it's not a life aspiration. But it can work when it comes to investing. We had a rush of gains coming into the end of the year with the S&P[1] up 22% over the year. But it's also one of the more relaxed markets and start we've had in years. The political agenda is still front and clear and we're in a lull until the debt ceiling arguments gain steam. The markets know this but seem comfortably complacent. They're probably right to be. Some deal will be worked out and it's highly unlikely we'll get to the point where debt interest, social security, Medicare or veteran benefits won't get paid. Meanwhile, we had a welcome consolidation week with treasuries ahead, the S&P holding onto gains and Europe mercifully quiet. The one surprise was the ongoing strength of the euro which quickly caused some alarms in export sectors. Talking a currency down or up is tough and while it's good to see stabilization in the euro, any prolonged strength above €1.40 will be hard for recovery.

US Economy
Clear and encouraging signs in a busy week. Here's the summary:

Favorable	Housing, unemployment, monetary policy (much better in recent weeks), claims, bounce in durable goods, inflation, Europe quiet and steady.
Still challenged	Debt ceiling, wage and compensation growth, nominal GDP, industrial production, exports, top line growth, ISM and NFIB surveys weak.
"Good" but troubling	Inflation. PPI and CPI this week were well below Fed guidance. Most of the drop is gasoline and even OER is down. But this allows no top line growth for companies

Housing is a lead story.
Prices, transactions and starts are all good. The NAHB survey had a strong report on buyer traffic. Residential fixed investment is on track for the best quarter in years. And the Sandy rebuilds are still to come. The house price increases are important as is the lower inventory overhang because six months ago, only 55% of mortgages had a loan/value ratio under 80%. That's the threshold for refinancing. If prices continue to climb we're going to see more people eligible for refinancing as well as a positive wealth effect. Last week housing starts came in at 954,000, which is up 37% YOY and the best level since June 2008. Regular readers know we also keep an eye on the 5-units or more build which came in at 330,000 or twice the rate of last year. Why? Well more multi-family housing should relieve any rent pressures and accommodate household formation that would otherwise sit tight until single family houses become affordable. Here they are together:

The underlying trend in nearly all measures of housing is up and we have also seen sizable decreases in unemployment in some of the states with the hardest hit real estate problems. So in the last year, Nevada and Florida saw overall rates of unemployment fall nearly 3% and 2%, respectively.

Another good sign was a big drop in jobless claims to 335,000. The market is very sensitive to employment statistics and part of last week's action is because of the improved trend. Here's the four week moving average of claims against the S&P:

Four Key Numbers
Growth will be slow for Q4. The recent trade numbers did it in for any robust growth and retail sales were soft. Q1 has the payroll tax hike to contend with but there's some slow recovery in corporate confidence. Here are four key numbers that came in last week: industrial production up 2.2%, retail sales up 2.5% (but core was weak) and real personal income eking out small gains. There all at two year highs. They're also all coincident indicators that tell us more where we are than where we're heading but, hey, it's good news.

Confidence is still fragile.
The Empire and Philly Fed indexes are the first indicators we have of 2013 data (most others are from December). The news was not good. The Empire showed its sixth straight month of negative conditions and the Philly Fed had new orders dropping to -4.3 from +4.9, reversing almost all the December increase. Worse news is probably coming as tension over the debt ceiling rises (HT Pantheon Economics). The Beige Book, which covers all twelve Fed reporting districts, described growth as modest or moderate with almost no wage pressure.

Another casualty of the debt plight was the University of Michigan confidence index which dipped to 71.3 from 72.9. The rise in the payroll tax also did some damage to confidence and this may worsen as the month unfolds.

International
In Europe we have much better reads on financial conditions. Spreads have tightened and stabilized, equity markets sustained their gains and current accounts surpluses improved. This has greatly helped the euro but the real economy is worsening. Bund yields look way over bought and if there's any fiscal stimulus in Germany later this year (and odds are good), equities will perform well. Bonds will not. That's the trade we're on.

Japan...see the report we put out on Japan last week. We think this stimulus is different because 1) it comes with a loosening inflation target 2) PM Abe has a majority and clear mandate 3) the yen weakening and possible eurozone government bond buying look sustainable.

The China rebalancing story is stalled. Friday's GDP numbers show that infrastructure spend remains the driver. The speculation of new companies coming to market is way overdone. It may be a contrarian indicator as company owners are finding ways to off load their investments and diversify out of the renminbi.

Bonds
We saw the GT10s trade around 1.82% for much of the week. We recently had auctions of 3s/10s/30s with the 30s bid at 3.07% and the 10s at 1.86%. The 30s saw a rally to 2.98%. The treasury market has no supply for two weeks and we have nine buy-backs of which five are in the 30-year part of the curve. So we have tended to buy treasuries later in the day and hold overnight. Remember the buy-backs from the NY Fed come in the mornings. Some of the Fed's recent buying is shown in the MBS holdings here:

And in the Treasury holdings here:

We also had a week where regional Fed presidents mostly confirmed the buying program. Dallas president Fisher talked about buying having a "lesser impact" but did not go so far as to talk of any policy change. Hyper hawk turned dove, Minneapolis Fed president Kocherlakota, gave three speeches in as a many days confirming that while "ultra low rates" were no panacea, the target was 6.5% unemployment and there was little change needed until that was achieved. So last week's misplaced fear of a possible early cessation of the bond buying program looks over for now.

Credit is probably overbought in the short-term. Spreads feel a little tight. There are lots of well subscribed deals but the Dell news put some frighteners in the market. While M&A activity can be good for equities, it's decidedly bearish for credit when a private equity firm takes over. The standard business model is to leverage the balance sheet and narrow the interest cover. The bond market remains very headline sensitive and, given how well it's done in recent months, prone to sell-offs.

Equities
We have a rotation into equities. This is everything from 401(k) rebalancing, financial advisors adjusting down bond over-weights and some "catch up" from the equity rally in 2012 that did not have lot of participation. Expect more sprints on the market. Probably to around 1500. We're still early in earnings season but banks leading so far have been good.

Bottom Line: Range definition for treasuries remains in the 1.75% to 1.95% level. This is a quiet earnings season so far. Around 70 of the S&P companies have reported and earnings surprises are a very modest 9%. This coming week sees more action but for now the amount of flows and general calm in the market should keep things well supported.

Sources: Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics, CRT Ader Capital Economics, Federal Reserve Bank of St. Louis, Federal Reserve Board, FT Alphaville, J.P. Morgan Market Intelligence, High Frequency Economics, Pantheon MacroEconomic Advisors, Tim Duy's Fed Watch, US Treasury Department, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Land of the Rising Dead, 01.14.2013

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Yes, you knew we were going to talk about Japan. It's all the rage and the big standout in market performance in the last few weeks. Since November the broad Nikkei-225 average has risen 24% because there's new thinking in town. It's hard to describe Japan's 20 year malaise. Once proud companies shaken, the shattering of a property market and total collapse of stocks. Even if the market rises at the same level of the last few months, it will take six years to re-reach its peak. A more reasonable 10% growth rate will take 14 years. Weird things happen when economies enter deflation. Real growth of 2% with a deflator of 2% allows 4% revenue increases. And if you click along at that rate then GDP growth looks like this:

Which is the headline story in Japan and kind of looks ok. But if real growth is 2% and there is more and more price deflation, then real growth looks unchanged but your nominal growth looks like this:

Which is 20 years of catastrophe. No one wants to lend in deflation. The real value of any long-term obligation increases and collateral values decrease. Professor Bernanke was very worried about this in 1999 when he talked about Japan's liquidity trap, output gap and the dangers of zero inflation. What he didn't point out was that this also gets particularly dangerous when there is a large, moneyed rentier class that in the absence of higher nominal rates, demands price deflation. And that usually strangles any nominal growth bursts at birth. Bernanke also went on to recommend a close collaboration of the MOF and BOJ. That's something that never happened and explains why he urges policymakers in the US to do the same.

But wind on to today. There's an unfolding strategy of Abenomics, named after the new Prime Minister, who campaigned on i) getting the BOJ to buy eurozone denominated bonds to weaken the yen ii) a higher inflation target in the form of an "anti deflation" program and iii) a large fiscal stimulus plan. Last week this was announced as a ¥10tr ($117bn) stimulus with added local government and private sector programs to lift the entire package to ¥20tr or around 3.8% of GDP. Stimulus packages have come and gone in Japan before but this one is different because of size, the lift to confidence, the parliamentary super majority and the yen. Here's the latest on the yen:

For the first time in years, we have clear guidance on a policy to competitively devalue the yen. This helps the economy greatly at time when both trade and current account surpluses are under pressure (and yes, there are limits to FX manipulation). Some are worried about the potential loss of central bank independence in all this. We're not. The bank has seen a nail in every problem for the last 20 years and applied the same hammer every time. They've worn out their stay. If relationships between fiscal and monetary authorities are dynamic over time, then this is overdue. So for now we like the triple play in Japan: easy money, fiscal expansion and growth.

Two Central Banks
The Fed remains steady and despite the FOMC minutes from a few weeks ago is on a dovish, accommodatory course. Last week we had presidents Bullard of the St. Louis Fed and George of Kansas again raise the risk of inflation. Bullard's approach is to keep inflation forecasts at the top end of the range. The St. Louis forecast for PCE is 2.0% compared to the Fed's 1.5% to 2.0% range. He also curiously stated that the FOMC can not target unemployment which is spiritually, if not semantically, at odds with the "foster maximum employment and price stability" mandate that precedes every FOMC minutes. George's comments are more traditional balance sheet imbalance issues which we don't buy into because money bought by any central bank need never be released. Sure, any high powered money will add to bank reserves and allow them to expand liabilities through loans. But if loan demand isn't there, then the cycle of excess money to inflation can never start.

Much closer to the mark is hawk turned pragmatist Kocherlakota of the Minneapolis Fed. We like this from his presentation which clearly shows how much of an output gap the US labors under:

And with remarkable clarity he concludes that "...if anything monetary policy is currently too tight, not too easy." Which neatly reminds us of Friedman's point that it is fallacious to identify tight money with high rates and easy money with low rates. Today's rates suggest that may be the case with the gap between nominal GT10 and 10-year TIPS basically unchanged.

The ECB made no changes to policy. But Draghi's tone was very upbeat. And so it should be. Since the mid-year announcements bond yields and CDS are lower, stocks up, capital inflows higher, deposits in peripheral banks up, Target2 balances down and the ECB balance sheet smaller. He recognized that this has yet to flow through to the real economy and, indeed, many major economic indicators are in rough shape. But it has been quite an achievement to keep Spanish bond yields low. Last week Spain issued 2-year paper at 2.47% compared to 3.95% in October and 15-year bonds at 5.55% compared to 5.76%. It's probable that we have seen the last of rate action for a while but this at least puts a floor under more worries in the banking sector and should also underpin the spectacular equity gains we've seen in recent months.

US
It was generally a quiet week for economic stats. The NFIB was pretty bad but at least didn't worsen. Small business took it on the chin for pre-cliff uncertainty and they're not about to start hiring or building out inventory of any kind. Trade was a bigger deficit than it has been in seven months and saw a big jump in imports of consumer goods, particularly of cell phones (not from China!) and autos, possibly post Sandy replacements. The net result is a possible downside revision of Q4GPD of around 0.4%. But December trade numbers are still a month away.

Bonds and Equities
Yields stayed between 1.85% and 1.95%. New issue flows have eased as we go into the reporting cycle. We seem to be flat. Equities remain well pinned. The big story in equities remains dividend growth and, no, don't give up on it. An average stock with an average 10% growth rate in dividends will end up with a running yield of 3.5% in five years. Even assuming no change in price, that's a return that will not come through bonds. In last year's search for yield (always a bad strategy), high dividend stocks performed well. But we currently see dividend growth stocks trading at their biggest discount to high dividend stocks in at least two decades.

Bottom Line: Fine with a moderate overweight to equities and corporates even at the 1470 level. So far earnings have been good, especially from some financials where we see growth in fee income, expense control, growing capital ratios and a surprisingly stable mortgage banking resurgence.

Sources: Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics, Capital Economics, Congressional Budget Office, CRT Ader, Federal Reserve Bank of St. Louis, Federal Reserve Board, FT Alphaville, FT Money Supply, High Frequency Economics, ISM Chicago, J.P. Morgan Market Intelligence, Pantheon MacroEconomic Advisors, TrendMacro, Citigroup Capital Markets, Federal Reserve Bank of Minneapolis, Sentinel Asset Management, Inc.

Thought of the Week: Brave New Start to the Year, 01.07.2013

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Well that was fun. Negotiations went to the brink, we had politicians dropping the "F" bomb a few steps from the Oval Office, the Senate described as "sleep deprived octogenarians" by a congressman and an all around feeling that it was better than nothing. Welcome to the American Taxpayer Relief Act, which actually, er...raises taxes for everyone. That's right. No one in 2013 pays less than they paid in 2012. This is our best estimate of the fall out. It's definitely better than what was at risk back in November but it's still a net drag on the economy of around 1.0%.

A few points starting first with the obvious danger that three big issues are postponed a few months into a Part 2. These are i) the sequestration on spending cuts, mostly defense ii) the debt ceiling and iii) continuing resolution to keep the government funded. So everything so far is prelude for another round of acrimony. Second, the restoration of the payroll tax from 4.2% to 6.2% is perhaps the most regressive tax hike imaginable. Everyone pays it, except for some municipalities that have Social Security opt outs, yet only up to $113,000. This clips around $115bn from wages and salaries of $6.8tr so around 1.7%. This will hit after-tax income hard especially as compensation growth is barely 2.0% anyway. The net effect is a big fat zero for ordinary workers in 2013. Third, the drag on the economy is about the same as we've had for the last few years. Remember, despite headlines about out-of-control spending, the government component of GDP has slowed growth by about 0.8% for the last two years and the deficit had decreased 22% in dollar terms and from around 10% to 7% as percent of GDP. The reason the deficit has improved so quickly is because of the rise in income tax receipts, which requires either new jobs or higher pay and is far and away the quickest way to reduce deficits. Personal current tax receipts are 26% above their 2009 lows and still very low by historic standards. Here they are as a percent of GDP over the last 10 years:

The new taxes and some job growth should improve the fiscal picture a little and there's no real risk of a slip into recession. Unless of course Part 2 threatens already fragile confidence. There are some other things to like in the deal. The AMT patch looks fixed, the income and estate taxes are indexed and made permanent, dividends and cap gains rise modestly but far less than estimates and various favorable treatments of depreciation and leaseholds remain.

The first reaction to the news was a spike in risk assets, especially in US stocks which have held onto their gains of 8% since the November lows. Here's what happened in the three months either side of the big political events in the last few years:

In other words, markets seem to take the political theater in its stride which reminds us of bitter descriptions of No Man's Land in the Great War when writers would describe birds singing overhead, oblivious to the carnage below. If past is any guide, the debt ceiling debate is guaranteed to spook markets and there are already downgrade whispers. So the fears will remain and we are in for more drama.

Entitlements
A large part of the debate is about entitlements. Sometimes it's easier to call them "eligible" benefits because workers have typically paid into Medicare, Medicare, Social Security Disability and Old Age Survivors insurance. These are three of the big five government expenditures (the others are defense and interest) which make up 75% of government spending and count for $1.6tr. These expenditures are getting bigger. Here's the present value of scheduled benefits for people born in the following cohorts and the benefits to tax ratio (i.e. for every dollar paid into the system, how much do I get?):

The reason the ratio does not rise above 1.0 is because this measures payable benefits which are less than scheduled benefits and payable benefits can not rise above the hypothecated taxes collected for Social Security unless there's a surplus in the trust funds. The total outlays today are around 5% of GDP and are scheduled to climb to 6% by 2035 at which time the trust funds run out and payments drop back to 5%. A recent CBO report summarized the whole Social Security dilemma neatly by showing that if payroll taxes increase by 1.9% or benefits are reduced by a similar amount, the problems for Social Security are solved. Completely. Until 2086.

This is why recent debate about changing the inflation measure for benefit payments is important. For now, benefits are indexed to wages but the case has been made to change it to a chain-weighted measure that allows for greater substitution. Here's how the two indexes look:

And yes, the Chain-Weighted Inflation is lower than Wage Inflation by about 0.3% a year. So expect a lot of debate on the entitlement structures as we enter the debt ceiling rows...which we think may make the Cliff negotiations look like a walk in the park.

And the real economy?
Progress. Starting with the headline employment numbers which were 155,000 new jobs, down from the revised November number of 161,000 (it had been 146,000). Over the last six months new jobs have summed to 958,000 compared to 877,000 in the first six months of the year for a total of 1.8m during which the labor force grew by 1.5m. So, this is about job growth hovering around the underlying growth in population which has been pretty much the trend since the recovery began three years ago. To some extent it could have been worse. We knew only 10% of NFIB firms added workers in November and they were especially pessimistic on the tax negotiations. Larger companies report through the ISM surveys with the manufacturing companies' employment index still showing weakness. Here's the December number with some rebound but way below the 2012 average.

Nothing in the economy to change the Fed.
And there was little in the reports to give credence to the overblown fears from last Thursday's release of the FOMC December minutes. The paragraph that worried the markets was the one that said "several [members] thought it...appropriate to slow or stop purchases well before the end of 2013." In Fed speak, "several" is more than a "few" and could mean up to five out of twelve voting members. But three things make it unlikely we're heading into any sort of tightening:

The immediate response from markets was to send an already weak bond market to nearly 2% on the GT10 and the dollar to a two month high. A lot of this is the market getting used to the Fed's new language which ties policy to outcomes and uses qualitative language. It's a lot easier for a market to deal with a rate goal put to a date than to a policy predicated on a "substantial" improvement in the labor market. Bottom line, no change to actions.

Bonds
While the bond market held below 2%, there were a number of technical breakdowns. The prior resistance and support for the 10-year was around 1.55% to 1.89%. The When-Issued 10-year, which is the one setting the price range, rose to an intra day high of 1.98% taking out the recent highs. This means a new range could be more like 1.85% to as much as 2.40% which would be a price swing of around 4 points. This is why it pays to be defensive, nimble and trading in treasuries right now. Any move risks wiping out much of the coupon payments. As a point of comparison the Spanish 10-year printed last week below 5% compared to nearly 7% before the August "whatever it takes" speech. The total return has been around 15% compared to a loss of 1.5% for US GT10s. Such is the speed of change in world bond markets theses days.

Equities
Equity returns for the year were around 16%. But it had a low participation rate. We know that $150bn flowed out of equity funds in 2012 and was the fourth year in a row that investors pulled money from stocks. Valuations are quite attractive. Last time the S&P 500 was at the 1500 level in 2000 and 2007, earnings were around $54 and $83. Today they're closer to $100 on a 1460 price. It's been a slog but earnings are there and many companies are in much better shape financially, with lower input and labor costs. We're quite comfortable buying into the more economically sensitive stocks given the clearer, if not stellar, economic horizon.

Bottom Line: Still a moderate overweight to equities and corporates. There's political risk in the market but news out of Europe (bad but worse) and China (better but not great) are a good support.

Sources: Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics, Capital Economics, Congressional Budget Office, CRT Ader, Federal Reserve Bank of St. Louis, Federal Reserve Board, FT Alphaville, FT Money Supply, High Frequency Economics, ISM Chicago, J.P. Morgan Market Intelligence, Pantheon MacroEconomic Advisors, TrendMacro, HSBC Global Research, The Economist, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: The Fed's Giant Stride, 12.17.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

FOMC
The news from this meeting was widely telegraphed (see Yellen, Evans, etc. last month) but produced some real and welcome developments. Here's the quick summary:

1. Low rates language changed from until "mid-2015" to as long as unemployment remains above 6.5%.
   
   Reaction: This is good. The constant date extensions underlined how the Fed was widely amiss on rate forecast. Tying actions to outcomes is a first.
2. The 2% inflation target moderated; the Fed could keep rates unchanged up to a 2.5% rate.
   
   Reaction: Again good. The economy is nowhere close to the 2% rate and the unintended signal to the market had been that tightening would occur as soon as the threshold was broken. This gives Fed actions time to work.
3. Introduction of "well anchored" criteria for inflation which means they won't tighten if there's a commodity-type uptick.
   
   Reaction: Monthly inflation numbers are volatile. Recent scares on inflation in food and gas prices quickly abated so we needed a less rigid inflation target.
4. Added that other "labor market conditions" would drive decisions; take this to mean that headline rate matters but so too do things like employment / population ratio and U-6 rates.
   
   Reaction: There are some fundamental changes going on in the labor market with unemployment falling faster than growth indicators alone would suggest. This gives the Fed room to maneuver if there's slack elsewhere in the labor market.
5. A Treasury purchase program would replace the current maturity extension program at year-end.
   
   Reaction: Good. Twist led to no new money creation but new purchases do. As St. Louis Fed Chairman James Bullard noted two weeks ago, "outright purchases are likely more potent than twist operations." So even though the nominal purchase amounts are the same ($40bn of MBS and $45bn of treasuries), the net result is further easing.

Why the Changes?
Several Fed board members had argued for a change in communication policies. The Fed started forward guidance back in December 2008. Back then, it was about rates staying low for "some time." Wind on to March 2009 and we got the first "extended period" language. Then in August 2011 we saw the "exceptionally low... through 2013" and finally in January of this year, we had the "at least through late 2014" language. Note the trend. Each time the Fed was trying to shift expectations and establish the ground rules of stability. This was of course accompanied by the portfolio rebalancing polices of LSAPs and MEPs. But in all this, it was never clear when or how the Fed would change policy and the fear grew that as soon as the economy grew, inflation climbed or unemployment fell, for whatever reason, policy would change. Abruptly.

So what we now have is commitment to clear target criteria and thus a better understanding of how the Fed deliberates. On top of that the new Treasury buying policies do two new things. First, the Fed has only $20bn of securities maturing in less than one year, so in effect they have nothing left to sell at the front end. In the new program, 68% of the new purchases will be in the four to ten year maturity range so the Fed's balance sheet will end up looking even more back ended. Second, this expands the monetary base by around $540bn in the next year. Remember Twist had no real effect on M2 stock. This seems to follow Friedman's prescription for the Japanese economy a few years ago:

Which is fine but the conditions under which the market unwinds will weigh heavily on the market, which is probably why the first reaction of the long bond was to sell off by around 3% and pop the yield by around 12bp.

The Projections
There can't be much fun in the meetings. The economic outlooks remain cool. Trends matter more than month to month changes. Employing that maxim, we can compare the adjectives used by the Fed to describe the economy twelve months ago and in the recent statement. Spot the difference? No, nor me.

Let's have a look at the forecast from a year ago and compare those with the latest estimates:

The basic story is that growth is slower, unemployment estimates barely changed (although 2012 turned out better) and inflation woefully below target. And finally a year ago, only five out of 18 members thought easing should commence in 2015. Now 13 out of 19 do.

Put all this together and we see the Fed with more room to maneuver, a flexible definition of unemployment and some latitude on inflation definitions. The changes are more stylistic than substantive, for now. But good ones nonetheless.

Finally, putting this into context. We remain in very accommodative territory. Here's the Chicago Fed National Financial Conditions Index which groups various leverage, term rates, spreads and shadow banking stats. Any read below 0 means "looser than average." We're in the same territory as we were in prior asset bubbles.

And where's the economy going?
Nowhere fast. First start with the financial balances. The household and corporate private sectors continue to run surpluses. Net private savings are now at $1,200bn, according to the Fed's Flow of Funds report, almost double the 2008 level and net liabilities have fallen by $1,700bn. So saving more and cutting debt means that balances sheets are in slow repair. Here's the run down in liabilities:

And with foreclosures, loan forgiveness and recent upticks in house prices, here's the home equity feel-good factor for households.

Now add in rising securities markets, lower liabilities and a big increase in time and savings deposits, for the total net worth: back up to pre-crisis levels.

So this is all good except that the private sector is struggling with negligible growth in disposable income, still paying down debt and reluctant to return to dissaving on any scale. That leaves only the public sector with a savings deficit and thus filling some of the demand gap. And as we know, that's about to go into negative territory in 2013 as the negotiations are not about whether government spends less but by how much. The fiscal drag in 2013 is likely to be around 1.5% of GDP. That's quite a change because for the last two years, it has been around 0.5% (which includes the big pull backs from state and local government). As all the sectors (so that's public, households, corporate and foreign) in the economy must balance, and with three out of four in full savings mode, the outlook for stronger, higher, faster income growth is pretty flat.

And that showed up last week where we saw small business optimism, in the NFIB survey, pull back six points to one of its lowest levels since 1986. The biggest detractor was the answer to the simple question of "do you think business conditions will be better in six months?" The overwhelming response was "no" with a volume almost twice that of early 2009.

Trade also took a hit from the global slowdown. The higher deficit is equivalent to about a 0.1% drag on growth. Capital goods exports fell 4% and imports from China rose. Why? Well the iPhone 5 is made there and shipping started on September 21st. So this is what it looks like when your favorite smart phone is counted in the balance of payments:

Other news this week saw slower retail sales, a bounce back in industrial production (but with the prior month revised down), and a very slow producer and consumer price change, less than 2% in both cases. That leaves the Fed room to focus on efforts to boost activity in the real economy.

Europe
A relatively quiet week. The EU met, talked about more fiscal and banking union but didn't mention it in their final communication. Bond yields held steady. Even the Italian 10 Year recovered from the Monti resignation announcement. As 2012 closes, one loud and clear theme has been the resilience of the euro concept and unity despite numerous commentaries on break up inevitability. We hear that some hedge funds have gone seriously underwater betting that the Hollande policies in France would lead to a massive bond sell off. No such luck. French 10-year bonds returned 14% so far this year.

Bonds
There's a lot of auction pressure right now with the whole curve out for bid last week and this. So last week we had auctions of 3s, 10s and 30s. Next up are 2s, 5s and 7s. Last week's 30-year auction was lukewarm with a bid/cover ratio below the average of the last four. Stepping back, this shows the income to total return ratio in the 10-year bonds and the S&P[1] in the last two years.

Note that you would normally expect bonds to provide the stability of principal and surety of income. But right now, the risk is very skewed towards price action...and price action that can wipe out yields in an intraday move. The numbers for the S&P look far more solid, especially factoring in some dividend growth.

Fiscal Cliff
If there's no deal, payroll taxes go up and extended UI disappears. This hits the lower-paids hard. Expect a drop in personal disposable income the first paycheck of January.

Bottom Line: With all the news items, the markets barely moved on the week. The Fed news is of longer significance, and meanwhile we have the dance to the music of cliffs to entertain us. We had an almost straight line upturn from the post election lows. The market has increased 4.5% in less than a month and YTD performance is around 15%. No one wants to risk the gains booked so far. We expect low volumes for the remaining sessions and are making no changes to allocations. So that's a moderate overweight to equities and corporates.

We'll review our 2012 forecasts the first week in January. Suffice to say some worked, some didn't. But the one I was most confident about dinged: Casey Stoner nerfed himself off his machine at 130mph and had to sit out four rounds. So the MotoGP crown went to the Spanish diehard, Jorge Lorenzo.

In closing, a tragedy. One that leaves us yearning and uneasy. Such wickedness has no meaning or reason. Our thoughts are with all those touched by the horrors of Newtown, any town.

Sources: Bloomberg, US Bureau of Economic Analysis, US Department of Commerce, FT Alphaville, Capital Economics, Economist Free Exchange, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Chicago, Federal Reserve Board, J.P. Morgan Market Intelligence, CRT Ader, High Frequency Economics, European Commission, European Central Bank, US Census Bureau, Pantheon MacroEconomic Advisors, TrendMacro, Bureau of Labor Statistics, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: "Have the new paper clips arrived, Enid?", 12.10.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Jobs
If there's one economic stat that spans the economic/political spectrum, it's jobs. Last week's NFPs had a headline of 146,000, way above estimates, and an unemployment rate of 7.7%, the best since December 2008 and a comfortable one point below a year ago. The post-Sandy numbers were always going to throw up mixed signals. Two weeks ago, the Fed thought that industrial production was depressed by a full point of the October data, which is around $2.8bn. But over at the BLS, they thought there was no substantive impact and any bullet was well and truly dodged. The prior two months were revised down by a net of 49,000 compared to the two months before that which were revised up by 114,000. There was a decline in the labor force after two big gains. There's a lot of monthly noise so YOY figures clear the air a bit. We now have 3.7m more people in the population (using the narrow BLS definition), 1.6m more in the labor force and 2.2m more employed. That explains the drop in the employment rate but not the participation rate which dropped to a multi-year low.

This is what has the pessimists worried and the argument is that lower unemployment is masking a voluntary withdrawal of labor. There are some grim sub-components such as no real change in the 40-week average duration of unemployment, weekly hours or earnings. And there's also some longer term forces at work which we don't fully understand yet. For example i) the male workforce population is growing more slowly than women ii) participation rates are coming down across the age cohorts iii) an ageing workforce probably lowering the participation rate by 0.2% just on its own iv) a slow pace in job openings (JOLTS only rose by 60,000 in the year to September) and v) an increase in part-time status for economic reasons. Normal cycles would see a greater drop in part-timers by now, but then, of course, this was no ordinary recession or recovery.

So while we don't yet see how all changes will work we're pretty convinced that there's very little structural unemployment. Sure, there are plenty of anecdotes about unemployable construction workers but take a look at these samples:

And these are some of the big employers:

Note that construction and transportation tend to have high frictional unemployment. If structural employment were a problem, we would clearly see: i) wildly different rates of change in unemployment by industry, as businesses would be forced to increase wages to compensate for skill shortages and ii) very different changes in unemployment rates. We don't really see much of either. The improvements in employment in this (yes, very select) sample suggests things are broadly improving across the board but that this is a chronically weak recovery which we measure in inches.

And two more points
First, the two ISM indexes came in last week. The non-manufacturing rose and manufacturing fell. This is a rough GDP-weighted average of the two:

The ISMs have a large company bias to them so we will have to see what small businesses feel about Sandy and cliffs later this week. The ISM manufacturing took a hit to orders and employment with a worrying increase in both firms' own and customers' inventories. That's not a good sign for future production. Only one company cited the storm as a problem so the report seems to reflect the wider lack of overall business confidence we've seen since September. The services index rose to an eight month high and there was probably some kicker from relief efforts, although as one respondent said:

We would put these two together and scientifically cross our fingers and hope that that the Cliff/Sandy distortions will unwind in the next few months. It's still too early to put a meaningful GDP forecast together for Q4 (there's no trade or inventory data yet) but the pace looks slower than the 2.7% rate coming out of Q3.

Second, the U. of Michigan confidence survey took a big hit on Friday. Consumer and business confidence have been at odds with each other for a few months. We put the consumer confidence levels down to improved housing prices, stock markets and jobs. But the headline drop from 82.7 to 75.5 wiped out the gains from the summer. Part of that may be the lagged effect of the increase in gas prices (HT Pantheon Macro), which feeds into an expected increase in inflation. Here's the YOY change in gas prices with a slowing rate of increase in recent months:

Some of this may be reversed but a poor consumer sentiment does not sit well with robust seasonal shopping. So, one more thing to worry about.

ECB Steady
He's much better than his predecessor and the constraints under which he works are pretty intolerable. But Draghi's performance last week was very understudy. Rates were unchanged because of possible inflation from high energy prices and taxes. The last reason is precious. Countries are encouraged to correct fiscal balances so they reduce borrowing and raise taxes, which increase prices, which means rates don't change which slows the economy. And so the ECB duly reduced the outlook for growth. The quick summary is:

• no new monetary or QE policies,
• acknowledged that the LTROs have not found their way into the real economy, and
• hint that the rate decision was a close call and that they might cut next time.

And that last item was quickly reflected in a lower Euro/Dollar rate. Put all this together and we have i) weaker but priced-in economic data from Europe ii) the likelihood of a prolonged slow loan demand and iii) er...that's about it.

Bonds
Not much moved in the markets last week. The 10-year treasury range has narrowed to around 1.60% to 1.70%, which is less than a one point price change. At that level, the duration to yield ratio is around 5.6x compared to recent mortgage pools we've been buying where 15-year MBS are at a 2.8 ratio and 30 years at 2.4. Corporate new issues slowed. We don't buy into the story of companies issuing debt to pay special dividends. It's not a real trend. A few companies have done it but there are other, less costly ways to return capital to shareholders.

Equities
Two weeks ago, a headline could move a stock 1% on no volume. Last week a recycled headline did the same trick. We're in a very narrow range and stocks can move on a real story like a botched M&A splurge (thanks for nothing FCX[1]) or on rumor and catch up (AAPL[2]). We still on the sidelines unless we see prices drop away.

Bottom Line: No real change. There's no point trying to reposition the book ahead of the year-end what with the politics of the market. Remain long equities and lower duration in the mortgage market but bringing in duration. We've brought in our treasury allocation a lot from the September highs but remain open to trading opportunities.

Look for this week's FOMC meeting. It's a big one with full presser. Recent noises from Evans and Bullard are more dovish and we have a new slate of voting members starting in 2013. Expect a conversion of the Twist program.

Sources: Bloomberg, Bureau of Economic Analysis, Federal Reserve Bank of St. Louis, Federal Reserve Board, ISI, High Frequency Economics, Capital Economics, Bureau of Labor Statistics, CRT Ader, J.P. Morgan Market Intelligence, European Central Bank, Pantheon MacroEconomic Advisors, Tim Duy's Fed Watch, U. of Michigan, US Treasury Department, Institute for Supply Management, FT Money Supply, Federal Reserve Bank of Chicago, Monty Python "Nothing Happened" (Michael Palin, Terry Jones, Eric Idle, Graham Chapman, Terry Gilliam, John Cleese) Sentinel Asset Management, Inc.

[1] There is a position in Freeport-McMoRan Copper & Gold, Inc. as of December 7, 2012. To see Sentinel Investments' Top 10 Holdings for all funds, please click here.

[2] There is a position in Apple, Inc. as of December 7, 2012. To see Sentinel Investments' Top 10 Holdings for all funds, please click here.

Thought of the Week: "Headline Roulette", 12.03.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

That Fiscal Thing dominated the week. Every twitch out of Washington was greeted with over analysis by the press and us. Less so the markets. Truth is, markets are not very good at discounting political uncertainty. Sure, a tax scare here and a debt ceiling impasse there might lead to a sell-off but ultimately it's about earnings, corporate health and outlook and on those metrics, nothing last week really upset the markets in a major way. The bond market tends to get this right. The GT-10 traded within 1.60% to 1.69% all week which is a round trip price change of less than 1%. The dollar ended unchanged and the Fed's custody holdings increased by nearly $10bn. Eh? Well, this measures securities held by the Fed for foreign official transactions, essentially central banks.

So by at least a few measures, the cliff dive is a domestic affair with the financial markets spectating and foreigners buying.

Where Angels Fear to Tread
We laid out the cliff numbers two weeks ago. They haven't changed much. One area that might impact the market is dividend tax rate, currently around 15% and scheduled to rise to the highest income band, so possibly a marginal 40% which translates into roughly a 13% increase for the highest rate taxpayer. On a crude measure, with the SPX[1] at 1414 and a 2.19% yield, netting to 1.8%, the S&P would correct to around 1240 to maintain the same net yield. That's a scary 12% correction. But dividends are already estimated to rise by about 11% in the next year and indeed last week we saw some special dividend announcements, bringing the prospective yield to 2.43%. So netting out the 13% tax hike and the 11% dividend increase brings the market right back to where it started. Remember also that payout ratios at 38% are low by historical standards so there remains potential for higher payouts and perhaps more efficient cash returns to shareholders. Finally, here's a rough measure of how stocks perform against the top rate dividend tax.

It's not clear that the dividend tax rate makes much of a difference to the returns.

US Economy
There's a lot to work with right now. Here's how we summarize it:

Housing is the lead story: prices, transactions and starts. Only 55% of mortgages have a loan/value ratio under 80%. That's the threshold for refinancing. If prices continue to climb we're going to see more people eligible for refinancing as well as a positive wealth effect.

This is why confidence is high: and which overrides the fiscal cliff. People should be worried about the cliff and reduced after tax income. But they're not yet because the rebound in home prices relieves the negative equity story.

And meanwhile the economy is slightly better. We saw a revised GDP number from 2.0% to 2.7%, primarily because of the improved trade figures (deficit was Q1: ($147bn), Q2: ($137bn) and Q3: ($126bn)). Also the inventory number was better than originally thought. It's the most volatile component of GDP.

But there's some hair in the details. First, the investment component of GDP has flattened. Here it is as a proportion of GDP.

The level of investment in the economy still seems to be way below trend and output potential. We had better durable goods orders, especially in the core, non-defense, non-aircraft series but it's still puzzling why investment remains low. Uncertainty, cliff, taxes all play their part. Gross fixed investment is usually tied to profits and here are the corporate profits with inventory valuation, which should flatter the numbers, against GDP. It bounced slightly from the previous quarter but looks peaked out.

Another point is that consumption growth was revised down from 2.0% to 1.4%. This became clearer on Friday when the personal incomes numbers for October came in flat and expenditures fell 0.2%. One measure we track is this, real disposable income per capita, which fell for the third straight month.

Not surprisingly, with that kind of consumption and income pattern, the core PCE index, the Fed's favorite, rose only 1.6% YOY, well below the stated target. Some of this can be explained by Sandy but that came very late in the month.

The one thing that seems clear is that Fed policy will remain unchanged. They have stated their views on tightening of any sort until there's more momentum in the employment numbers. The November Beige book used "modest" thirty-seven times when describing economic conditions, so there's no relief there. And two speeches in the last few weeks, one from Chairman Bernanke and the other from ¨ber-dove Evans, reinforced the likelihood of further asset purchases in the New Year after Operation Twist expires.

Europe Remedies
Continued quiet drip of ok news. The deal with Greece was a bail out in all but name and quite craftily handled by all: i) interest rates on the Greek loan facility were cut, ii) interest payments deferred, iii) EFSF loan maturities extended and iv) buy-backs of privately held, deeply discounted sovereign debt allowed. That's a good deal and done away from the glare of Euro summitry. Even Draghi made comforting comments on Greece in his speech on competitiveness, two weeks after he said he was done with it. Bond markets mostly liked what they saw and it was a good week for euro sovereigns. The one to watch is France, which, after its recent downgrade by Moody's, trades at a 40bp lower spread to Spain.

Bonds
Credit was wider in sympathy with equities but more importantly the street is beginning to get saturated with paper from the volume of new issues. More and more companies are coming to market to raise money to fund special dividends in advance of higher taxes in 2013. It was a $100bn new issue month for corporates, with much of that coming from high quality investment grade, non-financial companies.

GT10s at 1.7%...the technical resistance is at around 1.87% so that's holding. The market does not fear an acceleration of the recovery so rates will stay around 1.65% to 1.85% mark. That's a round trip price change of 3% on duration of 9.0. Expect a lot of trading but not strong directionals.

Equities
No volume. It's "headline roulette"...a headline will move SPX by 1% on really low volume. It's a traders' market but not sure any traders are making money. We are on the sidelines and we'll buy when we see the prices drop away.

We have seen exceptionally low volumes for last couple of months. But the basic drivers of the market are positive:

• earnings coming in around $103 for the S&P;
• a 2.2% yield...highest it's been all year; and
• earnings yield of 7%. Very competitive relative to high yield.

But what about all the bad stuff? Yes, that would be:

• Europe
• deficits
• politics
• taxes

All of which are well understood and are probably going to diminish in importance. They will remain as obstacles but their ability to really upset the market may wane.

Bottom Line: Buying stocks when we can but out of the traffic of noise and fury. We're staying in the mortgage market but bringing in duration.

Sources: Bloomberg, Bureau of Economic Analysis, US Department of Commerce, Capital Economics, CRT Ader, Federal Reserve Bank of Chicago, Federal Reserve Board, Federal Reserve Bank of St. Louis, High Frequency Economics, Pantheon Macroeconomic Advisors, Tim Duy's Fed Watch, TrendMacro, J.P. Morgan Market Intelligence, US Census Bureau, US Dept of Housing & Urban Development, ISI, Peterson Institute for International Economics, CLSA Asia-Pacific Markets, Paycheckcity.com, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Bumpy End to the Year, 11.19.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Europe would like to have America's problems. Here we have declining public spending, increasing receipts, falling debt to GDP ratios and unemployment 3% below the European average. This puts the Fiscal Cliff (and I was so hoping to avoid that cliché) debate somewhat in context. It's serious enough to draw the attention of corporate CEOs, put a heavy dampener on business confidence, which we saw in the recent NFIB report, and postpone hiring plans and capital investment, which showed up in last week's Empire and Philly Fed surveys. This is how the cliff breaks down:

	Budget Item	$bn	Hit to 2013 GDP	Hit to 2013 Employment
1.	Defense cuts	$24	0.4%	0.4%
2.	Medicare cuts	$40	0.4%	0.4%
3.	Tax increases for lower incomes	$288	1.4%	1.8%
4.	Tax increases for higher incomes	$42	0.1%	0.2%
5.	Payroll Tax	$108	0.7%	0.8%
	Total	$502	2.9%	3.5%

So five points come out of this: one, the big, unadulterated number clearly slams the economy straight into recession; two, the tax increase for the top brackets (line 4) , which gets most of the press, counts for very little; three, the payroll tax cut number (line 5) includes $26bn of extended Unemployment Insurance (UI) benefits and both payroll and UI have a very big multiplier, meaning, especially in the case of UI, spending decreases by exactly the amount of the cut, which is not the case for the income tax (lines 3 and 4); four, there's little support for an extension of the payroll tax deduction; and five, there's less talk of a cliff and more of a slow burn economy as the changes take effect in early 2013 and consumers and businesses adapt. This last point is surely right. If nothing changes and all current legislation lapses, the full impact won't occur immediately. Any decline in the economy could accelerate if left untended and the deficit would improve almost immediately. But the full-off/remain-off scenario is highly unlikely.

So...what will happen?
The issue is attracting deserved attention. There's marginally less polarity than a few weeks ago and that's because the stakes are arguably higher. The election was always going to delight half the population and annoy the other half. With that out of the way, legislators can turn their resolve to something which affects everyone and where the pressure to "just do something" is as high as it was back in 1995-1996 when the Clinton Administration and a Republican Congress faced a similar stand-off that shut the government down for 21 days. So the pressure to reach an agreement quickly will be high. One cynical view is that the changes would take effect, which of course results in an across the board tax increase, that paves the way for a deal where all parties can point to siding with tax decreases. Which is a bit like starting a fire and then claiming hero status for rescuing the children. Hopefully, the scenario is more like:

• extend the tax cuts for the low and moderate income households;
• let the top taxpayer rates expire but point out that they benefit anyway because a portion of their tax falls into the lower bands;
• drop the estate tax limit and increase dividend taxes;
• index the AMT; and
• eliminate the automatic defense and Medicare payment rate cuts.

All of which would lead to only minor changes in the budget deficit. The recent Treasury statement for October, the beginning of the fiscal year, is distorted somewhat by the timing of the number of business days and government invoicing, so the adjusted headline number was little changed from FY2012. But in the year to September, revenues increased 6.4%, outlays fell 1.7%, net interest on the debt fell 2% and the deficit to GDP came in at around 7%. These are not great numbers but the deficit is on a downward track and that makes it easier for everyone to do a deal. So put this all together and the risks of the cliff seem manageable. We just need patience. Clearly the bond market seems far more worried about growth slippage than runaway deficits and inflation.

Minutes and Yellen
Not to pick historic landmarks but the speech from Janet Yellen, Vice-Chair of the Federal Reserve, ex president of the San Francisco Federal Reserve and possible successor to Bernanke, was a game changer. The Fed minutes from the October 24th meeting saw the participants wrestling with how the employment and inflation indicators combined with the target dates. At the moment, an unspecified unemployment target and a 2% inflation target sit with a commitment not to touch rates until 2015. But as we have mentioned before, the Fed is i) nowhere near convinced that unemployment is at a full, non-accelerating rate of inflation (or NAIRU) and ii) well below its inflation target. Here's the latest on the core PCE which hasn't been anywhere near 2% for years.

So the minutes acknowledge this and the Fed positioned itself for more asset purchases in the New Year once Operation Twist ends. So at that point, many expect the announcement of a renewed Treasury purchase program. The trouble with that is the composition of the Fed's balance sheet. It's at $2.8 trillion of which 57% is in treasuries and 30% in MBS. Let's call those marketable securities. The rest is mostly FX reserves and some TALF assets which are not useable open market instruments for the Fed's immediate purposes. And of the marketable securities, all of them are of maturities of over one year and 83% are in maturities over five years. So this presents a bit of a problem as the Fed is now the de facto market in many individual market issues...in the Treasury bond sector, Fed monthly purchase volumes are about 150% of supply. And that means the Fed doesn't have much more short-term paper to sell. This chart shows the YOY growth change in Fed buying. The question of what and how to buy next clearly looms:

This is where Janet Yellen comes in. Her basic thesis is to jump in where two Fed presidents have already spoken, namely to start tying monetary policy to specific employment levels about 2% below the current 7.9% and let inflation at least catch up to its target...in other words to exceed 2% until it reaches the compounded 2% level. That would mean rates would stay low even though the primary indicators had met targets. The crux of the proposal is that the committee would:

"Eliminate the calendar date and replace it with guidance on the economic conditions...liftoff [of rates] would not be automatic once a threshold is reached."

This would provide more confidence to the market that policy would remain in place until the recovery is fully underway. This makes sense because most of the September impetus to the markets has already given way. The five year forward inflation expectations are back where they started and the five year TIPS break-even rate climbed and promptly corrected 40bps. It's back to where it was a year ago. Stocks, gold and the dollar have all seen the same trajectory.

What we think is going on is a probe by the Fed to try new policy tools and recommit to growth by reshaping future expectations. Or anything to up-change the gears on this very weak recovery.

Europe looks over the edge and takes one step forward.
In the last few weeks, ECB President Mario Draghi has made frequent comments about the risk of deflation. Much of this went over the heads of the audiences because eurozone inflation is at 2.5%. But a lot of this is VAT driven. Demand is in terrible shape. The latest spat in Europe is about Greece's next aid package. Draghi said he's "done" with Greece and the IMF and EU are not even on the same page as to what the debt targets are. So it seems like the deflation fears are about to be self-fulfilling with the entire zone now officially in recession and business surveys pointing for more to come. Yields would normally come down with that kind of news but in Spain they rose about 30bp and in Germany they fell.

The only thing that keeps us from throwing in the towel on Europe is that banks are getting stronger, the ECB has done a great deal to diminish the risk of a break-up and that the bad news is pretty well discounted.

Other US Stats
Claims and industrial production saw post-Sandy distortions. That drop in the blue line is claims jumping by nearly 100,000 from the October low. Stocks took their immediate cue.

Industrial production also fell 0.4% along with capacity utilization. The annual growth rate fell from 2.8% to 1.7%. The Sandy hit was very localized with the Philly Fed business report falling substantially (down 15 points) but the Empire broadly unchanged. There may be some pick up in November but broad activity was already weak from Europe and China and there has not been much change to either's outlook.

Bonds
Familiar story of a i) robust new issuance market with quick take-downs ii) treasuries seeing weaker economic growth and dropping yields to 1.58% from a pre-election high of 1.80% but iii) credit spreads under short-term pressure as dealers adjust inventories and reduce liquidity. This could mean slightly wider spreads for the next few weeks but we expect the IG space to outperform other risk assets, especially equities, CMBS and high yield.

Stocks
We have seen a 7% correction in the SPX[1]. More could come as analysts adjust down earnings expectations. The biggest hit in equities has been in small cap land where the correction has been even larger. Investors are looking for relative safety and we have seen a substantial outperformance of large cap this year and for most of the last 18 months. This is the longest period of sustained large cap outperformance over small cap in over six years.

Bottom Line:
Risk assets could be under a lot of pressure between now and year-end. There's very little reason for a year-end rally what with the gains already in the market and the tax overhang. Any rally from the 1350 levels would be short-lived given the slow economy.

Sources: Pantheon MacroEconomic Advisors, Center on Budget & Policy Priorities, Congressional Budget Office, Tim Duy's Fed Watch, US Census Bureau, US Dept of Commerce, US Treasury Department, Federal Reserve Bank of San Francisco, Federal Reserve, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of St. Louis, Bloomberg, Economist Free Exchange, European Central Bank, ISI, FT Alphaville, Capital Economics, High Frequency Economics, CRT Ader, J.P. Morgan Market Intelligence, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Four More Years..., 11.12.2012

Kate Schapiro
CFA, SVP and Portfolio Manager
Sentinel Asset Management, Inc.

Americans went to the polls this past Tuesday and re-elected President Obama to four more years in office. In addition, the partisan breakdown of Congress stayed roughly the same in both the House of Representatives (Republican majority) and Senate (Democratic majority). So after nearly two years and billions of dollars spent on campaigning, debating, polling, grand-standing and mudslinging, the leadership is unchanged. A good argument for campaign finance reform if ever there was one.

The US stock market did not take kindly to the outcome, declining sharply in the aftermath. With the election out of the way, investors turned their laser focus onto the looming "fiscal cliff" come January 1. Investors should have no doubts that public policy measures will continue to play a major role in determining the course of economic events for the foreseeable future. While there is certainly room to hope for a "Grand Bargain" of sorts, it is also possible that no agreement will be reached, an outcome that would put the US economy back into recession according to recent estimates by the CBO. The markets do not appear to be discounting either extreme possibility at the moment, perhaps expecting more "can-kicking" temporary measures instead: extension of some tax cuts in exchange for suspension of some spending cuts. Fortunately, because the US dollar remains the world's reserve currency, and the US economy remains the world's largest and arguably the most stable, funding costs to maintain the status quo will remain low for the foreseeable future.

With all the focus on the US election, perhaps developments elsewhere did not get as much air time as deserved. For the fifth month in a row, the European Central Bank left interest rates unchanged, despite the deterioration in the economic outlook for the region. Declines in the Eurozone Composite Purchasing Managers' Index and Economic Sentiment Indicator point to slower growth in Q4 over Q3. Talk about a fiscal cliff, Spain introduced an increase of its VAT to 21% and proceeded to see retail sales plummet nearly 11% year-on-year in September. Greece narrowly achieved parliamentary approval for another austerity package which included cutting salaries for public sector workers and pensions for the elderly, in order to secure another tranche of bailout funding. Once again, anti-austerity protesters took to the streets hurling stones. While a Greek exit from the euro bloc is unlikely this year, it can not be ruled out for next year.

Across the Pacific, China's Communist Party began its week long congress that will shepherd in the new party leaders for the next decade, beginning with Xi Jinping poised to take the reins of president from Hu Jintao come next March. Many China observers believe the new leadership will be more active in government reforms, such as greater transparency and lesser state controls over certain economic sectors. It is unlikely that such reforms will happen quickly; but with economic growth slowing and the wealth divide growing, maintaining a harmonious society could become more difficult. Still, it should be noted that China's economic slowdown appears to be taking a breather with signs that industrial output and fixed asset investment were a bit stronger in October and aggregate retail sales were growing at a double-digit rate. We believe Beijing has preferred the easing of restrictions to implementing stimulative policies, but with inflation rates down over the last 18 months, there is room to stimulate if necessary. China's growth rate at 7.5% or so still provides some welcome relief for global multi-nationals.

All this is to say that investors must not be complacent as we head into the final months of the year. For most markets, it has been a good year despite economic headwinds. There is reason to be cautious going into the year-end period, but stock markets tend to rise in the fourth quarter, so it may not pay to be overly pessimistic. Nevertheless, the re-election of Mr. Obama suggests that we will see many of the same trends over the next four years as we have over the last four. Markets, most likely, will continue to force the reduction of accumulated debts resulting from past excesses which will keep the issues of potential higher taxes and/or spending cuts on the front burner. Debate will continue over the unconventional monetary policies instituted by the Federal Reserve and increasingly adopted by other major central banks including the ECB and Bank of Japan, but these policies are unlikely to be withdrawn anytime soon. And it remains to be seen whether the fundamentally deflationary forces facing the world economy can be held at bay by ongoing massive doses of inflationary policy response. The range of potential outcomes remains unusually wide.

Bottom Line: For global equities, stay focused on owning businesses that can prosper in a variety of economic environments. Emphasize good companies, which we define as those that deliver high returns on invested capital, require little additional investment in order to grow, enjoy relative pricing power in their markets and so are able to defend profit margins, as well as generate good cash flows. Valuation is important, especially as the rising market becomes increasingly narrow in scope. Over the long run, these types of stocks should generate attractive returns no matter the short term policies coming out of Washington, Berlin, Tokyo or Beijing.

Sources: Sentinel Asset Management, Inc.

Thought of the Week: Favorable Reports Post Sandy, 11.05.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The devastation of Sandy blighted the week. We were lucky in that most of our employees escaped the worst effects. We had some evacuations and plenty of lost power. But the images of devastation were overwhelming and we hope our clients and friends of the firm are safe. Perhaps, as a non-native, my perspective is warped but in the US we have an uncanny ability for industry, problem-solving, drive, inventiveness and optimism. Sometimes the very best of us comes out in these times.

The economic impact of Sandy is difficult to determine. We have seen estimates as high as a 0.6% drag on GDP in Q4 which is about $100bn. I'm not sure how they came up with the number other than a quick calculation on 2 days of total lost production times the population. In 2005, Katrina reduced consumer confidence, industrial production and increased jobless claims but that was more geographically focused than Sandy and some infrastructure, such as the damage to off-shore oil production capacity, was never rebuilt. That won't be the case with Sandy. One of the first places we looked, but are wary of, were the price of Cat Bonds (catastrophe bonds which sort of behave like floaters but pay principal depending on insurance losses); these dropped in price but we're not sure how liquid they really are. The S&P[1] property and casualty or P&C stocks (so the CB, ALL, BRKs[2] of the world) had already fallen from around October 22nd, when the first whiff of Sandy was in the air. They have stabilized recently partly because the statutory surplus of P&C companies is around $600bn and the insured losses, which are not the same as total losses, look like they're around $20bn.

Clean up will lead to some economic growth. This is because we measure Gross Domestic Product not net. So even though we're replacing infrastructure, autos and houses and thus not adding to the total stock of capital, we are spending and generating income. And that contributes to GDP. Add in some other metrics like reinsurance proceeds, which typically come from offshore companies and so show up in the current account, and the time lag for repair and improvement and there might even be an overall positive impact on GDP.

Standby Europe
As we have written elsewhere (see our Market Insights piece), Europe has stabilized for now. The Bundesbank is appeased; the ECB stands ready to backstop sovereigns who ask for help; rates are zero bound and the euro some 7% above recent lows. The markets had expected a slowdown for some months and, right on cue, they're coming in:

US: Signs of Q4 Recovery
Another good month of NFPs with Friday's number in at 171,000, and big revisions up for the last two months. So far this year, upward revisions lead downward revisions 7 to 2, and the net gain in new jobs is over 1.5m. Civilian employment, which measures those with jobs, looks like this:

It's probably never been a worse time for government employment. Here are all government employees, so federal, state and local government employees, as a ratio of the total workforce. It's just over 14%.

The dispersion of unemployment is uneven. Behind the 7.9% rate is unemployment of between 13% to 19% for the under 24 cohort, 9.2% for those with no college and 14% for African-Americans. There's still a low wage bias on the employment number so more in leisure, retail and temporary services than we should have. But the average rate of monthly job growth for the last three months has been 173,000 which should be enough to bring the unemployment rate down gradually.

Who holds the debt?
Remember the scares that funding the budget deficit requires massive amount of foreign buyers and that deficits would scare them away. Well, here's the latest numbers on federal debt held by foreign investors, up every quarter since 2008.

Why? Well the US is still a very safe haven, foreign investors from Asia are still protecting their currencies so buying US bills, notes and bonds is a way to maintain their competitiveness. Confidence in the US remains high...even if we don't see it all the time.

Bonds:
We have had quite a run in corporates. Here's the BBB spread[3] against 10-year treasuries.

These have come in about 90bps this year and signs are that the rally may be tired. We have increased the quality and liquidity of our bond portfolio, focusing on large issue, on-the-run securities. There may be volatility to come in the rest of the year and this seems a reasonable protection trade.

Equities:
It's been a market of mega caps recently with the OEX index[4] of the largest 100 companies outperforming the broad S&P by 130bps and the RTY[5] by 530bps YTD. In the widely followed Russell 1000G index[6], which confusingly has 478 constituents, the top 10 companies are 26% of the index. The market has run well but we'd prefer more breadth.

Bottom Line: New money is moving towards more value play in equities. We're taking some risk off the table between now and year-end.

Sources: Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics, Capital Economics, High Frequency Economics, TrendMacro, European Central Bank, ISI, J.P. Morgan Market Intelligence, Federal Reserve Bank of St. Louis, James Hamilton at econbrowser.com, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.
[2] There is not a position in either Allstate (ALL) or Berkshire Hathaway (BRK.A). However, there is a position in Chubb Corp (CB) as of November 2, 2012. To see Sentinel Investments' Top 10 Holdings for all funds, please click here.
[3] BofA Merrill Lynch US Corporate BBB Option-Adjusted Spread, BofA Merrill Lynch
[4] Standard & Poor's 100 Index is a capitalization-weighted index based on 100 highly capitalized stocks selected from the S&P 500 index for which options are listed. An investment cannot be made directly in an index.
[5] Russell 2000 is an unmanaged index that measures the performance of 2000 small-cap companies within the US equity universe. An investment cannot be made directly in an index.
[6] The Russell 1000 Growth Index is an unmanaged index that measures the performance of the large-cap growth segment of the US equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. An investment cannot be made directly in an index.

Thought of the Week: Nice Speech, Tough Crowd, 10.29.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Sandy is pummeling everything we know on the eastern seaboard. I hope everyone stays safe and we can ride this out without too much damage. Thankfully markets are closed. Meanwhile, here's our views on capital markets on Monday.

A quieter week but some valuable insight into the skillful game played by the ECB's Mario Draghi. At the risk of oversimplifying, what we have in play (and see TOTW passim) is: i) an asset repurchase program promised but neither funded or exercised ii) and the same for a Spanish bank bailout iii) a major reliance on bank lending for growth but banks tightening credit standards and lowering loans by €250bn in the last year. So when Draghi presented himself at the Deutscher Bundesdtag last week he explained about the very real threat of deflation and that it was a bigger risk than inflation. He was in town to assure the Germans that any policy actions by the ECB would not finance governments (so no monetization), nor compromise central bank independence (so no political pressure), nor create taxpayer risk (so no increased taxes) and nor create inflation (the German nightmare). It was a deft maneuver by the ECB into a position with its most important political partner so that it could continue policy at time when banks seem unwilling to pass on monetary stimulus to the real economy.

There's a pretty dismal picture of growth in Europe with recent PMI surveys falling fast and Bund yields with them. But two smaller stories remind us that slow successes happen. First, the IMF reported "progress" in Greece and Portugal so freeing up some €1.5bn in funding. And second, the IMF noted that Ireland was in line to meet the budget deficit target of 7.5% next year and had regained market access for its sovereign debt. This shows up in the sharp reduction of the Irish 9-year benchmark yields from nearly 8.3% last year to 4.7%, a gain of 34% over the year if one had the stomach for it (few did). So quietly, perhaps the periphery is mending albeit at some significant social cost.

FOMC:
The meeting last week was a "no presser" so expectations were low and they met them. Which was good because the new polices announced in September were radical and the market needs further time to digest. The wording changes from last month were minor and Richmond Fed president Lacker upped his dissent, this time disagreeing with both the forward guidance and the low rates. He must not put too much store in his own region's manufacturing and service sector surveys because both were down in October after a brief respite in September. The Fed is surely right to pursue unchanged policies. Compare adjectives in their outlook last week compared to six months ago. Same as it ever was:

	March 2012	October 2012
Economy	Moderate	Moderate
Employment	Declining but elevated	Slow and elevated
Household Spending	Advancing	Bit more quick
Fixed Investment	Advancing	Slowed
Inflation	Subdued	Stable
Securities Repurchases	Maturity extension	Continue outright purchases
Housing	Depressed	Improvement

Nor is it much changed from a year ago. The Fed knows that today's growth is insufficient to bring about any material gain in employment, even with demography and labor withdrawal helping recent improvements. Looking ahead, the Fed will probably keep the asset purchases in place beyond the maturity extension (Twist) program in December. That means they will likely revert to treasury buying to maintain the $85bn per month rate. The reaction to QE3 diluted fast. At first stocks rallied 5%, mortgage rates fell 16bps and the Fed's Five Year Forward Breakeven Inflation Rate rose 40bps to 2.87%. But recently, stocks fell, mortgages backed up and inflation expectations fell. One can imagine the Fed's anxiety in trying to come up with targets for both inflation and employment in light of the palpable lack of momentum. Part of which is explained by...

Fiscal Cliff:
We have tended to ignore this on the basis that it has been in the news since the spring and was one of those "surely they won't do it" threats. But it's coming closer and it's the topic of many an earnings call. The actual figures for the drag on the economy range from $540bn to $610bn and their effect depends on whether one believes that a negative multiplier will go into effect or that increased revenue and lower deficits will spring confidence back into life. But we do know that the Bush-era tax cuts, expiration of the payroll tax holiday, reduced unemployment benefits and the Budget Control Act spending cuts are already weighing on people and businesses. Last week the Chairman of General Dynamics said that as far as he was concerned, the sequestration was a question "no one on earth could answer" but that it was:

And that he had already seen slowing contract awards from the planned $1 trillion in defense cuts over 10 years and that he would have to reduce costs. That also explains the general slowing of capital expenditure despite a small rebound in durable goods orders. The increase was 9.9% but almost all due to the volatile series of aircraft orders. Here's what it looks like after Boeing received only one order in August and 143 last month:

Across a broader group, here's the downturn in non-defense capital goods, so that's all the plant making capex stuff. Normally, when companies cut capex, staffing follows. This time could be different because so many costs were cut to the bone in 2009-2011 and companies may defer spending until the cliff is out of the way. Still, sobering stuff.

There was also some slippage in two key order components. In the three months to October Durable Goods Orders excluding aircraft were at $441bn compared to $455bn in the prior three months, so a 3% decline, and Orders for Non Defense Capital Goods were $205bn, down 7% from the prior quarter's $221bn. Put all this together and we see businesses running scared ahead of the tax changes and so a big slow down in inventory build and investment. These two components have contributed around 50% of growth for the last three quarters so unless we see a pick up in exports (unlikely based on two out of three months data) or from government (probably not) then the personal consumption side has a lot of pulling to do to keep growth at around 2%. All this makes Q3 GDP growth a real challenge...

Q3 GDP:
The first estimates for any quarterly GDP change are a bit dicey. The swing between first estimates and final numbers has been between 0.2% to over 1.0% in the last two years. The flash numbers that came out Friday had a few interesting points: i) nominal GNP was up 4.9%, the fastest rate in twelve months, which is critical for revenues ii) government defense spending jumped 13%, that hardly looks sustainable but meant iii) government was a contributor for growth for the first time in nine quarters iv) businesses pulled back on investment and inventories, which is no surprise as the Fed regional reports were telling us that for months and v) personal compensation grew at around 2.5% which was slower than last quarter. Put all this together and it's probably not enough to dent unemployment.

Some of the consumer side of growth is picking up. Following on from the new housing starts two weeks ago, we saw pending home sales increase. But it's very slow and personal consumption growth continues to struggle. And if the Fiscal Cliff hits, it will hit those in the bottom two thirds of earnings the worst, which will stop the recovery dead in its tracks.

Bonds:
It was a quiet week in treasuries with the GT10 price moving around less than a point. Two auctions at the 7- and 5-year went well with slightly higher direct bids. Credit continues to outperform equities as investor demand remains robust. For the retail investor, industry flow data showed inflows of $1.9bln into IG, just $10m into HY and $666m into municipal funds.

Equities:
We're looking beyond the current earrings season. Revenue misses are more important than earnings misses and the market's reaction has been muted. The cause of the guidance corrections has been very specific, namely the September slowdown and fiscal cliff. If a deal is done, market relief will be swift.

Bottom Line:
Treasuries remain in a range which is good given the news from companies. We're making few changes to the equity/fixed allocation. The dividend yield on the market is back to its highest level since August.

Sources: IMF, Bloomberg, Bureau of Economic Analysis, Federal Reserve Bank of St. Louis, Capital Economics, High Frequency Economics, US Census Bureau, US Bureau or Economic Analysis, US Dept of Housing & Urban Development, European Central Bank, TrendMacro, CRT Ader, J.P. Morgan Market Intelligence, Q3 2012 General Dynamics Earnings Conference Call, Sentinel Asset Management, Inc.

[1] There is a position in General Dynamics as of October 26, 2012. To see Sentinel Investments' Top 10 Holdings for all funds, please click here.
[2] There is a position in Boeing Corp. as of October 26, 2012. To see Sentinel Investments' Top 10 Holdings for all funds, please click here.

Thought of the Week: More traction...just look through the earnings season, 10.22.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Last week saw an important debate on how the US has fared in the post recession recovery. The short answer is, "not well" if measured by a return to GDP growth trends or per capita income. But the counter, as explained by Reinhart and Rogoff, is "faster than you would expect." We're in the second camp. The nature of the 2008 recession was a systemic financial crisis. These permeate the entire financial system from banks, mutual funds, insurance companies, real estate and debt. And measured by depth, duration and dispersion, the crisis was the worst in living memory. In those recessions it takes about 5 years, in the post war period, and 10 years in all other depression periods, to recover lost ground. This makes it very different from a Fed induced recession to curb inflation or growth (e.g. 1981, 1992 or 2001). In those recessions, a return to growth happens in around four quarters. And these are the types of recession that we got used to in the last 30 years and against which the current generation of financial managers grade.

The average growth rates from financial recessions are around 1.2% and by that measure, the US has done well. How well?: i) we're still around 2% below the GDP per capita rate of 2007 but at one point we were nearly 7% below ii) we're at 7.8% unemployment or about 3% above the 2007 level but prior crises saw unemployment triple and stay that way for many years and iii) the US has grown a lot faster than other countries hit with the same problems. You can see the US story here, which measures wage growth and benefit costs. Benefit costs remain very sticky but wages have yet to regain all of their current ground after the big hit in 2009 to 2010.

Yes, recent growth is better but as any investor will tell you, a loss of around 5% is not offset by two years of 2.5% growth. We're just back at where we started. So all this tells us that the US is doing quite well, although is doesn't feel like it. This brings us to....

US and Budget Deficits:
Terrible, no? No. They're in good shape. The US ran a surplus in September for the second time this year. Total spending for the fiscal year just ended was down 1.6% and the deficit down 15%. In GNP terms, it fell from 8.5% to 7%. Receipts were up and spending in four of the big 5 agencies (so that's Social Security, Medicare, Medicaid, Defense and Interest payments) was down. Any fiscal concerns are about drag, not ability to fund or out-of-control spending. And that's why the bond market is relaxed about the deficit...which is not quite the same as being relaxed about the "Fiscal Cliff." That's a political will not a funding capability issue.

We also saw a few pick up signs of growth after the dismal summer months. Starting with housing starts which were up 26% YOY and there were more starts in the first nine months of 2012 than for all of 2010. Here they are, with a long way to go until we ever see bubble levels, thankfully, and the continued growth in 5-units or more.

We think this is an important trend. Because one, the ratio of 5-units to total units continues to climb from around 15% of total starts to more like 25%. These will typically be rental units, which should put a cap on the all important OER component of the CPI. Two, the number of new households constructed (so single units plus an estimate for the multi-family average) is around 1.9m up from 1.2m a year ago. That's a good pick up to a small but important growth contributor. Retail sales also gained traction and it wasn't all about the iPhone 5. Finally both the Empire and Philly Fed indexes reversed their weaker trends but in both cases the overwhelming number of respondents just recorded "no change." In sum, the US looks like this:

Favorable	Housing, unemployment, claims, auto production and sales, bounce in activity since summer, inflation
Still Challenged	Wage and compensation growth, nominal GNP, industrial production, exports, top line growth

The best news for the markets is that there are two backstops working in our favor:

1. Fed and QE: We're on a committed path from the last Fed meeting. The dovish camp has the momentum and the remaining hawks are either coming round, not voting or don't have an alternate strategy. So the Fed will support any upswing in activity and, crucially, let current policy run.
2. ECB and OMT: Yes, these are still miles away before we sleep, but they are there as a bulwark against too much downgrading and deterioration in the European economies.

Europe: Another week another summit. We are still waiting for words to become action. What we have is (HT Lorcan Kelley over at TrendMacro):

• Spanish bank bailouts, promised not delivered;
• ESM up and sort of running;
• OMTs in the background.

We're reminded of the scene from Singin' in the Rain where the starlet is convinced the staged romance with her leading man is real:

For now it doesn't matter that these are all "policies in waiting", unimplemented and mostly air. We can witness the economic numbers falling but also see i) a successful auction of Italian bonds ii) a steepening of the Spanish yield curve from the horrific 2-year 7% rate back in July and iii) confirmation of Spain's credit rating. Don't expect much and we're certainly not active in the bonds because we see Bunds as overpriced. But some non-financial equities are looking more attractive.

Bonds:
Credit has been on fire as investors continue to clamor for bonds. Issuance is light due to earnings blackout. The Barclays US credit index[1] is 20bps tighter for the month to close last week at 123bps and the Moody's BAA[2] spread is down to 280bps from 324bps in August. High quality paper is being taken down and there's plenty of foreign buying. Here's the Moody's spread against 10-year treasuries in the last couple of months:

GTs at 1.76%...the technical resistance is at around 1.87% so that's holding. The market does not fear an acceleration of the recovery so rates will stay around 1.65% to 1.85% mark. That's a round trip price change of 3% on duration of 9.0. Expect a lot of trading but not strong directionals.

Equities:
We saw low volumes for the last couple of months but there's been a recent pick up. We have also seen modest multiple expansion, rather than earnings growth so the market has gotten a little more expensive. But the basic drivers of the market are positive:

• earnings coming in around $100 for the S&P;
• net margins stable;
• dividends up a lot, at around $35 from $22 two years ago...so that's up 35% compared to the SPX[3] gain of 20%;
• broad spread of EPS gains, so it's not all concentrated in one area;
• around 60% of reporting companies have beaten estimates.

Earnings:
Not expecting too much this quarter because of a weak Europe and US nominal GNP. There's strength in housing stocks and data. Plus there are more positive tones from Europe. This may well be a turn.

We're at the upper end of the ranges...SPX at 1456...next resistance will be at 1475. The market is still moving on a few big days. Since July, the 120 point gain has been done on about 6 trading days. So this is still a market trading on big, mostly economic news events.

Bottom Line: Continue to like the equity trade. Treasuries have bounced around a 20bp range and every time equities correct, we get a gain in bonds. Foreign buying steps into the bond market on any weakness.

Sources: "This Time is Different, Again..." , Carmen Reinhart and Kenneth Rogoff, Harvard University, October 2012; TrendMacro; Federal Reserve Bank of Philadelphia; Federal Reserve Bank of New York; Federal Reserve Bank of St. Louis; US Treasury Department; Bureau of Labor Statistics; Federal Reserve Board; ISI; High Frequency Economics; Capital Economics; Empirical Research Partners; Goldman Sachs; Singin' in the Rain, Betty Comden and Adolph Green; Bloomberg; Sentinel Asset Management, Inc.

[1] The Barclays Capital U.S. Credit Index is an unmanaged index that measures the U. S. investment grade fixed-rate bond market, with index components for US corporate and specified foreign debentures and secured notes. An investment cannot be made directly in an index.

[2] Moody's Seasoned Baa Corporate Bond Yield, source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis, Economic Research

[3] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Fuzzy Math from the Continent of Peace, 10.15.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Whoops! The IMF made two announcements last week that caught our attention. But to set up the joke in all this, it's worth remembering that for decades the IMF preached austerity economics to any country that needed balance of payments assistance. So its reputation in troubled developing countries in the 1970s through to Argentina in 2002 follows a blueprint: slam on the monetary brakes, force wages down and unemployment up and devalue the exchange rate. It sort of worked although there was never any alternative. So no control group, no proof. The second part of the background is the use of multiplier assumptions. These basically gauge how much of a given stimulus, whether tax cuts or government spending, feed through the economy. Some believe it's greater than 1.0, which means any stimulus increases overall GDP, some that it's zero and some that it's negative, i.e. if public spending rises, the private sector cuts back by a similar amount. And the multiplier worked in both directions, holding for both expansion and austerity programs.

Long set up but this is what happened. First, the IMF drastically reduced its global growth assumptions by 0.3% for 2012 and 2013 of which the eurozone was down by 0.5% and Italy and Spain by nearly 0.7%. This will exacerbate already sad numbers in world trade, emerging markets and reform attempts. Second, the IMF questioned its own assumptions on the multiplier. Going into the eurozone austerity programs of the last few years, they assumed contraction policies would multiply through the economy at a rate of 0.5. Every €1 cut in budgets would slow the economy by €0.5, completing the virtuous circle of reduced indebtedness and growth. But now they estimate multipliers between 0.9 and 1.7. This means that every €1 of austerity cuts output by up to €1.7. Suffice to say that when that happens, economies go into freefall. Which is exactly what has happened in places like Greece where debt was around 120% of GDP in 2010 and is now, acres of column inches later, 170% with its debt service burden growing.

All this matters because economic orthodoxy, whether from the IMF, ECB or EU (the troika), drives decisions in Europe and they are in danger of presiding over a wasteland. The rules have changed at the zero bound yet policymakers push the same remedies. Take last week's launch of the ESM. Missed it? Well it's now a tidy intergovernmental organization domiciled in Luxemburg. Announced in July 2011 and inaugurated on October 8th. It even has its own language with things like "contribution keys, multilateral surveillance, Precautionary Conditioned Credit Lines." Apparently rooted in English.

Anyway, it's going to raise €700bn over the next few years from all EU members and start buying bonds of countries who receive aid approval and sign their MOUs. So that means a country like Spain (a BBB- rating) subscribes €83bn into the fund (with an AAA rating) to receive what might end up being €100bn of assistance to recapitalize its banks (where most bank CDSs trade at 600bps). It's a triumph of bureaucracy but makes little economic sense. Hence, Spain remains very reluctant to cede control over its public finances for very thin assurances that support will be forthcoming. Moody's welcomed the ESM's birth by promptly downgrading its debt.

So growth in Europe looks very challenged. If the IMF multipliers are right this time, then to counter fiscal contraction, the implied underlying growth in places like Spain, Portugal, etc. have to be in the region of 3% to 4%. And if they miss those growth rates, then they miss fiscal targets, too. It's a cycle. Not a good one. All the EU and ECB programs in the world will find it hard to address these basic issues. Even with a Nobel Prize in their back pocket.

US: Slow Chug
We saw some promising signs that the pattern of the last few years, weak summer and better fall, is underway again. We know the effects of the summer drought, slower business investment and global demand down so the trade deficit widening slightly to $44.2bn was no real surprise. We won't see the first estimates of Q3 GDP for another two weeks but the new trade gap may cut growth by around 0.3%. The NFIB numbers dropped a little with the same basic story of plenty of access to credit, slow job creation and worries about sales growth and government regulation. Producer prices rose slightly to 2.1% YOY but a lot of that was down to the 7% increase in gas. There's probably nothing in the numbers to suggest that CPI will track much above the Fed's inflation target of 2%.

There was big drop in claims to 339,000. The last time it was that low was in February 2008. It may not last but the four week moving average is trending down nicely. Markets like jobs. Take a look at the S&P[1] against the four week average of jobless claims.

If the numbers continue to come in well, we should see solid protection on equities. There has been some harrumphing around the validity of recent employment statistics. But the trends are all in the right direction: around 165,000 per month in payroll gains for the last year, expired unemployment benefits, broader use of part-time employment and a declining pool of labor. These may not be the best reasons for gains but they get the all important unemployment rate down. And that's the one that matters.

Finally, the Fed's beige book had plenty of solid news on housing, which was better in eight out of the twelve Fed districts. Overall the tone was better. In the cryptic world of Fedspeak, "economic activity expanded modestly" compared to "gradual" in August and "moderate" in June and July. A couple of Fed governors kept up the pressure on the employment front. The 7% target was most commonly cited. We expect the Fed to stay quiet as the new asset programs work their way through the system. Households are still in debt reduction mode. Here is the absolute level of mortgages against the 30-year mortgage rate.

The current rate is around 3.6% for a conforming mortgage and about 30bps higher for non-conforming. But banks are still unwilling to lend. The average HELOC was around 8% and car loan 6.3%. So banks prefer to lend shorter against a depreciating but certain asset than longer against a still dubiously valued asset. This is one of the problems with QE. Replacing government bonds and MBS with other assets may do lots of things for asset prices and confidence (the U of Michigan survey is at a 5-year high) but they don't stimulate lending and spending.

Bonds:
Two solid auctions on the 10-year notes and 30-year bonds. Rates are back to where they were at the time of the Jackson Hole speech so it seems the bond market has absorbed the inflation and growth risk for now. We have been loading off riskier assets, particularly CMBS, among the most volatile of fixed income assets, and bank IGs. There's less price reaction to the QE effect. Right now we're more defensive. Mortgages have given up some of their sharp gains and there's some nice reentry points on the 30-year MBS.

Equities:
The Fed has long argued that QE would boost risk assets. The SPX reacted but has since fallen back. Earnings started this week. Only 35 of the index stocks have reported with about half disappointing on the sales side and about one third on earnings. Forward guidance and margins are going to be important. Companies have cut so much from operating expenses and are only investing at the depreciation rate. There may not be much more in the market until top line growth kicks in.

Bottom Line:
Unchanged on the equity to bond allocation but lowering the risk profile of our fixed income portfolio. For equities we feel on surer ground. All the talk recently is on four well known themes: Europe, US deficits, politics and taxes. We doubt that will change. Ennui will win over any resolutions. Meanwhile, there's plenty of yield support and value relative to treasuries.

Sources: "Underestimating Fiscal Policy Multipliers," Antonio Fatas, Ilian Mihov, Economist Free Exchange; UBS; Federal Reserve Board; Federal Reserve Bank of St. Louis; FT Alphaville; Bloomberg; US Census Bureau; US Bureau or Economic Analysis; National Federation of Independent Business; Capital Economics; Bureau of Labor Statistics; High Frequency Economics; IMF Fiscal Monitor; International Monetary Fund; J.P. Morgan Market Intelligence; Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Strong Employment But Still Lots of Slack, 10.08.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The ECB's dearth of tools came through loud and clear last week. Rates remained unchanged not because the economies have a ghost of a chance of recovery but because inflation, at 2.7%, scored well above the 2% target. There's a certain amount of in-built inflation in European economies not present in the US, for example, indexing across many industries and pensions, VAT and euro denominated commodity costs. The combination of higher oil costs and a weaker euro put some of the YOY increases in energy costs as high as 40%. Not all fall through to final consumer prices but it does make the inflation target a very difficult animal to pin down.

So with declining economic outlook and inflation unbound (at least by their own standards), Mario Draghi laid out a stout defense of recent programs. Recall that OMT a few weeks ago was to help countries that i) delivered reform programs ii) formally requested help and in return iii) the ECB would buy short-term bonds to relieve funding pressures. Since then the OMT program has bought precisely...nothing. So the obvious questions were when, where and how much? There was clarification in the press conference. Here it is. Apologies in advance but, really, there's not much license in this:

That's a rather opaque set of guidelines in our book. But let's try. Now, given that the ECB runs monetary policy, the start gun would seem to be in the ECB's hands. But it appears not. And if they start a bond buying program they will stop if a reform program is in review. Does that mean they would sell the bonds they bought? And if the transmission mechanisms are broken in Europe, as the Bank regularly states, what would be the point of any rate changes?

This is not to pile on opprobrium. But there's a toxic combination of M3 growth barely above inflation, contracting credit and nearly all economic indicators unambiguously downbeat. Recommendations for unified bank supervision and fiscal compacts are all well and good. But direct action is a still a distant prospect for Europe. There's also probably more to come. So far, Germany has been the driver for change and been able to point to its own deft economic performance, export success, labor reform, low unemployment and growth. All that is set to change. Third quarter GDP may well prove to be negative which will limit Germany's ability to pressure the European bodies and its willingness to back stop ESM and OMT type programs.

Brief Shining Light
The employment numbers surprised. There was a thread in the last few weeks that looks clearer now. The NFIB reported optimistically on employment a few weeks ago, which also showed up in better ADP numbers, and we saw some bounce in the ISM numbers. The ISM series has two components, manufacturing and services. The manufacturing report is older and enjoys a solid record for tracking growth. It gets a lot of attention because manufacturing is such a high value added part of the economy, around 7% of employment and 11% of GDP. Both indexes gained in September. A useful way to think about them is to GDP-weight them at around 89% for services and 11% for manufacturing. This gave us a score of 54.7 in September and 53.2 in August, which led us right into the NFPs for September which showed a 114,000 gain.

There were a number of positive developments. We have discussed for some time government's net drag on the economy for a number of quarters. Here we show the consistent 0.5% negative contribution to GDP growth of only around 1.5%. It's the longest period of negative growth from the government sector in over 40 years.

So you would expect that to show up in the number of government employees and, helpfully, it does with the number dropping consistently since 2009 with only a brief respite in the census hires.

A final part of the puzzle is the participation rate which is shown here inverted in blue against the headline unemployment rate. Usually, and not surprisingly, as participation declines, unemployment climbs and vice versa. What we see now is a secular fall in participation rate (it peaked in 1999) stabilizing at round 64% but now with a declining unemployment rate which on Friday came in at 7.8%. This is the lowest it has been since the dark days of January 2009 when the crisis hit full square across the economy.

And there was more good news especially on the revisions front. The first NFP prints in the last three months came in at 373,000 but have been revised to 437,000. That's on top of the annual revision for the year ended last March which increased the payroll numbers by 386,000. So put all this together and since January 2011, we have seen the number of people employed grow by 3.6m, of which 2.9m were in the private sector. The starting numbers for that period, and remember it's the initial numbers that get the attention, were 2.56m new jobs. So that's over 1m more once the final count is in.

This all must be gratifying for the Fed which placed much greater emphasis on unemployment in its last meeting. The new 7.8% rate is better than its 2012 projections and about in line with the 2013 forecast. Of course, we're not quite out of the woods mainly because personal income is still under extreme pressure, falling 0.3% in real terms and only up 2.7% in the last three years. Here it is on a per capita basis, stuck at around $32,500.

And even that number is inflated because of this, which shows income from interest and dividends, both of which have risen faster than the rate of overall compensation.

Bonds:
Most of last week GT10s stayed around 1.62%. There was little to move it other than ongoing fiscal cliff noise, election outcomes and a set of "just the facts" FOMC minutes. And China was out all week. Then on Friday we saw a pop after the NFPs with rates climbing some 10bps and about a point in price. It probably won't last. This is a data dependant market and so gives us a chance to extend duration. We continue to like the corporate space despite September being a heavy issue month.

Equities:
There's plenty to like in equities despite the straight 15% run since June. We're about to enter earnings season and the data to watch will be top line, Europe warnings and cash usage. The SPX[1] is on track for around $104 in earnings with $31 in dividends. That's one of the lowest payout ratios in years. Expect dividends to grow faster than earnings.

Bottom Line:
Markets are quiet. There seems to be a back stop of sorts what with the ECB programs and Fed easing. We continue to favor the large cap names. Call us skeptics but any beta trade looks short lived.

Sources: Bureau of Economic Analysis; US Department of Commerce; Bureau of Labor Statistics; David Ader, CRT Capital Group; Federal Reserve Board; Institute for Supply Management; European Central Bank; Federal Reserve Bank of St. Louis; High Frequency Economics; Bloomberg; Capital Economics; J.P. Morgan Market Intelligence; Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Typical Post-QE, 10.01.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Two weeks into a new era of ECB and Fed policy and it is a tie between the gains in equities, with the US and European broad indexes up around 2.2%. But it's the lack of follow-through and opacity of the ECB moves which are perhaps the most disconcerting and so, probably, the more short-lived. While both central banks reported easing in the form of securities purchases they had very different origins and aims. Here's a quick summary:

The problem is readily apparent. The ECB is trying to address a market fear of euro convertibility and preserve a unity of monetary policy. It's a bold move by historic standards and moves the markets onto the next phase of problem, such as Greece, political union and growth. But the pattern of ECB and EU solutions remains: lots of fiery talk, hugely complicated programs and delayed actions. It's the same again. This explains why equities and bonds rallied post the September 6th decision then gave up the ghost for most of the last week. The purchase program is not the answer to Europe's problems. The flash PMIs fell again, to their lowest level in three years, and Germany's lead indicators are rolling over as exports fall, tight monetary conditions prevail and austere fiscal policy crushes demand.

But over at the Fed
The Fed is very clear that the labor market must improve and, additionally, that it's prepared to let slip some inflation targets. It was clearly a hard won battle by Bernanke and the doves to bring employment to the fore of the argument. To date, there's been no target for employment and scattered debate on whether the economy was near full employment. But these arguments have changed. In recent weeks, we saw the Evans rule pushed forward. This was the 7%/3% target for unemployment and inflation that was all but heretical a few months ago. Then last week, we saw Narayana Kocherlakota from the Minneapolis Fed, arguing for "extraordinarily low" rates until unemployment falls below 5.5%. This is the same president who, back in May, thought that the then current unemployment rate of 8.2% was close to "maximum employment." He now thinks that structural issues are not at the heart of unemployment (an argument we have put forward here many times) and is all about demand.

Why the change? There's nothing more suspicious here than the Fed coalescing around a more dovish stance and wanting to see decisive results from their actions. The economic stats have shown clear weakening: exports down, ISM Manufacturing lower, inventories up, retail sales slower, industrial production and capacity utilization down and, of course, NFPs lower. There are some brighter spots in services industries and housing but take a look at the latest housing starts:

They have a strong bounce from the lows but remain way off the 50 year averages. Some of this is demographic but some is mortgage accessibility, confidence and low prices. Mortgage rates are still expensive relative to GT10s. Here's a recent history of 30-year mortgage rates less the 10-year bond rate.

We think the Fed would like to drive mortgage rates to around 2.5% and that partly explains why they are targeting MBS purchases. Housing prices are beginning to show some gain and, if the housing wealth effect works, we should see continued improvement over the next few months. It's razor edge stuff, of course, because the macro headwinds and dreaded fiscal cliff could stop any nascent confidence dead in its tracks. But the logic is all in place: i) target unemployment ii) buy MBS to iii) push portfolios into risk assets to iv) get banks to ease up on lending standards to v) encourage house purchases.

Where's all that inflation?
Still not there and unlikely to be unless we get wage push or demand pull. Some of the inflation indicators are still deflationary. Prices of intermediary goods fell YOY in each of the last four months and the headline core inflation looks like this:

Inflation is flat and has consistently undershot Fed goals and forecast. There has been some talk about a revival of inflation expectations partly based on this: the 10-year TIPS break-even rate, which jumped about 30bps after the Fed announcement.

But two points. First, the TIPS market can be notoriously illiquid, accounting for about 7% of Treasury issuance but only 1% of trading and can be even lower in off-the-run securities where daily volume is around $22m. Compare that to average Treasury daily volumes of over $230bn. So some of the price signals from TIPS are a bit weird. Second, 10-year TIPS last week auctioned at negative 0.75%. This is, yet again, at record lows. So the rise in the break-even spread has been all about an increase in nominal yields and not a rush from TIPS. Put all this together and it's very tough to see any rise in inflation expectations. Finally, the concern that the rise in the Fed's balance sheet will surely lead to failed auctions and inflation is misplaced. Here's the change in the Fed's balances over twelve month periods.

Holdings peaked in early January and have been on a declining rate of growth for over a year. The latest purchase programs will not make much difference in overall holdings. Sure the exit strategy is unclear but we're so far from reaching broad economic goals, like employment, more inflation, a closing of the output gap, that this seems a dim risk.

Bonds
Action in the last week has all been in the MBS market. The GT10/MBS spread now trades at 6bp compared to a 90bp average for the last year and 110bp for the last five years. Of course, part of that is because the Fed is buying $40bn of every month's $120bn of issuance which makes them begin to look expensive. So the trade may revert back to treasuries, some of which we have already seen.

Equities
Markets have held steady but volumes are light and moves driven by big events. There's no steady drip of good corporate news. Since late July, when Draghi made his "whatever it takes" speech, to September 21st, the market rose around 123 points. All of those gains were bunched into four days. Strip those out and there's no change in the markets. So while we continue to like the domestic large cap story and attractive earnings yield, it's not quite "jump in with both feet" time.

Bottom Line: Good news on the Fed, easing and rate outlook. Any consolidation looks healthy and we're buyers around the 1450 SPX [1] level. The big headwinds are the macro events.

Sources: Federal Reserve Bank of St. Louis; Federal Reserve Bank of New York,; Federal Reserve; Bloomberg; FT Alphaville; High Frequency Economics; Capital Economics; Tim Duy's Fed Watch; European Central Bank; US Department of Commerce; Bureau of Labor Statistics; US Census Bureau; US Bureau or Economic Analysis; US Dept of Housing & Urban Development; David Ader, CRT Capital Group; Goldman Sachs; Federal Reserve Bank of Minneapolis; Trend Macro; Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Clear Progress, 09.24.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Two weeks into a new era of ECB and Fed policy and it is a tie between the gains in equities, with the US and European broad indexes up around 2.2%. But it's the lack of follow-through and opacity of the ECB moves which are perhaps the most disconcerting and so, probably, the more short-lived. While both central banks reported easing in the form of securities purchases they had very different origins and aims. Here's a quick summary:

The problem is readily apparent. The ECB is trying to address a market fear of euro convertibility and preserve a unity of monetary policy. It's a bold move by historic standards and moves the markets onto the next phase of problem, such as Greece, political union and growth. But the pattern of ECB and EU solutions remains: lots of fiery talk, hugely complicated programs and delayed actions. It's the same again. This explains why equities and bonds rallied post the September 6th decision then gave up the ghost for most of the last week. The purchase program is not the answer to Europe's problems. The flash PMIs fell again, to their lowest level in three years, and Germany's lead indicators are rolling over as exports fall, tight monetary conditions prevail and austere fiscal policy crushes demand.

But over at the Fed
The Fed is very clear that the labor market must improve and, additionally, that it's prepared to let slip some inflation targets. It was clearly a hard won battle by Bernanke and the doves to bring employment to the fore of the argument. To date, there's been no target for employment and scattered debate on whether the economy was near full employment. But these arguments have changed. In recent weeks, we saw the Evans rule pushed forward. This was the 7%/3% target for unemployment and inflation that was all but heretical a few months ago. Then last week, we saw Narayana Kocherlakota from the Minneapolis Fed, arguing for "extraordinarily low" rates until unemployment falls below 5.5%. This is the same president who, back in May, thought that the then current unemployment rate of 8.2% was close to "maximum employment." He now thinks that structural issues are not at the heart of unemployment (an argument we have put forward here many times) and is all about demand.

Why the change? There's nothing more suspicious here than the Fed coalescing around a more dovish stance and wanting to see decisive results from their actions. The economic stats have shown clear weakening: exports down, ISM Manufacturing lower, inventories up, retail sales slower, industrial production and capacity utilization down and, of course, NFPs lower. There are some brighter spots in services industries and housing but take a look at the latest housing starts:

They have a strong bounce from the lows but remain way off the 50 year averages. Some of this is demographic but some is mortgage accessibility, confidence and low prices. Mortgage rates are still expensive relative to GT10s. Here's a recent history of 30-year mortgage rates less the 10-year bond rate.

We think the Fed would like to drive mortgage rates to around 2.5% and that partly explains why they are targeting MBS purchases. Housing prices are beginning to show some gain and, if the housing wealth effect works, we should see continued improvement over the next few months. It's razor edge stuff, of course, because the macro headwinds and dreaded fiscal cliff could stop any nascent confidence dead in its tracks. But the logic is all in place: i) target unemployment ii) buy MBS to iii) push portfolios into risk assets to iv) get banks to ease up on lending standards to v) encourage house purchases.

Where's all that inflation?
Still not there and unlikely to be unless we get wage push or demand pull. Some of the inflation indicators are still deflationary. Prices of intermediary goods fell YOY in each of the last four months and the headline core inflation looks like this:

Inflation is flat and has consistently undershot Fed goals and forecast. There has been some talk about a revival of inflation expectations partly based on this: the 10-year TIPS break-even rate, which jumped about 30bps after the Fed announcement.

But two points. First, the TIPS market can be notoriously illiquid, accounting for about 7% of Treasury issuance but only 1% of trading and can be even lower in off-the-run securities where daily volume is around $22m. Compare that to average Treasury daily volumes of over $230bn. So some of the price signals from TIPS are a bit weird. Second, 10-year TIPS last week auctioned at negative 0.75%. This is, yet again, at record lows. So the rise in the break-even spread has been all about an increase in nominal yields and not a rush from TIPS. Put all this together and it's very tough to see any rise in inflation expectations. Finally, the concern that the rise in the Fed's balance sheet will surely lead to failed auctions and inflation is misplaced. Here's the change in the Fed's balances over twelve month periods.

Holdings peaked in early January and have been on a declining rate of growth for over a year. The latest purchase programs will not make much difference in overall holdings. Sure the exit strategy is unclear but we're so far from reaching broad economic goals, like employment, more inflation, a closing of the output gap, that this seems a dim risk.

Bonds
Action in the last week has all been in the MBS market. The GT10/MBS spread now trades at 6bp compared to a 90bp average for the last year and 110bp for the last five years. Of course, part of that is because the Fed is buying $40bn of every month's $120bn of issuance which makes them begin to look expensive. So the trade may revert back to treasuries, some of which we have already seen.

Equities
Markets have held steady but volumes are light and moves driven by big events. There's no steady drip of good corporate news. Since late July, when Draghi made his "whatever it takes" speech, to September 21st, the market rose around 123 points. All of those gains were bunched into four days. Strip those out and there's no change in the markets. So while we continue to like the domestic large cap story and attractive earnings yield, it's not quite "jump in with both feet" time.

Bottom Line: Good news on the Fed, easing and rate outlook. Any consolidation looks healthy and we're buyers around the 1450 SPX [1] level. The big headwinds are the macro events.

Sources: Federal Reserve Bank of St. Louis; Federal Reserve Bank of New York,; Federal Reserve; Bloomberg; FT Alphaville; High Frequency Economics; Capital Economics; Tim Duy's Fed Watch; European Central Bank; US Department of Commerce; Bureau of Labor Statistics; US Census Bureau; US Bureau or Economic Analysis; US Dept of Housing & Urban Development; David Ader, CRT Capital Group; Goldman Sachs; Federal Reserve Bank of Minneapolis; Trend Macro; Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Main Street Policy...Seriously?, 09.17.2012

Jason Doiron
FRM, PRM, Head of Fixed Income
Sentinel Asset Management, Inc.

In case you did not catch the press conference last week, Ben Bernanke believes that his latest round of quantitative easing will benefit Main Street. Seriously? The notion that Main Street will benefit from the Fed purchasing an additional $40 billion per month of agency-backed MBS is preposterous to us.

Why? Because for the past four years, investors have accepted the fact that central bank headlines and liquidity have a greater impact on asset prices than underlying fundamentals. To use central banker parlance, the fundamental valuation transmission mechanism has experienced a transitory interruption. The market has accepted this interruption and successful investors have found a way to ascertain the relevant facts and base their investment decisions on these. For successful investors, relevant facts drive the investment decision-making process. The same cannot be said for central bankers.

At Sentinel, our natural curiosity as investors leads us to ignore the Fed's story and focus on the facts. Bernanke provided the economic rationale for how the transmission mechanism works but the facts do not validate the story. Looking at the last three rounds of quantitative easing (QE2, Twist 1, and Twist 2) we see that 30-year mortgage rates were actually higher 60 days after the announcement by an average of 24.3bps.

The magnitude of the move may not be material but the fact that mortgage rates moved in the unintended direction makes us believe there is an error with either the rationale or the transition mechanism. Given this lack of factual support to the Fed's story, we thought it would be interesting to explore some of the additional intended and unintended consequences of the latest round of quantitative easing.

As bond investors, we find the unintended consequences of the Fed's actions on the MBS market most troubling. The Fed is already the dominant player in the agency-backed MBS market with $844 billion in holdings. They currently consume $25 - $30 billion of MBS per month through reinvesting the principal payments from current holdings. Starting immediately, the Fed will consume an additional $40 billion of MBS per month (open-ended) bringing the total amount to $65 - $70 billion per month.

To put this amount in context, the agency-backed MBS market issues roughly $135 billion of debt per month. Of this amount, our desk estimates that $35 - $40 billion is retained by MBS servicers / originators and therefore not available to investors. That leaves roughly $95 billion per month for investors. The Fed intends to purchase $70 billion per month or almost 75% of that available supply.

There are always and everywhere unintended consequences when a government entity consumes 75% of the supply of a functioning asset class. Agency-backed MBS play a critical role in fixed income portfolio construction. As an asset class, MBS provides us with an income producing, low volatility building block. We consider agency-backed MBS the dominant volatility anchor in a complex fixed income portfolio. It is the asset class that allows fixed income investors to take additional, perhaps uncorrelated risks in other markets such as high yield and CMBS. The Fed's actions have the potential to force investors into less effective alternatives to source this low volatility building block.

The Fed would really prefer to just buy treasuries but at this point, the Fed cannot expand its balance sheet with outright treasury purchases. Why? Because it is reaching the saturation point where additional purchases would simply monetize the debt. By purchasing 75% of the available supply of agency-backed MBS, the Fed is forcing traditional buyers of that asset class into substitutes. Given the size, liquidity, credit risk profile, and negligible capital charge for agency-backed MBS, there is only one substitute...US treasuries! With an open-ended commitment to purchase agency-backed MBS, the Fed will force other investors to do its dirty work for it and buy treasuries.

Bottom Line: Throughout the earlier rounds of quantitative easing, we have been very active in explaining to our clients why they should not be concerned about inflation. Given this latest round of open-ended quantitative easing, we no longer have a sanguine view on inflationary pressures in the US. To us, there is clearly an issue with the transmission mechanism that the Fed is too quick to dismiss. The Fed has been so concerned with the accelerator that it has not tapped the brakes to see if they still work. More discussion to follow on this topic.

Sources: Securities Industry and Financial Markets Association, Sentinel Asset Management, Inc.

Thought of the Week: Back to School: Summer Vacation Ends for Central Bankers, 09.10.2012

Andrew Boczek
Vice President, Portfolio Manager of the International Equity Fund
Sentinel Asset Management, Inc.

The heady days of "Maestro" Alan Greenspan may be long gone. Nonetheless, most of us still take for granted that similarly wise men and women, aloof from the pressures of politics and short term market fluctuations, have the capacity to set the proper price of our most precious commodity: time. Or said another way, to set an effective interest rate policy that encourages either savings or spending, today or in the future, to help manage long term economic stability. And there remains a persistent view among investors and market commentators that central banks have the power to rescue markets, if only they have the will to do so. Given the global rally in stocks last week in the wake of the European Central Bank's (ECB) addition of Outright Monetary Transactions (OMT) to the alphabet soup of "extraordinary" policies, and in anticipation of a third round of "Quantitative Easing", already nicknamed QE3, by the US Federal Reserve, the markets certainly seem to think so. But is such hope warranted?

In order to answer this question it's helpful to understand the origins of central banking and what central banks actually do. If we think back to the era of the pure gold standard, before modern central banks existed, we picture a world where growth in the monetary base was limited by man's ability to dig more of the yellow metal out of the ground. Money sloshed around the world, chasing opportunities and leading to bubbles and busts as banks here or there expanded the broader money supply by extending credit and taking deposits, but the total supply of gold in the world didn't change much from year to year. On one hand, in the absence of central banks, such business cycles were necessarily self correcting, and so tended not to last long. On the other hand, the strains that the resulting volatility placed on financial systems and economies shouldn't be underestimated. When asset prices corrected, commercial banks could be wiped out, often taking down not just greedy bankers but innocent depositors as well.

Not surprisingly, commercial bankers weren't particularly fond of this state of affairs and neither were democratically elected politicians. Through the creation of a lender of last resort, governments would allow for an elastic money supply, helping prevent liquidity crises from turning into serious economic downturns and, not coincidentally, providing job security for commercial bankers. A central bank run by wise men sounded like just the antidote to recurring periods of economic depression. The United States Federal Reserve was part of a wave of central banks that were created around the world in the early 20th century.

So how do central banks perform their magic? In theory, by buying approved financial assets from or selling and lending them to the banking system, central banks are able to set the level of reserves on bank deposits that constitute the most important part of the monetary base in a modern economy. In practice, the authorities usually establish a level of interest rates that corresponds to a desired level of reserves; but the result is the same. These reserves are the raw material for credit creation by the commercial banking system, which drives broader money supply growth and ultimately inflation. ( "Quantitative Easing" (QE) is simply an effort to further increase reserves once interest rates have reached the lower bound of zero by using unconventional asset purchases such as longer dated government bonds or mortgage-backed securities.)

It should be stressed, however, that though it can increase bank reserves at the stroke of a pen the central bank can not make the banking system lend and therefore has limited control over the broad money supply. That is because commercial banks have two other important binding constraints on lending: their level of available capital and the existence of creditworthy borrowers with good collateral. And these constraints are precisely why the huge growth in bank reserves in the US over the past five years has not led to any significant growth in bank lending.

The fact remains, however, that the monopoly power over base money creation clearly creates the potential for mischief and bumps up squarely against the fiscal role of government. Lessons have been learned from poorly constituted central banks which crossed this line between monetary and fiscal policy---many of us have read about the experiences of Weimar Germany in the 1920s, Latin America in the 1980s and Zimbabwe in the last decade. Consequently, central banks are usually constrained by law as well as political considerations. For example, a central bank might be limited in the type of financial assets it can own or in its ability to buy debt directly from the government---importantly, modern central banks are meant to be politically independent.

Essentially, the modern central bank can only impact the economy in two ways. The first and most obvious way is by shifting an economy's purchasing power across time. In the absence of a central bank, interest rates would reflect the supply and demand for savings in an economy and thus balance society's aggregate preference between consuming now or spending later. Higher interest rates are an incentive to save more today and thus delay spending for that rainy day in the future; whereas lower interest rates are an incentive to spend/invest more today, and worry about saving later. The intersection of these savings and investment functions determines the natural interest rate. Thus, if the central bank sets rates too low, then the economy will behave as if it has more resources available than it does, leading to a bubble in consumption and/or investment---purchasing power shifts from the future to the present. Normally, a side effect of this rise in demand relative to resources would be increased inflation.

The other way in which central banks influence economic behavior is by shifting purchasing power between creditors and debtors. By setting rates below the market rate, central banks are, in effect, forcing lenders to subsidize borrowers and creating a transfer of real resources from creditors to debtors. Keep in mind, however, that any intervention favoring particular classes of creditors or debtors is considered an encroachment on fiscal policy. Central banks (in democracies) can't force commercial banks to make loans to favored sectors, for example, or make loans directly to borrowers, including the government. But in times of financial stress there can be a fine line between fulfilling its responsibility of maintaining confidence in the financial system and acting as a fiscal branch of government.

All of which brings us to our current circumstances. Although the world's major central banks continue to hold rates close to zero, an acceleration in growth remains elusive for key economies, including the US, Japan, and of course, Europe. Thus, we have seen speculation increase that the Fed will soon implement another round of QE, or QE3. And last week, amid much fanfare and to the delight of markets everywhere, the ECB announced a policy of potentially unlimited purchases of peripheral government debt, the so-called OMT. So hope springs eternal that, once again, the monetary authorities will ride to the rescue of struggling financial markets.

Given the above framework, however, it is clear that there are both institutional as well as practical limits to what central banks can do, regardless of what US Fed Chairman Ben Bernanke or ECB President Mario Draghi say. Note that the level of reserves in the US banking system is, in no way, a constraint on bank lending today, so any further QE is unlikely to change the behavior of banks or borrowers in the near term. With interest rates already close to zero, we have already maxed out on borrowing purchasing power from the future. Furthermore, on closer inspection, the ECB's new OMT policy may be less than it appears to be. For example, the program imposes significant conditionality on the governments of participating countries, limiting its expansionary effect; and in any case, the intervention is meant to be fully sterilized, meaning that the central bank intends to sell other bonds in proportion to its purchases of peripheral country debt, thus keeping reserve levels constant. As discussed above, such a policy treads dangerously close to choosing winners and losers, which is ultimately the role of fiscal policy. In the long run, this has the potential to undermine confidence in the ECB's independence, putting at risk its ability to fulfill its real mandate of protecting the purchasing power of the euro.

Bottom Line: Key economies remain locked in a battle between the deflationary force of excessive debt levels and the inflationary policy response of extraordinary monetary easing. Ultimately, time remains the most precious commodity. Absent further unorthodox monetary policies that encroach upon the fiscal role of governments, we need time to increase savings to fund debt payments, and we need time for moderate inflation to gradually erode the value of the debt that weighs down much of the developed world and prevents a stronger economic recovery. Patience is required.

Thought of the Week: Curious Repetition, 08.27.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Dog Days of Europe
There wasn't much news coming out of Europe. These caught our eye:

Meanwhile, none of that has stopped the Bundesbank from sniping about any form of bond buying and underlying economic trends continue to deteriorate. Eurozone GDP fell 0.4% in the second quarter and the all important German numbers like PMI and sentiment have fallen off a cliff. So why has the euro remained well bid? Here's the answer:

The eurozone showed a €12.7bn current accounts surplus in June, its twelfth successive month of improvement. It now stands at a surplus of around 0.5% of GDP compared to a deficit of 0.2% a year ago. Normally a current account surplus is a good thing: a healthy balance of trade and more earnings from overseas assets and credits on transfer payments. But the eurozone surplus is driven more by a big decline in imports and portfolio investments. So while the net result is to create more demand for euros, it is more a symptom of weakness and decreasing confidence. Over at the Swiss National Bank, we saw the consequences of euro intervention. Foreign exchange reserves grew 50% in 2Q to over 65% of GDP and the € component expanded 77% to about 60% of total reserves. A record.

All the above means that, yes, Europe's economy is weakening but the euro currency has remained strong. And while that may represent the whole zone reasonably well, it certainly does not reflect the weaker peripheral economies that have to reconfigure their workforces and government programs under a chronically overvalued exchange rate.

Cliffs of Insanity
The CBO's report last week outlined i) how much progress has been made in reducing the deficit, down over a point as a percent of GDP to 7.3% in 2012 and ii) the cost of the run off in the programs scheduled for January 1st. As a reminder, these include tax rate increases, elimination of a number of deductions, a 27% drop in Medicare physician payments, automatic and enforced discretionary budget cuts and reduced unemployment benefits. These will all increase revenues by 20% and leave outlays pretty much unchanged. Think of it as fiscal discipline/idiocy, depending on your view, all at once. The immediate effect would be to improve the deficit/GDP ratio to 4.0% and lead to a decline in GDP of 0.5% which in turn increases unemployment to 9.1%.

This would crush the economy of course and, because the stakes are so high, we're likely to see more brinkmanship over the next few months. That's why 40% of companies are delaying investments. If there's any probability of a recession of that size, then no company wants to be caught expanding, especially if they have government contracts. The federal government terminated 13,579 contracts this year, more than double the level of five years ago. This is going to be the biggest ongoing scare to markets for the remainder of the year.

FOMC
The minutes from the late July meeting were released. The tone was concerned with the key phrase being the Committee's willingness to "provide additional monetary accommodation." These include the usual suspects of an extended date range for low rates, asset purchases of both treasuries and MBS, reducing interest on reserves and a look at the Bank of England's new Funding for Lending program. They also booted around the idea of managing policies tied to specific outcomes (at least that's the way we read it) which would mean the Fed would do something (say, buy assets) until something happened (growth). Which would be a very sensible departure. Since the meeting, economic data has improved. Here are the NFPs:

These show some marked seasonality in the last two years with a spring/summer slow down and an increase in the back end of the year. It's a bit start-stop but if there's any pick up in the NFPs, then the Fed will hold off. We also had two Fed presidents give two interpretations of the minutes last week. Bullard of the St. Louis Fed said that the slow pace did not justify more action. Evan, over at Chicago, said that employment was not nearly good enough and that the Fed's action in the fall of 2010 and last year, fully justified more action. On balance it's not likely we will see a big move, if only for this reason:

This shows the S&P[1] divided by the VIX[2] and it's at very high levels, meaning that the market is showing strong signs of confidence. This time last year and two years ago, the ratio was well below 50 and the S&P was 14% and 17% below its highs for the year. This time we're close to the year's high and 10% up on the year. For a Fed that believes in the wealth effect, it probably means less action.

Mind you, that does not mean rates are at the right levels. Yes, nominal rates remain low with GT10s at 1.68% and have returned 44% in the last five years but real rates are high. Here is the nominal yield less the 10-year TIPS yield.

And that explains why there's been no rush to invest, expand and consume. The real rate of borrowing is higher now than it has been for the average of the last 10 years.

Equities
There's little fear in the market and recent moves seem to be explained by the initial jobless claims number (four-week moving average inverted).

As long as the claim numbers come in at around 350,000 to 370,000 the market seems to be well underpinned. We continue to believe in the cash flow story. Not yield. Cash flows. It keeps track of spending cycles and some of the pay off comes in the economically sensitive stocks like industrials, materials and energy.

Bottom Line: Bonds staged a brisk recovery last week retracing some 20bps in yield. Much of this is technical and we don't see much volume. The 10-year TIPS auction went well: a selling yield of negative 1.28%, a 3:1 cover and the second highest direct bid on record. Most of the attention will be on the Jackson Hole speech and any hints of easing. We doubt much will come of it. So we're in for more drift.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.
[2] Chicago Board Options Exchange Market Volatility Index is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

Sources: Zentrum für Europäische Wirtschaftforschung, Capital Economics, FT Alphaville, CLSA, Swiss National Bank, Bloomberg, Tim Duy's Fed Watch, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Chicago, Federal Reserve Board, Congressional Budget Office, European Central Bank, Empirical Research Partners, Chicago Board Options Exchange, Sentinel Asset Management, Inc.

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Thought of the Week: Anniversary Weaks, 08.20.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

A couple of anniversaries last week: five years since the start of the credit crunch and one year since the US downgrade. The ramifications of both are still evident daily, of course. We all probably underestimated that day in August 2007 when BNP suspended liquidity on a money market fund in France without telling the Finance Minister. They reopened with a Gallic shrug a week or two later, but we had seen the first bite from the layered collateralized assets that were embedded throughout the financial system. The downgrade came amidst toxic debt-ceiling negotiations and so took on heightened alarm. There's no conclusion from either event. We're still living the consequences. So this is as good a time as any to take stock.

Europe, dear Europe
Almost everything in Europe over the last months has been a band-aid. Here are a few: i) the Spanish bond buying program from last year petered out leaving rates unchanged but with numerous interim scares ii) the LTRO rally lasted only a few months before petering out iii) the Spanish bond recapitalization agreed in June has yet to happen and iv) financing the ESM remains in legal limbo. The miserable profession of forecasting has been found wanting, too. Last December, the IMF report on Greece said growth would be -3% in 2012 and unemployment 19%. The latest numbers are -7% and 22%.

One European member to watch is Finland.
Not just because i) their bonds yield one of the lowest in the eurozone ii) have returned 7% YTD against Bunds of +5% and iii) seen their CDS tighten to become the cheapest in the eurozone. No, it's their history. This is a country with few historical or linguistic links to either the Nordics or Europe. The language is similar to Hungarian which is similar to nothing else. And the country fought off the Soviets twice in the war and the Germans once. When the Russians invaded in 1939, Finns joked "They are so many and our country is so small, where shall we find room to bury them all." They proceeded to out kill the Soviets 5 to 1.

And from there the Finnish term sisu became famous. It's best described as doggedness or stubbornness. In the euro crisis, they're the ones who demanded collateral for any bailouts and last week stated, very clearly, that the ESM must have IMF loan status. That means seniority over other creditors, a principle which the ECB is loathe to apply because it would scare off new investors from any Spanish or Italian debt deal. The foreign minister, Erkki Tuomioja, then said that it was all a "total catastrophe" and as far as the ECB, EU and Troika powers were concerned, well, that "I don't trust these people."

Now Finland is unlikely to provoke a unilateral exit. But they can simply refuse to go along with more aid and prepare for a break up. They're the only super solvent euro country with no ties and no illusion about going it alone if they must. These are the all important stats to have if you want to throw your weight around in Europe:

Public sector debt is well below the Maastricht limit of 60% of GDP and is barely moving as Europe i) heads towards a 0.2% decline in GDP and ii) increased their collective debt from 66% of GDP to 87% in three years. That's simply not sisu. If there's one lesson we have learned from 30 years of investing, it's that trouble comes from the flanks. Things like AEG (sic), Orange County, LTCM, peso devaluation in December 1994, came out of nowhere. Worth watching.

Meanwhile the rallies in Spanish and Italian stocks since the Draghi "whatever it takes" speech in late July are unlikely to stick. They're back to April levels and some 65% below 2007. We're in a torrid period of expecting a fiscal/monetary solution but with no follow through. Pity Spanish Prime Minister Rajoy who was asking for more details on how the bailouts will work and what conditions might apply. If he doesn't know...who does?

Are we too austere with the Fiscals?
Combing through the Monthly Budget report showed some surprises. Depending on your point of view, government either spends way too much, is out of control and the debt burden is just killing free enterprise or is cutting programs with abandon and hurting the economy. Ok, so not a lot of people believe the second but way too many believe the first. So here are some fun facts. But first remember that the "Big 5" programs of Defense, Social Security, Medicare, Medicaid and interest account for 75% of spending. The other 27 agencies scramble for the rest.

Each one of the big five has decreased spending this year by between 3% and 5% in nominal terms. And interest payments are down 13% to $196bn, one of the lowest as a proportion of GDP since the early 1960s. Now that's not the number that is talked about. The scary numbers are the $440bn on the $16tr of gross debt. But $4.6tr of the debt is held by the federal government to fund retirement programs, the biggest of which, of course, is Social Security. The interest received on these assets from the Treasury goes right back to the Treasury, hence the net interest paid is far less than the gross (scary headline) interest paid. The net debt is thus more like $10.8tr. Social Security, meanwhile, pays out $680bn on hypothecated receipts of $710bn. So with its funded assets of $2.6tr and unchanged revenues from payroll taxes it would run out of money around 2038. Note the word unchanged. FICA tends to be indexed.

The reason why we have a deficit is because private sector demand plummeted following the collapse of the housing market. And that's why we advocate more spending to make up some of the demand shortfall and why we talk about the fiscal drag. And here are the all important numbers from Treasury:

Item	2011	2012	So...
Receipts	$1,893bn	2,008bn	More revenue
Outlays	($2,992bn)	($2,982bn)	And less expenditure
Deficit	($1,099bn)	($973bn)	Produce a lower deficit
GDP	$15,003bn	$15,595bn	On a growing economy
Deficit/GDP	8.6%	7.4%	Meaning lower debt ratios

And can we fund the deficit? Well, yes we can. Quite easily it turns out. Foreigners bought around $493bn of securities in the last 12 months so that's more than enough to finance the current account and keep the dollar well supported. So that's why we feel the deficit, spending and rates debate boils down to slow, aggregate demand and why it's going to be a long, slow haul with no inflationary pressure.

Other Stats
Inflation came in at 1.4%. Even the core inflation fell to 2.1%. Here it is:

And inflationary indicators like spending and excess credit remain very sullen. Here's the revolving credit numbers which would have to start moving if there is to be any major consumer uptick.

But they probably won't because employee earnings are still under pressure. Here they are and these are the nominal rates of increase:

To put that in context, that amounts to an annual raise of about $42 for the average private sector wage earner. That's why we're sanguine on inflation and, so it seems, are more Fed members. Last week, one of the hawks, President Narayana Kocherlakota of the Minneapolis Fed, hinted that the FOMC may allow inflation to rise above its 2% target (hint, which they're missing) to tackle "elevated" unemployment (hinty, hint, which they're also missing).

Bonds
The Fed remains active in MBS which is why that's unlikely to be a target for any QE3. Part of that is technical as the Fed's MBS portfolio is seeing high levels of prepayments so to keep the book somewhat constant, they have taken up to 60% of originations and buying $6.5bn of MBS per week, up from $3.5bn last October. We have seen a rapid back-up in rates over the last three weeks from 1.39% to 1.81%. And it has come with a bearish yield steepening (the GT2/GT10 spread) from 115bps to 152bps.

Demand for credit from mutual funds remains. We saw IG funds inflows of $1.4bn, HY $378mm (slowed from $809mm the previous week) and municipal funds inflows of $964mm. At this point we'd probably like to see some give back to the 1.70% level. Not a big move.

Equities
Mostly repositioning as we see a slow move up to within a whisper of the March highs and 7% below the all time highs. The market is more expensive than those in Europe but that's easily explained by i) the better growth potential in the US and ii) the downright awful position of European financials.

Bottom Line: Still in profit-taking mode for equities. Spreads, equities and CDS spreads have remained mostly unchanged on the week. The relative returns of equities have stood up well but that's not the most compelling of arguments. Remain cautious.

Sources: Cepr.net; Daily Telegraph; All Hell Let Loose, Max Hastings; Suomenpankki (Bank of Finland); Bloomberg; High Frequency Economics; Capital Economics; US Treasury Department; Federal Reserve Bank of Minneapolis; Federal Reserve Bank of St. Louis; Bureau of Labor Statistics; Bureau of Economic Analysis; Sentinel Asset Management, Inc.

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Thought of the Week: Careful with that beehive, Eugene, 08.13.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

When you move a beehive, you must move it more than three miles or not less than three feet. Anything else confuses the bees. Markets can be the same. And that's why President Draghi's comments reverberate still after two weeks. No one seems to understand what he meant. It seems open market operations are within the ECB's mandate and do not violate the principle of monetary financing if there is high convertibility risk. That last part means redenomination risk, especially of the troubled peripherals, and is termed the risk premia. But the only way to reduce the premia would be direct purchases to lower Spain and Italy's cost of borrowing. The market hopes the ECB will follow through which is why European equities rallied some 10% these last two weeks.

That seems decidedly thin gruel. There are 23 members of the ECB Governing Council, six executives and 17 representatives from the national central banks. Germany, which is liable for around 30% of the ECB's risks, has the same voting power as the Governor of the Bank of Malta. Germany remains implacable to any program which might cause inflation and is convinced that any bond buying does exactly that. This week Bundesbank President Jens Weidmann said "Financial assistance must remain a last resort" which, even after applying the well-known Teutonic smiles and sunshine (HT Mr. Burns), sounds pretty definite. So investors expecting follow through from the ECB are likely to be disappointed. It's more likely that the new found risk appetite will wane quickly.

Things are grim in the real economy, too. The Bundesbank released its bank lending survey which showed a collapse in lending to medium sized businesses, a significant increase in risk perceptions and a drop on collateral quality. Industrial production in Germany, which is the last EU country standing for export and manufacturing competitiveness, fell and business surveys like the PMI point to steeper contraction in coming months. Germany is about to be sorely tested as to whether it can grow while the rest of Europe declines. Italy, Spain and Belgium have already reported growth down by around 0.7% in the second quarter along with worsening employment trends.

Many of the eurozone markets look cheap but that's because of the heavy financial weighting. In Spain and Italy financials are 40% and 25% of total stock market capitalization. For the eurozone as a whole it's 18%. Most of those financials are on forward P/Es of 5, yields of 5% and price to book of 0.5. But we're highly skeptical on the tangible book values. European banks have never taken realistic write downs. This all makes the markets very unappealing. So, if you want to move the bees, please orient them to a new and better place. Otherwise you face a mighty impasse and confusion.

Fiscal Action
In recent testimony, Bernanke urged policymakers to put the fiscal house in order and manage policy uncertainty. Wise advice. But as a recent paper from Vox by Jeffrey Frankel pointed out, policy history has nearly always been one of pro-cyclicality: fiscal indiscipline in good times and deficit hawking in weak times. In 1981, the inaugural address was about immediate action on the deficit when the economy had been in freefall for six months. Result? Another eighteen months of weakness. The same pattern happened right through to February 2009 when there was a block on the recovery programs. So are the pro-cyclical policies any better with stock market cycles than economic cycles? If so, then the dysfunction may have predictive use. Here are seven separate programs that either cut taxes (green dots) at the economic cycle top or cut spending (red dots) at the cycle bottom, superimposed on the S&P.

Result? Well, in four cases the market rose over 18% in the subsequent twelve months, (numbers 2, 3, 6, and 7), in two cases the market fell over 18% (1, 5) and in one case nothing (number 4). But in the cases when there was support for large tax cuts (numbers 2, 5 and 6) then the swings were acute. So the more we hear wrangling about taxes the more we're likely to see very nervous market moves. And that's what we're seeing now and that's why there can be no clear course for the market while we're in pro-cyclical policies (i.e. government fiscal drag) and debating taxes.

And where else do those government policies show up?
Why in the labor statistics, of course. In the last two years, private employment rose 2.4m but state and local government (federal government employment stays pretty stable except for the Post Office) lost 836,000. And one profession was badly hit. Teachers. There are around 320,000 fewer teachers than there were three years ago and the percentage of teachers in the workforce is at almost record lows.

As we have argued before. Yes, the economy is on a slow growth path, barely able to eke out 4% nominal growth and with trimmed PCE inflation not even breaking 2%. But this is made worse when government has reduced growth by around 0.5% in nine out of the last ten quarters. Recent data showed there is little chance of a Q3 rebound so we await the next steps from the Fed.

And some of those stats
The June trade figures, which are a plug in the advance estimate of Q2 GDP that came out in late July, were better than expected. The estimate was a deficit of $597bn or a 0.3% drag on growth. The new numbers came in at $566bn which would cut that to about 0.1%, all things being equal. Which they're not because there was a big drop in oil imports due to the stronger dollar (it rose 3.8% in the quarter) and a drop in capital goods imports. So that more reflects the recession in the eurozone and points to a dampening of growth. One of those "good numbers for the wrong reasons" things.

The growth in personal revolving credit came to a halt. Of course, it has never recovered from the pre-recession peak and may not reach those numbers again given the proclivity for household debt draw down. Here's what it looks like:

And a good part of the total consumer credit is because of student loans which are 18% of all outstanding credit compared to 3.6% in 2007. On a brighter note, the Senior Loan Officers' Survey showed that loan standards on autos, C&I for both small and medium sized companies had eased over the last three months and nearly half of all banks reported an increase in the demand for mortgages. This is good news because at the same time banks are requiring high FICO scores and seeing less price competition from foreign-owned banks. That's because most of the foreign-owned banks in the C&I business are the European banks rapidly contracting their loan books. The upshot should be that the Fed tries to help emerging loan demand in the form of some sort of reserve management.

We still need more monetary action because the ratio of GDP to money, i.e. velocity, remains very low. Here it is, reflecting the zero opportunity cost of holding money.

Or as Samuelson put it, "You can force money on the system...but you can't make the money circulate against new goods and new jobs." For now, money is quite content to sit in demand deposits yielding 4bps or 3-month CDs yielding 9bps. There's no appetite to start spending. So again, the Fed will probably look at further asset purchases in September to try and loosen some of the cash preferences.

Bonds
We have had a very rapid back-up in rates, over 30bps in three weeks and a loss of 2% on GT10 and 6% with the GT30. We saw an 8 point swing on the long bond. The 30-year auction went well but these tend to be dealer led concerns and the street took 55% of the issue compared to 43% a month ago. This points to a nervous market neither convinced that economic growth is on the mend or that there will be Fed action. We don't dwell too much on the Fibonaccis unless there's little fundamental action. And there isn't. The trading range looks around 155bp to 175bp. Meanwhile credit spreads are coming under pressure. Corporate treasurers continue to flood the market with new issues but the aggressive pricing of many deals is beginning to hamper secondary performance. It feels like the market could use a breather.

Equities
There's some fatigue in the market. It has come through a near 10% gain since June and this is August. We get lots of "Out of the Office" pings. We're easing out of some big performers especially in the more challenged mid-cap space.

Bottom Line:
Some profit-taking and easing back of the risk trade. Spreads, equity runs and CDS spreads have all done well. There does not appear to be a lot of room to advance in the short term.

Sources: Federal Reserve Bank of St. Louis; Federal Reserve Board; VOX, "The Procyclicalists: Fiscal austerity vs. stimulus" by Jeffrey Frankel; US Census Bureau; US Bureau of Economic Analysis; Federal Reserve Bank of Dallas; Deutsche Bundesbank; European Central Bank; High Frequency Economics; Capital Economics; Bloomberg; Der Spiegel; Bank of America Merrill Lynch; Economics: An Introductory Analysis, Paul A. Samuelson; Sentinel Asset Management, Inc.

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Thought of the Week: All That and Nothing To See, 08.06.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The ECB learned a tough media lesson last week. If you say, as Mr. Draghi did in a pre-Olympic euphoria, that you will do "whatever it takes to preserve the euro" then markets will take you at your word. But if it's followed a week later with "well, we may start bond buying of an adequate size but we're not sure and anyway, further fiscal consolidation is needed and we haven't checked with the Bundesbank yet, but we stand ready to activate whatever's necessary" (ok, some license) then you are going to sorely test the market's patience.

Markets like detail and conviction and if you talk big, then be ready to follow through. If you don't, then the consequences are a 5% drop in stocks for Spain and Italy, a reversal of the recent bond rally in both countries, a big drop in the euro and a flight back to the temporary safety of Bunds. The problem remains that it has rarely been a question of what the ECB should do (i.e. recapitalize banks and buy down debt securities) but how to finance it. We await the activation of the EFSF bond buying. And as that requires every member state to sign off and ratification by a skeptical German government, that could take some time. Meanwhile, deterioration in European economic sentiment continues with the consumer, service and manufacturing sectors all down in the last week. Unemployment is at 11% but that masks a spread of Germany at 6.8% to Spain at 25%. I can't remember a time when Europe exercised such a stranglehold on capital market sentiment. It's relentless and there's more to come. All this is negative for bonds, FX and stocks.

And over at the Fed
They had two questions to answer last week: 1) was more action required following the 1.5% GDP number and employment numbers and 2) would the existing tools do more harm than good? To the first, the new statement acknowledged "decelerated" growth, announced nothing but livened up its "closely monitor" language, which in the past has meant a strong bias towards action. Just not yet. The bar to more action is set high. This means either that the internal Fed discussions are at an impasse or that they are looking at new ways to create an effect. We believe it's the latter which was why we had hints about sterilized QE, changes to IOER and maybe some version of the Funding for Lending program recently undertaken by the Bank of England. Or maybe just plain asset purchases. But it seems doubtful that we have seen the last of easing actions by the Fed this year.

And the Economy?
Continued torpor. The ISM index was unchanged. Not surprisingly the export order index was way down to 46 from nearly 60 in April and the employment index slipped to its lowest since December 2009. The Chicago ISM and Dallas Fed's manufacturing showed small changes with the same underlying story: weak price changes, orders flat and inventories soft. If we see the same pattern as the last two years, all these could reverse. The Fed must be hoping exactly that. Meanwhile, note the trends from last week's GDP number. Here are the major GDP components, excluding the volatile inventory series, indexed to the beginning of the recovery.

It's very much the same story with exports leading the way, slow investment and consumption growth and the government systematically decreasing its part in the economy. The White House last week projected the deficit for 2012 to be 7.8% against 8.5% forecast in February. So that's 0.8% the government is taking out of GDP growth. Depending on your view, this either frees up capacity for a more productive private economic growth or is a misguided pro-cyclical consequence of inertia. Answers on a postcard please.

Meanwhile, the Personal Income and Outlays report came out and showed, again, that real personal income per capita has yet to reach 2007 levels. Until it does, the outlook for consumption and housing must be weak.

And because i) we're of the school that inflation comes through wage push and ii) demand pull, and iii) there is no wage push and iv) saving rates are up by around two points from the last big growth period, core inflation is stuck at around 1.8%. So we are looking at more weak growth with all eyes pinned on the employment numbers.

Bonds
The 10-year note took another four point swing last week ending at roughly the same place. It was a banner month for corporate lending for the very large companies with a number of them borrowing for three years at rates below 1%. The New Issue Market topped $70bn in July. But it's only for a select few and spreads between Moody's BAA [1] yield and treasuries, shown here, remain high.

Which tells us that the market is not quite ready to believe that corporate America should be able to borrow without a high required risk premium.

Equities The market lost its post-ECB excitement when, err, the ECB prevaricated. There was no change in the week. With about 60% of SPX[2] earnings in, the story is that 60% disappointed on sales and 72% surprised on earnings. The earnings surprises don't mean much as analysts tend to huddle around a very narrow band of estimates. The miss on sales is more of a problem. It was highest in Consumer Discretionary where 70% of companies disappointed.

Bottom Line: A good trading week in treasuries. Equities are on track for around $103 in earnings but guidance is deteriorating. We're sellers of some of our better performers.

[1] Moody's Seasoned Baa Corporate Bond Yield, source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis, Economic Research
[2] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation.

Sources: Bloomberg, High Frequency Economics, Capital Economics, Bureau of Labor Statistics, Federal Reserve Bank of St. Louis, ISI, Federal Reserve Bank of Chicago, Federal Reserve Bank of Dallas, Tim Duy's Fed Watch, Federal Reserve Board, US Treasury Department, Sentinel Asset Management, Inc.

Thought of the Week: An ECB Rally, 07.30.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

We remain dependant on European statements but what a difference a year makes. This time last year we saw softening economic data and increasingly poor news coming out of Europe. But then we had a diffident ECB president who had just finished a round of rate increases as Europe slumped. This time we have combative words from Mario Draghi to support the euro, apparently at all costs. There's some bluster in the remarks but what was interesting was admission that the transmission mechanism has broken. We have a two speed Europe: slow and reverse. And it doesn't matter whether markets embrace austerity (UK) or recessionary austerity (Italy and Spain); the results are the same with all three showing a 2% contraction in GDP.

Rates in Europe are also divided by the super low, deflationary yields on German bonds and the +7% rates in Spain, with Italy close behind. The other peripheral bond markets (Greece, Ireland and Portugal) are temporarily immunized through support packages. Liquidity within Europe is manageable. Bank lending is made grudgingly with much tighter credit standards. That's not making it easy for SMEs to access capital. Lending is way down.

So what does this mean? Some possible buying of peripheral debt by the ECB and other looser actions. But remember, as things stand, the ECB can not flat out buy and monetize debt (which means the bonds remain on the bank's balance sheet indefinitely). That leaves the ESM, which does not yet have the funding or leverage. But Draghi's comments may keep things in check and stop the routs. Signs are not healthy in Europe. Spain's housing market is down 20%, with more to follow, labor costs are down and unemployment at 25%, a new high. These are classic problems that QE solves. And to cap it, we saw a big dividend cut from Telefonica in Spain. Expect the market to remain very wary.

The markets are down 6% to 7% but there's nothing obvious to buy. The Bunds trade remains vulnerable both to a break-up and Germany supporting more rescue packages.

US: Still Mixed, Still Just OK
Clearer signals that the Fed will lean towards easing. The recent reports are mixed with some weaker regional Fed reports...Richmond Fed new orders were particularly slow...but slightly better claims numbers and encouraging housing signs. So the "will they, won't they" debate breaks down like this:

And what will they do? This gets interesting as one of the lines from the last FOMC meeting was a concern about disrupting the Treasury market. So the tools this time could be i) MBS purchases ii) extending the language beyond 2014 iii) changing the way the forecast are communicated, so there's less apparent board dissension iv) changes to IOER v) making access to cheaper funding conditional upon loan activity and vi) assigning outcomes to policy actions, which we have written about before and makes a lot of sense as it would stop the on/off reactions to QE measures.

There's also more open support for NGDP-type targets and for more inflation. While the 2% target is not about to disappear, the 10-year yield and the TIPS market are pointing unambiguously towards much lower inflation fears. And, deflation probably remains one of the Fed's greatest fears.

US Economic Data
Nearly all data show how rapidly we have lost momentum but we are not at the point where there's a negative feedback loop, which would mean lower spending, leading to lower employment, lower confidence and so on. GDP is still in positive territory and we have seen the pattern of a summer slowdown in both 2010 and 2011. The Q2 GDP numbers were in line with expectations. Business investment picked up over 7%, which was good to see after the expiration of last year's accelerated depreciation allowances, and inventories were a net contributor again after a Q1 run down. Government continued its downward path, cutting 0.3% from growth. Federal and state government has now been a net drag on the economy for nine out of the last ten quarters. Corporate profits remain high. Here they are against GDP:

Our concern is that this can not be much improved without more final demand.

We also had some very welcome comments from two regional Fed presidents suggesting that i) inflation was not a concern but ii) employment definitely was. John Williams of the San Francisco Fed may have had this in mind, which shows the natural, or non-accelerating rate of unemployment or, more prosaically, where unemployment can fall without raising inflation.

The answer? About another 3% from today's 8% level. Williams mentioned that there's "a lot more [the Fed] can buy without interfering in the market function" which was a forceful thumb bite to the school that believes that a quiet withdrawal of QE would be just fine. And his final word was that it was "essential [to] provide sufficient monetary accommodation to keep our economy moving forward." He gets it! I'm hopeful this is a stalking horse for more QE and hopefully the open ended kind which ties policy to an outcome.

Claims were also a brighter spot this week at about 30,000 better, which took down the four week moving average. The GDP revisions played a role here. Q4 2011 grew from an initial report of 2.8% to a final of 4.0%, which explains both why we saw better employment numbers in the first three months of the year and the GDP catch up with the GDI numbers.

Bonds
A very tactical market and we're seeing a new, lower yield range given the auctions, the focus on Europe and domestic data. Curves are flattening. That's a typical softening message. The range is now around 1.50% with a swing of 25bps either way.

What could send it lower? Any and all the usual grinds, so that's Greece, slower growth in Europe, lower inflation, a really bad NFP report and a possible unwind of the credit trade if the earnings season reveals much weakness.

So a very skeptical view of the market and treasuries remain our favorite "hot potato" investment...short holding periods on the super long duration treasuries of 8.9 for GT10 and 20.1 for GT30.

Equities
Earnings are not that great; about 60% of companies are beating on earnings but the same number are missing on sales, which is far more important. We have had pre-announcements, which cleared the way for some positive news and generally the market seems to have discounted the warnings about the remainder of the year. Some multinationals are missing bottom lines because FX. One thing to note is that we're at about the same levels as this time last year but sitting on top of higher earnings and thus lower valuations. That creates a solid underpin.

Bottom Line: The core story is the S&P[1] yielding 2.1% and with major pockets of large caps trading on 13x with increasing payouts. We've seen much more stability in large cap than mid and small this year: mid cap is + 5% and small cap +4%. The US remains one of the strongest equity markets YTD and they're gradually getting cheaper given steady earnings increases and an S&P level which is mostly unchanged from March 2011.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation.

Sources: Bloomberg, Federal Reserve Bank of San Francisco, Bureau of Economic Analysis, High Frequency Economics, ISI, Federal Reserve Bank of Richmond, Federal Reserve Bank of Chicago, US Census Bureau, US Dept of Commerce, Capital Economics, European Central Bank, Federal Reserve Bank of St. Louis, Sentinel Asset Management, Inc.

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Thought of the Week: Weaker Headlines, 07.23.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Well, the whole Spanish banking solution from a few weeks ago was not destined to last. Back in late June, the EU welcomed, along with the ECB, EBA and IMF that the EFSF /ESM would provide around €50bn of capital, provided the financial sector gave certain conditions and horizontal restructuring plans. And, even better, the FROB would receive the funds and ensure at the time of the capital infusion, Spain would honor its Excessive Deficits Procedures. Got that? No, nor me. The market thought it sounded good and Spanish 10-year bonds rallied 5% to 6.2%.

But now, it's clear the help from the core will be slow to come and the ECB can not take up any slack through bond purchases. The Germans have so far delayed ratifying the ESM (that's the funding mechanism) and insisted the Spanish government place any bank capital on the same senior status as sovereign debt. So there you have the example of how a) sovereign and bank debt are inextricably linked and b) how a debt spiral works. If Spain takes the aid on offer to repair capital, its debt ratios increase and a new round of austerity kicks in. The 5-year Spanish bond auction on July 19th was a debacle. The bid/cover slipped to 2.0x and the yield, at 6.45%, was the same as the 10-year bond three weeks ago. By the end of the week, Spanish bonds were above the psychologically approved level of 7% at 7.2%, bringing the monthly return to -6.5%.

So this is the state of play in Europe:

1. ECB can not exercise any QE. That means the market sets the rates.
2. Funding costs for banks are set by the sovereign not by a CB, so...
3. the monetary transmission doesn't work and...
4. there's no access to funds if Spain needs government support between now and September, which they probably will because...
5. the slowdown in Europe's real economy means that deflation is a threat and so...
6. five European economies are offering negative rates, some as far out as four years which...
7. kills loan activity because real rates are high and collateral values keep falling.

The only way debt crises are solved is through devaluation, inflation or defaults. The EU has closed off options one and two. So that leaves defaults. And the only way citizens can avoid paying for it is to get out of the banks. That means keeping an eye on the Target 2 balances. There's no real asset class that's attractive in Europe right now. Sure Bunds have been a reasonable investment YTD with yield falling to 1.17% and the return at 7%. But a 20bp move would wipe out the income so it's a trading tool only.

US Headlines Weak
Last week's Beige Book mentioned the words "uncertainty" 30 times, "inflation/prices" 168 times and "labor/employment" 38 times. Back in March "uncertainty" was not mentioned at all. Nearly all of the "uncertainty" references were to economic policy, fiscal maneuvers, lack of sales and Europe. None, that I could find, had much to do with regulations and taxes. The Philly Fed said pretty much the same thing. Asked to what businesses attributed the slowdown, an overwhelmingly cited "the economy". Which comes back to demand being the major problem and most of that is because what's going on here:

This sums federal, household, non-financial and financial debt, but excludes states and some forms of short-term debt, and expresses them as a percent of GDP. It's basically flat at a time when household debt has fallen.

And we saw more of that last week with retail sales very slow, no inflation, yet moderate growth in industrial production. The production numbers also came with welcome news that capacity increased at a rate of 1.5% compared to initial estimates of 1.0%. So the broad manufacturing and production story continues to hold.

The rest of the week was on the Fed testimony. For most of it Bernanke had the perfect 1000 yard stare. Not that I can blame him. He reiterated that there are more policies in heaven and earth than can be dreamt of in congressional philosophy but named only Treasury purchases and more communication. He opted not to send a definitive easing signal and asked for compromise on the fiscal side. Bond markets tended to sell off a bit during the testimony but by Friday had round tripped to where they had started.

Bottom Line: We have had quiet sessions. The market is up 6.5% from the May lows and still ahead for the year. About a quarter of the S&P[1] companies have reported with 72% of those reporting positive earnings surprises. But that's less important than sales these days and in a slow nominal GDP world, it's sales that will make a lasting difference to valuation. On that front, nearly 60% have reported negative sales surprises. If this carries on, we're in for a bumpy but inconclusive ride.

Demand for IG and HY remains high. This week we saw deals from eBay [2] issued at +125bp with an order book that built quickly to over $9 billion from $3.5bn. We also saw a high yield issue from Ardagh Packaging Corp. [3] where allocations were cut by 90% or so. Much of this is liability driven and we may not see much in the way of a secondary market. But the underlying story is that yield assets are in short supply for long-term investors.

Sources: Michael Pettis, Capital Economics, Bloomberg, Federal Reserve, Economist Free Exchange, European Central Bank, European Commission, European Central Bank, US Census Bureau, US Dept of Commerce, US Census Bureau, US Dept of Housing & Urban Development, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of St. Louis, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation.
[2] eBay was not held in any Sentinel Funds as of July 20, 2012.
[3] There is a position in Ardagh Packaging Corp. as of July 20, 2012. To see Sentinel Investments' Top 10 Holdings for all funds, please click here.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

We are in earnings season. This is a welcome relief from the macro and political world that has dominated markets and sentiment for several weeks. Earnings allow us to look at what companies are seeing and how they're reacting. We know they're operating in world of miserable nominal GDP growth so we will look at margins, sales, pricing power, management and cash positions. But first, why so listless and skittish?

Start first with the central banks: The ECB lowered rates but would not extend the LTROs. These may not have helped Spanish banks but at least would have signaled willingness to extend the period of easing. This was a mistake. The ECB acknowledged that inflation is well under control, heading towards less than 2%. They then threw responsibility for mending banking, fiscal and budgetary problems firmly at governments. And in doing so abrogated their obligations to manage demand. Yes, the wording of the mandate is "price stability" but price is simply a function of demand and every signal screams low and slowing demand.

Both the BIS and ECB (and indeed the Fed, but we'll get to that in a moment) talked about raising pressure on governments to delever and make structural adjustments. This is way outside their purview. At a time when there is a palpable and ongoing output gap, an imprecise term for sure but evidenced by unemployment and deviation from trend growth, CBs should be raising inflation expectations and holding to policies until those goals are met. Some claim CBs are out of ammunition. Not so. Almost everyone believes that CBs can create inflation. If one believes that, one must believe they can raise demand. It's a sequitur. And how can they raise demand? More purchase of debt securities, without the claw back of a collateral repo, and more toleration of price increases in excess of 2% that has become the standard, "well it feels about right," target.

So what happened as the ECB stepped back? 1) The € lost nearly 4% against the dollar and the yen, 2) French and German bills went negative, 3) 10-year Bunds rose 5%, 4) Euro stocks fell around 3% bringing the YTD decline to nearly 15%, and 5) adjacent currencies like the Danish kroner saw bonds fall into negative yields all the way out to four years. Low rates are not enough to change risk-aversion and we expect almost every economic report to dim in coming months. Meanwhile capital flight remains a problem. Around €150bn of capital fled Spanish banks last quarter, a sure sign that attempts to contain the crisis lack bite.

What next at the Fed? The minutes mention the words "employment" and "labor" 85 times. They mention "price" and "inflation" 155 times. Which tells you a lot about a) what they're more comfortable trying to manage and b) priorities. We had two Fed presidents press this point, with Jeffrey Lacker at Richmond and James Bullard at St. Louis stating that employment was "close to maximum right now" and "the output gap is not as large as commonly believed." We certainly believe that unemployment is overwhelmingly cyclical. It's tempting to think that unemployed construction workers can not be retrained into industries where there's demand and that therefore the natural rate of unemployment must rise. But there's precious little substance. This chart shows total private sector employment against three sample industries: construction, transport and finance (it wouldn't matter which you chose). If there were structural unemployment, then one would see big variations in a) the rates of decline or b) wages. But there isn't. Misery likes company and few parts of the economy were immune.

Also the JOLTS report this week showed much the same. The blue line shows job openings, on an inverse scale so down means more jobs, against unemployment. If structural employment were in play, we would see the opening line fall much more quickly than unemployment. There's also little evidence that firms are finding it hard to fill vacant positions. Even in the NFIB, which historically finds it hard to compete for employees, only 15% of employers are unable to fill open positions. Pre-crisis it was more like 25%.

Neither of the employment/output views are in the ascendant. And thankfully so because if they were, we would be raising rates and exiting asset purchases and this is not an economy that can carry its own momentum. But they do show the struggle of balancing demand, inflation expectations and employment with zero-based rates.

The Fed lowered all economic forecasts: lower growth, PCE and core inflation and higher unemployment. The bar for more policy action was set at "if the economic recovery were to lose momentum...or if inflation [were] below...objectives." They got both in the last few weeks perhaps most dramatically with the PPI, here shown jogging along way below long term averages.

So that increases the likelihood that we may get another version of QE and the timing sometime between the next meeting in early August and the Jackson Hole meeting at the end. Watch for more hints of this in coming weeks.

The markets seem to be previewing some action. We had an extraordinary $21bn auction of 10-year notes at a record low of 1.45% with strong bid-to-cover and non-dealer demand. This chart shows the 10-year TIPS at record lows. This says simply that the government can borrow at negative 0.6% for the next eight years and so the inflation risk is minimal and that nominal rates will remain stuck. For most of the last 20 years the TIPS rate has been closer to 2%.

Other Economic Stats: The trade deficit for May declined by $2bn, mostly because of lower crude and petroleum product. They represent 18% of all imports and were at their lowest level since February last year. But while exports are still strong, it is likely that slowdowns in China and Europe will dampen growth in coming months and provide little contribution to 2Q GDP. Consumer credit appears to be on the mend and almost back to where it was in early 2008. But no, this is not a resurgence in consumer confidence. Quite the reverse because nearly all the growth is due to student loans. The government now owns 18% of all credit. And that's because jobs are scarce, conventional loans hard to come by and demand flat. And it's also, make no mistake, consumption brought forward which means that a whole generation of students is going to be very reluctant to form households.

Bottom Line: Bonds this week rallied with a mid week bounce to 1.45%. We think that's mainly foreign buying and, specifically, the Swiss National Bank which is defending its €1.20 peg against the CHF. The more they sell CHF to maintain the peg, the more they accumulate euros, some of which are swapped into dollars and GTs. Which all makes sense if you're a central bank with a limited appetite for your main trading partner's currency. The story in equities is watch and buy. The dividend story remains a main driver. S&P dividends have doubled since 2002, during which time the market has done nothing.

Sources: The Economist, Blogs, Free Exchange; European Central Bank; FT Alphaville; Peterson Institute for International Economics; Capital Economics; High Frequency Economics; Bloomberg; Federal Reserve Bank of Richmond; Federal Reserve Board; Federal Reserve Bank of St. Louis; ISI; US Census Bureau; US Bureau or Economic Analysis; National Federation of Independent Business; Sentinel Asset Management, Inc.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Europe: Slow Road to Perdition
Some crises linger for years. The sterling crisis began in 1964 and, despite periodic respites, was not solved until the early 1990s. The oil crisis burned for over ten years until the political and economic stars realigned and restored order. Latin America lingered for over ten years before a breakthrough of sorts...not for everyone though, as Argentina's GDP per capita is the same as it was in 1960. A crisis is not the same as an emergency. An emergency gets everyone's attention and on the road to solution. A crisis begets many orphans and a "make do" attitude.

Such is the nature of the European crisis. It takes a very long time for rich countries to fall from grace. There are safety nets, high but declining living standards and low birth rates that postpone the reckoning for a very long time. Way beyond the time of any elected government. And so in Europe we had a another summit which agreed: 1) to a single banking supervisory committee 2) to recapitalize banks directly so that 3) sovereign debt would not increase one-for-one every time a bank required capital support 4) more latitude for the ESM to buy government bonds and 5) some softening of the austerity programs for the Irish, who were a victim of No. 3.

So far so good. Spanish and Italian bonds rallied 3% which means they're back to where they were in May but still down 8% this year. Then Angela Merkel played a hard-line card that could come back to haunt her. She said there would be no debt sharing (which is the same as mutualization or euro bonds) "as long as I live." Her members of parliament promptly wished her a very long life. There's also the minor problem that the funding mechanisms for all this are the EFSF and ESM. The EFSF has already used €250bn of its €440bn lending capacity and the ESM is not yet legal.

Put this all together and we have a weak commitment that helps on some glitches but does nothing to stop the slow deterioration in economic data. GDP remains 2.4% below its 2007 peak, having never regained what it lost in 2008 and 2009 and unemployment will soon test record highs. Lower gas prices may help CPI by 0.2% or so. The ECB targets 2% so if there's a whiff of lower inflation in the air, they might announce rate cuts this week. Ultimately stocks need nominal GDP to grow. They're not getting it so it doesn't really matter how cheap markets look (e.g. P/Es of 10 and yields of 4%). They're going nowhere.

Fed: Parallel Parked
Two news items that caught our attention on the issue of the day: the role of the Fed and CBs.

First, the BIS issued a stern warning on the limits of central bank policy and second, the St. Louis Fed's Bullard again shied away from accepting employment as an acceptable target for monetary policy. Two notes:

US: rolling along but not quite over.
Two out of three important regional Fed indicators read slower last week. Richmond and Kansas showed manufacturing slowing mostly because of uncertainty (i.e. demand) and lower prices. The Dallas survey surged ahead. The chemical and petroleum industries are thriving down there. One respondent hit the nail on the head: "the availability of low-cost natural gas is a huge advantage to a US based manufacturer competing overseas." Exactly right.

The GDP numbers were not revised in total but there were some interesting changes from the initial estimates. The biggest revisions down were personal consumption and government expenditures. Here's government expenditures as a proportion of GDP.

If you're looking for a lower share of government in the economy to let, say, the private sector do its thing, then "job done." The private sector confidence and crowding in should begin any time soon. If you think there's an aggregate demand problem which fiscal policy could fill, then it's a very depressing chart. The very good news is that corporate profits remain at a high level which certainly helps balance sheet repair and overall general health of corporations. Here's the chart of corporate profits over GDP.

So while a mixed news week, there remain brighter spots. New home sales, despite inventory overhang and foreclosure sales, seem to be trending higher. Durable goods also rose 1.1% mainly because of an 8% increase in the volatile defense sector. This should remain in reasonable territory given a) the profitability of companies as shown in the chart and b) the still low level of capital spending.

Bottom Line: Equities were in quiet session all week long. June ended being a strong month, up 7.5% for SPX [1] and 9.3% for the Russell 2000[2]. We're back to early May levels. Some of the rally has been low quality. For the Russell 2000, the top quintile of performers (up 20%) also had negative ROEs and ROICs and stratospheric P/Es. This happens in oversold situations which we saw in mid-May.

Generally, we're in hold mode. There's no direction to treasuries. But there are still good days to pick up some of our favorite equity names.

Unless something breaks big this week, we'll probably skip TOTW for the upcoming week.

Sources: Federal Reserve Bank of St. Louis, Capital Economics, High Frequency Economics, Bloomberg, European Commission, Der Spiegel, Capital Economics, Bureau of Economic Analysis, US Department of Commerce, Federal Reserve Bank of Dallas, Federal Reserve Bank of Kansas, Federal Reserve Bank of Richmond, FactSet, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation.
[2] Russell 2000 Index is an unmanaged index that measures the performance of 2000 small-cap companies within the U.S. equity universe. An investment cannot be made directly in an index.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Since 2010, investors have traveled between optimism and pessimism every three months. It's negative right now. Here's why:

FOMC: What was that exactly?
A very timid move by the Fed. What was glaring was the entire board revised down their expectations on the economy: i) GDP down by $500bn ii) unemployment up 500,000 and iii) lower core and PCE inflation. Not just for 2012 but next year as well. That takes complacency to a new level. In April they said that the economy still had plenty of slack and that inflationary pressures were minimal. And so they were. So why only a modest extension of Operation Twist?

The one thing we like about it is the $270bn of treasury purchases from now until year-end. That runs down the Fed's holdings of 3-year paper to zero as they focus buying in the 6-10 year space, which is typically the benchmark for corporate bond issuance and 30-year mortgages.

Just to keep us on our toes: a non-voting member of the Fed, James Bullard of the St. Louis Fed, went on record that there would have to be a "very high hurdle" for any more QE and that having end dates on the programs is causing frustration. Two responses:

Where are we going with US Economic Data?
Nearly all data shows how rapidly we have lost momentum since the promising start to the year. Manufacturing, jobs and confidence have all rolled over, not disastrously but enough to question whether the early data was i) a back-and-fill from Q4 or ii) weather-related or iii) due to higher energy prices, remember oil never closed below $100 in Q1, or iv) reaction to what was then better news in Europe.

Probably all of the above. Thus most of what we have seen in the last two months is a steady drip of confidence impairments. The trouble with these is they can accelerate and start their own downward momentum. And that's what we'll be watching closely. Meanwhile, four brighter spots:

Europe: Met in Cabo and now what?
Will dominate the news for a while. If this were Grandmaster chess, they'd be four pieces down and at stalemate. All the major economic stats are flashing red. Those with structural reform plans, of which UK and Italy are the most important, are already seeing severe downturns. As we said last week, Europe lacks a hegemon: ECB: no mandate. Germany: too punitive. IMF: not funded. US: unwilling. EU: unable. And each a veto.

Back in May, the Governor of the Bank of Italy put it well:

Which is, of course, correct. If there were political union, Greece would be like Texas in the 1980s...a trashed banking system and federal rescue...and Ireland and Spain would be like Florida, receiving transfer payments in the wake of a housing frenzy. So, transfer payments and rebalancing could get on with their work.

But there isn't a political union so we hang on shorter term problems like can Spain get its target funding in place (yes, so bonds drop below 7%), are the stress tests going to be good for a week or two (perhaps), will Greece form a government, will there be a new LTRO to balance out the Target 2 imbalances in reserves? All serious problems and we will see twists and turns in capital markets. But nothing to repair fragile sentiment.

The markets are down 6% to 7% but there's nothing obvious to buy. Even the Bunds trade is coming unglued with a near 5% correction in June. This makes sense. They are not a safety trade. Most of the fallout in Europe will land at the door of the German economy and CDS have already risen 20% in a month.

Bonds: The defensive trade
We're at the top of recent trading ranges. We're fading our treasuries because the trade has been so volatile. The duration on the treasuries are 9.2 for GT10 and 21.2 for GT30. They trade with fast moves on thin news. Last week we saw the benchmark GT30 move on the back of a $5bn trade. In a market with $500bn of daily turnover, that's a nervous market.

The bank downgrades were well telegraphed. Many of the European large money center banks are de facto sovereigns and on life support from the ECB. That explains why the short-term debt ratings were mostly left unchanged. One area that is worth looking at is the US money market mutual fund (MMMF) industry. These tend to rely on commercial paper for much of their assets and banks are big issuers at nearly 50% of all outstanding paper.

Non-financial commercial paper has shrunk to less than 20% of the market. In other words, MMMFs rely heavily on bank debt, strive to maintain a $1.00 NAV but have no dedicated capital to support downgrades or impairments. That's why the Fed keeps pressing for reform.

Elsewhere, new issues remain very well bid as does CMBS mostly because of resolutions on multi-family and large properties (there's that property market theme again). The appetite in new IG names are very healthy especially as the treasury market remains well bid and a defensive trade. But don't get sucked in by the yield only story.

Long-term only please: Equities
The S&P[2] is doing better than it did in 2010 and 2011 when we also saw Q2 weakness: +8.9% vs. unchanged back then. The market has recently honed in on defensive sectors like telecoms, services and utilities. In a flight to yield market, they worked. The core story is the S&P yielding 2.1%, with major pockets of large caps land trading on 13x with increasing pay outs. We've seen much more stability in large cap than mid and small this year: mid cap is +7.3% and small cap 5.9%. The US remains one of the strongest equity markets YTD.

Also, the day of any FOMC meeting sees the market up 70% of the time and the day after it's down 70% of the time. So no surprises there. We were due for pull back. Expect to be in a range 1250 to 1350 for the S&P, so 75 pts lower than Q1. We'll stay there for a while. So need to pick up good names we want to own on weak days and stay with quality. Trim them at the top of the ranges.

Bottom Line: We're happy to hold 2.5% yielders and 12x. Sure, plenty people have spoken about it but none are doing it! Money is more on the sidelines than headed in. Remember these stocks were the laggards over three years.

[1] To see Sentinel Investments' Top 10 Holdings for all funds, please click here.
[2] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation.

Sources: High Frequency Economics, Federal Reserve Board, Federal Reserve Bank of St. Louis, Bloomberg, Tim Duy's Fed Watch, National Federation of Independent Business, US Census Bureau, US Dept of Housing & Urban Development, Bureau of Labor Statistics, CLSA, Banca D'Italia, Sentinel Asset Management, Inc.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

It is the job of investment managers to look beyond the gloom. There's plenty of it. The big list last week was the slow hand clap the market gave to the Spanish bank rescue, the probable downgrade of India, one of the dead cert BRICs we all read about, and queasy economic data from the US. Now we don't just jump in and buy on all the bad news. We're not likely to retain clients that way. But we do see some clarity on the number of possible outcomes, which is a healthier place to be than for most of the last few weeks. Here are four questions on our mind as we look at the week:

1. Spain: are we done?

No. Spain bailout is a patch...not a new beginning. One of the issues is how the loans are accounted for: sovereign or private? Answer: sovereign. So Spanish debt goes up and money comes out of the EFSF...so no net new money into the system. It also jumps Spain's already stressed debt/GDP ratio by about 10%. Remember the ECB played NO role in this. That's why Spanish bonds and stocks fell 6% on the news. If the Irish experience is anything to go by, the debt, bad loans and write-offs will far exceed the €100bn commitment. Sky high unemployment and falling property prices are hardly good omens for profitability. Spanish banks are at the same level as they were in 1997. And the economy continues to weaken.

2. Europe: moving towards what?

Tough call. The calls to move towards greater union (like deposit insurance, euro bonds, banking union) are fiercely resisted by Germany. And when the risk of anyone pulling out of the euro is still in the air, then a banking union solves nothing. Over in Greece, we had the second round of parliamentary elections this past weekend. Voter polling is not allowed two weeks prior to an election, so no one really knew which way it would go. As it turns out, a narrow, very slender and timorous victory for the pro-EU group, postpones problems another month. Meanwhile, we know there's capital flight to the tune of €500m a day and scenarios for an exit. The markets continue to slide in Europe; most of them were flat to down 2% last week, down 10% YTD and down 20% over the year. Spanish bonds ended up well over 7%, a critical threshold.

It was always going to be a disorderly queue from Greece to Spain to Italy (because Portugal and Ireland had hammered out deals ensuring comatose status). And so we now learn that Italy's economy contracted 3.2% and fixed investment fell 14%. Real GDP is only 1% higher than the 2009 depths. This is very grim. The worry here is that Spain has received assistance. So it is likely that more will come but from an ever diminishing central pot. That means stocks will be cheaper yet.

On a broader note, one clear image from Europe is the lack of any hegemon. ECB: no mandate. Germany: too punitive. IMF: not funded. US: unwilling. EU: unable. China: uninterested. Yet each retains a veto. So muddle through it is, then.

3. US Economic Stats: all weak, right?

Up to a point. Sure, the big ones, like NFPs and claims, are a lot softer than a few months ago. But trade revisions were favorable with revisions up for Q1 and down for Q4...so that creates a better base effect for Q1 GDP (remember the Q1 revisions aren't over yet). The other one is the NFIB survey (for small/med sized companies) where the headline number was unchanged but hiring decisions were strong indicating that NFPs may bounce back in the next few months. Another sign that may be good for jobs is weakening productivity growth, which fell in Q1. The more mature the cycle, the more productivity slows and so, with a given rate of GDP growth, generates faster job creation. It even went negative last quarter. Here's what it looks like:

So potentially good for NFPs.

Another key data point was retail sales, ex-autos, which fell 0.4%. A lot of this was a decline in gas prices which fell 2.2%. Compare that to March when gas prices were increasing closer to 7.5%. Now a funny thing happens when gas prices start moving around. First the CPI falls. And we saw that in the headline CPI which rose by only 1.7%. Second, because demand for gas is inelastic in the short term, meaning price changes barely alter demand because consumers don't have time to change behavior, the money saved equals stored up demand. There has been a distinct change in the way people get around. Here's a new data set from our friends at FRED showing vehicle miles traveled.

That's more than cyclical. It suggest new patterns of driving and probably ties into the rapid growth in the "5-units or more" section of housing starts: less single home formation, more multi-housing units, more central location, less need to drive. So we may see some benefits of gas prices come through in the next few months in the form of extra spending. What is clear is that inflation remains painfully low. Even in the otherwise grim Empire Manufacturing Index, the "Prices Paid" reading fell 18 points. And over in the monthly Treasury statement we continue to see contraction with the "Big 5" expenditure categories falling by $50bn YTD or a nice round 0.6% of GDP.

So headlines weak on sales, NFIB, Empire and jobs. But better on inflation, gas prices and housing. Put it all together: there's weakness but no rollover. Yet.

4. So, will they QE or not?

Probably not because, as David Brownlee points out, the market is already there. Taking long bonds down another 25bps is going to make no difference to lending practices. Remember Op Twist was all about selling short-term treasuries to buy long term. That made it different from QE1 which was outright purchases and reserve crediting. The Fed only has $180bn of short-term treasuries to sell so there's a limit to how much more they could buy in a Twist #2. For QE to come in more force, we would have to see significant loss of momentum in the economy (i.e. jobs, output) and inflation below 2%.

Another opening for the Fed could be to push equities higher (see the household balance sheet point in last week's TOTW) and the only way they could do that would be to take competing assets out of the market. That's the "portfolio balance" channel and it would take a hefty amount to push equities higher.
It's an important meeting this week. There's probably insufficient data to change forecasts now and the camps in the Fed still talk more about inflation credibility than they do employment. One option might be some really stern talking about an easing bias with the trigger ready to go on Twist #2. Yes, that's it. Unless Europe falls apart.

Bottom Line: Still a lot of price movement in treasuries. The 30-year traded between $103 and $107 in last few days and now yields 2.7%. The range seems to be 2.65% to 2.85%. This thing has a 20.1 duration, hence the volatility. The 10-year has a similarly tight range of 1.42% to 1.72%. The demand for longer term debt continues; both the 10- and 30-year auctions last week had healthy bid/covers and more active direct bidders.

When macro and political headlines keep crossing, markets ignore company fundamentals. We see plenty of opportunities to look through the gloom. So it's a good time to continue to pick up stocks.

Sources: FT Alphaville, Brad DeLong, Capital Economics, National Federation of Independent Business, High Frequency Economics, Tim Duy's Fed Watch, Federal Reserve Bank of New York, Federal Reserve Bank of St. Louis, Bloomberg, US Census Bureau, US Dept of Commerce, Federal Reserve, Bureau of Labor Statistics, US Treasury Department, Luc Besson, The Professional; Sentinel Asset Management, Inc.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Markets braced last week for a bailout on Spain which came this weekend. Its banking sector is in wretched condition and joins other European banks at 25 year lows in share price. The official downgrades came long after the stock market had voted with its feet. European leaders had little to add to the debate. There's some talk of a twin track: some European countries pressing on to further integration, some coping with contraction and austerity on their own. Neither makes much sense and we saw the umpteenth weekend conference where the pattern is usually:

Monetary Policy: Last week we had both the Fed and ECB state no change in policy was required but that they're both looking at the situation carefully. Well, thank goodness. But in some ways their insouciance in the face of weaker economic numbers is understandable because monetary policy can only overcome so much inertia on fiscal policy. Here's why.

Imagine the economy as a kitchen chair sitting in the middle of, well, a kitchen. You have to move it three feet. That's all. You have Bertha and Casey to help you. Bertha is a giant fan [HT to Miles Kimball]. You turn it on, it makes a horrendous noise, consumes a lot of energy and moves the chair haphazardly towards its target. It may not get there at all because friction and the transmission mechanism are indirect and messy. Casey, on the other hand, is a little six-year old moppet, and if asked nicely will push the chair, with one hand, in any direction you want. With very little fanfare and whining. And get there soon.

Bertha is, of course, monetary policy. It takes vast amounts of open market asset purchases to move the economy at the zero bound. Another way to think of it is that QE can work, that the excess reserves can be placed into the real economy, but the scale is very large and markets must be convinced that CBs can control the after effects. Casey, bless her, is fiscal policy. If one directs expenditure into parts of the economy (not tax cuts, they'll be saved) and targets a nominal rate of growth, consumers and businesses will start to spend cash instead of sitting on it. The power of fiscal policy is no more evident than now, where it's working in reverse. The federal government continues to be net drag on the economy and may be headed to an even worse detractor if the consequences of the fiscal cliff materialize. Here are the government's interest payments, the same level as they were seventeen years ago and so a much smaller part of GDP. And at the same time, personal interest payments are down nearly 40%. So when both the government sector and personal sector deleverage, the economy struggles, which is what we have seen since 2009.

Central Banks: Both the Fed and the ECB decided to stay on the sidelines. Bernanke pointed out the obvious risks of tentative new job creation, Europe and budgetary pressures and warned QE has diminishing returns. He used "moderate" paced language rather than "modest" and left a clear message that the Fed would ease more if there was a major disruption (i.e. Europe or fiscal cliff shenanigans). He held to the 2% inflation target which is where he's getting the most flack...on the assumption that monetary growth must feed into higher prices. The trouble is the market does not believe his inflation targets. Here's the 5-Year TIPs yield, as good an indicator as any for inflation expectations:

For most of this year it's unequivocally pointing to deflation and inflation expectations have dropped in the last two years. Part of the problem is the "stop/start" approach to monetary policy. This has meant one policy after another which sets a target amount of open market activity but pretty much fails to state what the goals are. So plenty on the means, not much on the end.

Over in ECB land, Draghi talked a good game and told everyone they must redress their imbalances. He left policy unchanged. The ECB is constitutionally much weaker than it looks. The eurozone is on the cusp of a technical recession which would argue for rate cuts, bank recapitalizations and stabilized bond yields. But the ECB does not control these and so only target inflation, which at 2.4%, is above the stated goal. They are likely to move to less conventional tools, like more LTROs or securities buying, which was around $3bn a week late last year but has been at zero for all of 2012. So they're unwilling to do much more just yet. Wait and see.

Why Latvia matters: A more disconcerting speech came out of the ECB the same day from a board member extolling the virtues of Latvia. Now, Latvia is the source of quite a bit of controversy recently because politicians and economists have been searching for an example of a country that fully embraced austerity and downsizing and led to a great success. And little Latvia, with a GDP of around $26bn, is the poster child. So there are two camps on this.

Camp 1: says Latvia's economy shrunk 24% and unemployment peaked at 20% but they kept the euro peg, adopted fiscal consolidation and structural reform and have now grown 5.5%. So move fast, be bold and you too can share Latvia's success.

Camp 2: says if you shrink an economy 25% and grow it 5%, it's still 20% below its peak, unemployment at 15% is a social hardship and that it takes delusion to new levels to claim that as success. The path to growth via austerity and penury with a vague assurance of redemption is not a model greatly to be desired.

So if you hear about economic models that work, make sure that Latvia is not the sacrificial case study.

Flow of Funds: The Federal Reserves' quarterly flow of funds is a great read because it gives all sorts of information on what households are up to. Two things caught our attention. One, last quarter many analysts pointed to the fact that the government had bought 65% of all treasury securities in 2011 and, beware, when they stop buying, rates would climb. Well it did stop, it dropped to 16% of buyers, but rates didn't climb. That's because households stepped in to buy 20% of issuance as part of their effort to put their balance sheet on a firmer footing.

Second, the composition of household balance sheets continues to change. Net worth increased $2.4tr mainly because risky assets, like mutual funds, equities and pension funds, accounted for 77% of assets and all increased in Q1. Meanwhile, over on the liabilities side, mortgages fell over $1tr from their peak and stand at 25% of net worth compared to 27% two years ago. This is possibly why the Fed believes the wealth effect of a rising market is more important than housing. Certainly, households are at least in a better place to support spending should wider spread confidence return.

China: cut rates. It won't have much affect on demand because the fiscal side is what drives the economy (that's Casey again). The domestic economy is what counts. Net exports have contributed around 0.2% to a 9% growth rate. It will probably slip below 8% this year.

Bottom Line: We trimmed some international stocks, mostly in Europe and into a rally that does not have much conviction to it. Bunds look vulnerable as shown by the rise in the CDS. If US bonds fall to Japan levels, there's only a 7% upside. That means we're comfortable with the equity overweight.

Sources: European Central Bank; Miles Kimball; FT Alphaville; Federal Reserve Board; Federal Reserve Bank of St. Louis; Tim Duy's Fed Watch; Capital Economics; High Frequency Economics; Simon Wren-Lewis, Mainly Macro; Bloomberg; Sentinel Asset Management, Inc.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Last week was a painful week for nearly all capital assets. The correction since April is now around 6% for US stocks, 13% for European and Japanese stocks and 9% for other Asian stocks. The run into safe assets, the list of which is shrinking, has been faster and further than we would have predicted. It seems the last few years have recorded one superlative after another. Last week we added the lowest ever level of GT10, which touched 1.44%, and the 7-year note firmly below 1%. German 10-year Bunds fell to 1.12%, bringing the total return close to 20% over the last year. Over in Switzerland, it will cost you nearly 0.5% for the privilege of holding a two year bond. If negative rates are on offer, distress and fear are not far behind.

Europe: There is no method. There is still talk of growth compacts but they yield more hot air than will to action. The slowdown in Europe is hastening. Why?

1. The ECB liquidity measures have not prompted banks to lend more partly because there's capital flight from periphery to core which is building up excess reserves. Germany is the main beneficiary of this because, simply, German banks must accept your euro deposits if you are in Italy or Spain and ever so slightly worried about the 25 year low in your local bank's share price. Hence the fall in Bund yields.
2. But it is not just a flight to quality story because at the same time that German yields fell, CDS on their sovereign debt increased nearly 30%. This means that investors have no real choice if they intend to hold euros, but to place them in the safest domicile and then insure themselves against either Germany bailing out parts of Europe or reverting to a "go it alone" strategy.
3. Credit conditions in France, Spain and Italy remain tight. Germany depends on these markets for growth. So exports are sagging and, indeed, we saw the PMIs fall in May. Then follows slowing growth in real wages and slower consumer spending, which has risen only 5% in the last decade. And GDP is only 1% higher than four years ago. Remember, this is the strong man of Europe. Calling the shots.
4. Meanwhile, Spain solved an imminent bank run with quasi-nationalization and revised up its budget deficit to 8.5% from a target of 6%. Proposals like "project bonds", a sensible idea as it ensures debt proceeds are used for revenue-producing capital assets, looser monetary policy, changes to fiscal programs and eurobonds, have all been killed by stealth and inertia. Indeed, the only economic prescriptions which one hears about are 3% and 60%: the twenty-year old Maastricht formulas for budget deficit and government debt targets. Only Austria and Finland meet those targets.

So, we have situation where the ECB wants more integration but can not even put forward a credible deposit insurance policy; Germany wants frugality but not at the cost of its exports suffering; France wants growth but not at the expense of labor reform and all want some deus ex machina to avoid break up. Basic things like lack of competitiveness, misaligned policies, role of the state, labor markets go unresolved. How much longer will this go on? It looks futile.

But in the US, it's good, really: Weaker data all around especially the big three of GDP, jobs and personal income. On GDP, the main change was in slower inventory rebuilding. This is the smallest and most volatile component of GDP and this time it contributed only 0.2% to 1.9% growth compared to 1.8% of 3.0% last quarter. The basic themes remain present. First, there's little upward price pressure on the economy. Here's the price deflator well below long-term averages and below the first three quarters of 2011.

Second, government continues to be a net drag on growth. Here's real government expenditures falling faster than at any time in the last 30 years. So of course that means that government demand continues to arrest aggregate growth. The government component of GDP has now dropped in nine out of the last eleven quarters. This slower demand is meant to show up in private demand, which of course it could and will...eventually but probably at a permanent lower level of productive capacity.

The employment numbers wrong footed us. We expected more than 120,000 and they came in at 69,000 with revisions down in the last two months. This is a volatile series (+/- 100k is our rule of thumb) and may still be adjusting to the higher "pull forward" demand in the first three months. The silver lining was that private payrolls maintained a decent momentum, which is in keeping with some of the hiring data we saw in recent regional Fed series and Friday's ISM data. Indeed, this index showed robust order growth and lower prices paid.

The third big one was personal income which grew only 0.2% and on a per capita basis, which we have tirelessly pointed out, was unchanged at $32,500. That number has not changed since 2007 and is the one reason why we're so confident on inflation. Here's personal income, which is not the same as disposable income which is what matters for demand, and personal interest payments. This is what a deleveraging economy looks like.

Despite these weak stats, I think it highly unlikely we will see a QE3. Why? Well what exactly would the Fed target? The markets are already doing the job of taking rates down so any intervention would have to take aim at very specific securities. Mortgages perhaps. Or a more overt/honest intent to rally equities. Or a pull from the play book from the deflation manual, i.e. targeting nominal GDP.

Equities: No not for the long term. At least not without constant vigilance. They have taken a hammering. The Japanese market is now at its cheapest trading at 11x earnings, compared to a peak of over 50x in the late 1980s because, well, things were different that time. And its absolute level is the same as 1983. In the US, bonds have trumped equities for the last 10 years and the only way to play equities is to be extremely selective about what companies to buy: management, products and balance sheet should be the start of any list. US equities are in much the best shape right now. Valuations are reasonable as measured by P/Es, earnings yield (which is roughly the same thing but a good gauge against corporate bonds), dividends, dividend growth, payout ratios and cover. Here are some quick notes which we use to keep sane in an indiscriminate fall:

1. Payout ratios are 32%, compared to a long term average of 54%. As demographics change, that is the "me generation" hitting 65 at the rate of 3.5m a year, the demand for income will increase.
2. S&P non-financial companies generate around $600bn in cash flow but pay out $240bn; the numbers are even greater if we include financials but they're busy building capital and will more likely repurchase shares before increasing dividends.
3. The same companies sit on record amounts of cash and have a 16% debt equivalent to equity, compared to a 21% average.
4. Dividend growers, those that regularly increase pay outs, sell at a discount to dividend yield plays and the potential return has nothing to do with tax rates. So mark this down: favorable dividend treatment from the Jobs and Growth Act of 2003 have no effect on dividend strategies or performance. None.

Why we don't invest in Facebook
A lot of press two weeks into its new life, but for us there are pretty simple principles at work which make this company a non-starter:

1. Share overhang: There are around $24bn of employee stock options that vest soon. That's around 150% of the float. That's way too many potential sellers and with more share option grants to come, coupled with low cash salaries, that's an expense that will come straight to current shareholders.
2. Valuation: At the current P/E, it will take around 80 years to make back your cost in current earnings. Put another way, to justify its price, FB must grow at around 40% a year with no margin contraction.
3. Governance: There has to be a very strong reason to disenfranchise shareholders through a dual class structure and wanting to retain control isn't one of them. Markets (like Shanghai) and companies that do this typically warrant a 20% discount to fair valuations.
4. Diversity: There is none. Not a single female on the board.
5. Comparisons: If FB is another AAPL[1], with the same breadth and caliber of management, then we are looking at nearly 20 years of flat share prices before it gets a second wind.

So it's not a healthy combination. Nor is the company totemic. There are plenty of ways for us to play the trends it aspires to lead.

Bottom Line: We're comfortable with long bonds as the flight to the USD continues. But the duration risk is high and the returns finite. Equities will recover but the catalyst will be from Europe, either a significant bank run or a pull through on coordination. We measure this in weeks not months.

Sources: John Milius, Apocalypse Now; Indigo Research; Byron Capital Markets; Capital Economics; Bank of America Merrill Lynch; Bureau of Economic Analysis; US Department of Commerce; Bureau of Labor Statistics; Federal Reserve Bank of St. Louis; ISI; Bloomberg; Sentinel Asset Management, Inc.

[1] Apple, Inc. (AAPL) was 5.7% of total net assets of the Sentinel Capital Growth Fund and 7.9% of total net assets of the Sentinel Growth Leaders Fund as of June 1, 2012.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

We're testing all sorts of lows: 1) record low for GT10 auction last week 2) GT30 yield, same level as Dec 2008 3) European banks are at same price level as 1987...so 25 years of gains wiped out 4) euro stocks same level as March 2009, so all the gains gone 5) US safest and best place to be 6) China stocks at same level as 2006, since then the Chinese economy has doubled and 7) to cap it all we had an IPO that should never have happened. We're back in risk territory and markets don't want to extend or commit. Reasons follow...

Greece: Wishful thinking that we would not have to go over the same issues here. Markets worry about it, rightly, because there is simply no precedent for what is being played out in real time. We've had defaults before. We've had countries and unions break up. We've had countries ditch one currency for another. We've had full blown capital flight. But we've never had a country where all funding could be cut off and where the attractions of repudiating debt seem to grow daily. What we do know is:

1. We have at least one more month of uncertainty.
2. Greek banks are seeing more capital and deposits up and leave, and they owe around €100 bn to other European banks...
3. And they have no central bank for support or act as lender of last resort.
4. Greek authorities increasingly have the upper hand...the more they're told they can not exit, the more they can bargain to remain.
5. Redenomination of debts has worked for others, most recently Argentina, which had a dollar peg, austerity programs that weren't working and bank runs, but who survived and thrived.
6. The steps to economic health - first devalue and inflate, second abolish a currency board and renegotiate principal payments and third internally devalue and start firing up exports - are not that complicated. They're just confounded by a byzantine legal structure around the EU.

The choices thus come down to 1) leave and manage a crisis response or 2) deal with a troubled Greece within the system and firewall as much as possible. The markets are betting on the latter. We would not bet at all in this game because there's no upside to either outcome. What concerns us is the "systemic" part of the banking system where money is pulled from weakest banks and the financial links come undone very quickly. According to the BIS, US banks claims on Greece amount to only 0.3% of Tier 1 capital but it is very much larger when it comes to European banks and, indeed, the ECB itself.

ECB: It's great sport to decry the Fed but the ECB takes the biscuit for bureaucratese nonsense. Last week, they stepped aside from the "macroeconomic imbalances" saying that unit costs must decline and competitiveness adjust but their focus was on price stability and integrity of the balance sheet. Thus, deftly passing the buck they assure us that the Macroeconomic Imbalances Procedure (MIP), the European Supervisory Authorities (ESA), the European Systematic Risk Board (ESRB), the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM), will all isolate the euro from financial turmoil (I feel better already). Last, one official said that there will be no policy action until July because that will focus politicians minds on reform. Way to central bank!

FOMC: There was a lot of "uncertainty" scattered through out the report. None of the participants sees much risk in inflation and the unemployment estimates cluster around the 7.5% mark. There was no discussion of any easing options. There was what looked like a plant story some weeks ago that they might engineer open market operations with sterilization, which in this case would likely mean selling an equivalent amount of any securities that they bought, but it was absent from the minutes. Nor was there any mention of mortgage purchases, which has kept MBS markets well bid in the last few months. So no easing or tightening. But with the two new Fed members on their way, more QE could come if the fragile condition in Europe deteriorates or we see a roll over in the economic stats. So stay tuned.

Economic Data: Most of the information last week, with the exception of the Philly Fed and the jobless claims, show a rebound. First up was housing, where starts broke through 700,000 and the March numbers were revised up 40,000. (For revisions, housing starts come second only to NFPs...they are nearly always off by 5% to 10%.) Here they are along with the 5-units or more starts. So we see a nice tick up in both measures and around 23% ahead of last year.

We watch the 5-units or more number because household formations are changing. For example, last week we saw non-revolving consumer credit grow by 5.5% but a good chunk of that was the federal government extending loans. And the only way they extend loans to consumers is through the Department of Education, i.e. student loans. These are now 26% of all non-revolving consumer loans and have risen four-fold since 2008 when they were 6% of loans. More loans mean less mortgage capacity. Which means less household formation. And here's another one showing how deleveraging works. This shows consumer credit as a ratio of personal income, which isn't growing much, coupled with a decisive drop in credit outstanding. Some of the drop is defaulting but either way, it's equivalent to about $900bn saved/not spent.

Other information this week broadly tells the same story of gradual rebound and "good under the circumstances," those circumstances being the net drag of government, deleveraging, unemployment and regulatory overhaul. Remember 87% of the US economy (i.e. GDP less the $2.6 trillion of imports) is domestic while the eurozone accounts for around 2.4% of total GDP. Any further damage in Europe will hurt S&P companies far more than the US as a whole.

Bottom Line: We touched treasury lows last week at 1.67%. The same happened with Bunds. Here they are.

They tell a clear story: 1) great concern on all assets except the most liquid and safest...even gold is down 12% since February 2) uncertainty on debt negotiations with ourselves in the US and intra-government with Germany 3) deflationary fears more resounding than inflation. The recent print on CPI showed lower gas prices helped keep a lid on prices but wages are not creating any upward pressure. With that, we have trimmed our long equity position and remain over weight in MBS. It's too dangerous to short treasuries.

Unless something breaks big this week, we'll probably skip TOTW for the upcoming week (Memorial Day).

Sources: J.P. Morgan Market Intelligence; FT Alphaville; ECB; Tim Duy's Fed Watch; Ian Shepherdson, High Frequency Economics; Federal Reserve Board; US Census Bureau; US Dept of Housing & Urban Development; Federal Reserve Bank of St Louis; Federal Reserve Bank of Philadelphia; Capital Economics; "Greece's Predicament: Lessons from Argentina", Peter Kretzmer and Mickey Levy; Sentinel Asset Management, Inc.

To see Sentinel Investments' Top 10 Holdings for all funds, please click here.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Last week saw more dire talk on the end of the euro, the lowest ever GT10 auction, a 2.2% swing in SPX[1] and an overly dramatic reaction to hedging losses at JPM[2]. But these are not big enough to push aside the broad positives: i) Europe will cobble together some compromise...there's already broad agreement that pure austerity needs dilution and the Bundesbank even made soothing noises on inflation ii) US economic data was broadly helpful iii) market metrics remain solid and iv) the federal government is in budget surplus. Yes, no lies. Read on.

NFIB: The monthly NFIB survey does not always get the attention it deserves. For months, businesses have said that, no, credit access is not a problem, but, yes, demand, sales, inventories and orders were, so there was no reason to raise capital expenditure plans. Then last week, they reported the strongest headline since December 2007 and signaled an intent to increase employment and capital outlays. We have seen a divergence between the ISM manufacturing numbers, which had been rising steadily since July, and the NFIB which is way off its peaks. They should move somewhat in tandem as the ISM is the big cousin of the NFIB.

But in the 2009 to 2010 period, small businesses were cut off from bank loans while larger companies enjoyed access to bond and equity markets. Now it looks like NFIB capex intentions are on the rise, not just to replace equipment but also to increase capacity. This should be good in the coming months especially if the trend to lower fuel costs continues. This is a very economically sensitive part of the economy and they are the key to a broader and more sustainable recovery closer to 3%. So watch this space. (HT, Ian Shepherdson).

Some of these Fed regionals: go along, not really saying much, then have a true "say what?" moment. Last week's was from Minneapolis Fed president Narayana Kocherlakota who argued that the dual mandate of maximum employment was all too hard to reconcile with a 2% inflation target. The basic thesis, not uncommon among those calling for inaction, was that labor participation rates were on the decline and that vacancy rates are higher than unemployment warrants. This is also called the Beveridge Curve. And the plots on the curve are not where they should be.

He then basically said if we're going to run 2% inflation (which for the record is just a Fed number and probably lower than the markets or the economy needs and it's an average number when it should be cumulative...but we'll let that go), then we may be near maximum employment. Ergo, he does not favor accommodative policies...luckily he's a non-voting FOMC member this year.

What's wrong with that?
1. There is scant evidence the natural rate of unemployment has climbed and that we're in some new era of labor scarcity. Certainly job losses and gains are pretty uniform across industries, if not wage cohort (see TOTW passim).

2. Calculating how Labor Force Participation Rates (LFPRs) change employment is tricky stuff but it probably has not led to much more than a 0.3% change in the unemployment rate, i.e. it would be around 8.4% not 8.1% if LFPR had remained constant.

3. Last week's JOLTS report saw a nice increase in private sector job openings but the drag from much lower growth in openings in the government sector means we are below what we need to increase employment. Here's the graph...still way off the peak.

And here's the difference between private openings to separations, so still running some 500,000 more separations than openings, which given the slowdown in government jobs, is not enough to create 144,000 monthly NFPs needed to reach 7.5% unemployment by 2013.

4. Wage inflation remains low. There's not much to suggest wage push inflation is on the way, whether we look at i) last week's Producer Price Inflation, which came in at 1.9% and has declined every month since last year's energy hike, or ii) wages. Here's wages as a proportion of all personal income...still some ways off inflation territory. And as we have suggested here before, a mild inflation overshoot would give much desired top line growth to companies.

Put all this together and the case for continued easing, especially in face of the fiscal drag, looks strong. An occasional straw man argument can be a fine thing but we need more momentum before positing inaction on the employment front.

That Fiscal Cliff: The expiration of the Bush tax cuts, payroll tax holiday, extended unemployment benefits and sequestration cuts on January 1st, 2013 amount to about 3.5% of GDP. And because it happens all at once, the hit to Q1 GDP could be as much as 5%. It's unlikely to happen but the talk is going to be around for a while yet. Interestingly, the April Treasury Statement came in last week showing a surplus for the first time since September 2008. April is, predictably, a good month for receipts so the trend won't continue. But diving into the numbers showed some reveals:

1. YTD spending in the big five departments, so defense, Medicare, Medicaid, Social Security and interest, was down 4%. Among the biggest hits was Medicaid aid to states, down 15%.
2. Federal interest payments were unchanged over the year, once the remittances back from the trust funds and QE are factored in.

Both of which suggest that the fiscal drag will continue throughout this year so GDP will be stretched to rise much above 2.5% this year.

One news item: that dominated the tape was the $2bn "loss" at JPM. This is not nearly as dramatic as it sounds. When a bank hedges its exposure it tries to overlay a risk control on its entire book. So that includes C&I loans, private loans, fee income, client trading, assets held at inventory, fees...everything. In this case, JPM most likely used instruments like credit default swaps, total return swaps, to hedge tail event credit risks. It's a complex balance sheet so the risk wasn't perfectly matched and they would have made some best judgments to minimize basis risk (i.e. the mismatch that occurs in every hedging transaction) to the underlying exposure. The hedge didn't work, maybe because the limits weren't set correctly, but the losses were netted against the gains in their available-for-sale portfolio and currently stand at around $800m.

Now, I'm all for a pig-pile on banks and this may not have been the smartest hedge. But they probably had the correlations right and it does not mean they misunderstood basis risk. So far, it does not sound like a breakdown in economic rationale nor does it appear systemic (i.e. no one else on the street is crying right now). JPM can easily absorb the losses and it barely affects their Tier 1 capital ratio. We doubt the story has legs. (HT, Jason Doiron and Helena Ocampo here at Sentinel) Generally, I support the Volcker rule, but you can't regulate stupid. And this was just stupid.

Bottom Line: For the last month, long duration governments outperformed MBS by around 500bp, the Barclays Aggregate [3] by 430bp, corporates by 380bps, high yield by 448bp and SPX by 883bp. So the place to be was i) long duration ii) governments and practically nothing else. But this may not last. Equities trade on an 8.2% FCF yield compared to Baa[4] bonds at 5.1% and multiples are not stretched. We still put new money to work in equities.

Sources: FT Alphaville, Ian Shepherdson, High Frequency Economics, Federal Reserve Bank of Minneapolis, National Federation of Independent Business, US Treasury Department, Federal Reserve Bank of St Louis, Bureau of Labor Statistics, David Altig, Bureau of Economic Analysis, US Department of Commerce, Bloomberg, Sentinel Asset Management, Inc.

[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
[2] To see Sentinel Investments' Top 10 Holdings for all funds, please click here.
[3] Barclays Aggregate Index is an unmanaged index that measures the U.S. investment grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. An investment cannot be made directly in an index.
[4] Moody's Seasoned Baa Corporate Bond Yield, source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis, Economic Research

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Markets tend to overreact and the last few weeks in France were no exception. Equities fell around 9% on the expectation of a change in government. On close look, the Hollande manifesto is modest...a change in retirement age here, a year difference to a balanced budget, a non-descript growth pledge, tax banks more, reduce immigration. There won't be much difference to the end game in Europe but there will finally be a more robust opposition to the German line. Markets also have notoriously short memories: socialist (i.e. left of center) governments are good for markets. Stocks rose vigorously in the years after leftist governments took control of France in 1981, Sweden in 1998, the UK in 1997, the US in 1992. The list goes on but the story is that ideologies give way to pragmatism with popular support. And it's the last item that matters most.

We also have a possible change in Greece, where things could get more hairy. Greece has a strange mix of first-past-the-post and proportional representation. Seven of the ten parties flat out reject the EU/IMF and two, with a combined 17% of the vote, would leave the euro all together.

This is all part of a bigger picture. Electorates everywhere are scalping one by one the governments who got them into, and failed to extract them from, the financial mess. We should not be particularly concerned as we need more answers than "austerity is the best policy."

ECB left rates unchanged. No surprise there. What was surprising is that Draghi thinks "recovery is proceeding" when the PMI composite (manufacturing and services) recorded its lowest level since mid-2009 and output growth hit a six-month low in Germany and France. The April numbers are thus likely to extend the downturn into the third successive quarter. There are two odd things coming from the ECB:

1. Repos: The ECB version of QE is all about repos. In the US it's all about government securities in a framework of asset purchase programs. Both place money into the interbank market and increase reserves. But in Europe the result is asymmetric. Southern country banks are holding government securities and contracting loans and northern country banks the opposite. And a large proportion of total liquidity remains in overnight deposits. Europe has no banking union so the result of ECB policy is hugely dilutive. And the repo means that if asset quality declines, the banks must re-up ECB collateral. It's all a very sticky transmission mechanism.
2. Bank recapitalizations: are needed in Europe and the message from the ECB is i) tighten credit standards and ii) recapitalize through retained earnings. Fair enough. But that means financing of demand growth takes third place.

On the bigger picture, adjustment by surplus and deficit countries must occur. Yes, labor reforms are necessary, but in the short-term, it would be good to see a rise in the relative price level in the core countries which would then deliver more dynamic demand. In this context, it's good to see that IG-Metall, Germany's influential cross-industry union, is likely to get a 6.5% wage rise.

The Nature of Jobs: A very modest jobs report of 115,000 but the revisions were solid, at 66,000 for the last two months. It's best to look at these numbers over a few months rather than just the headline. The last four months have seen job gains of 803,000 compared to 702,000 in the prior four months and total private payrolls have increased by 2.03m in the last year. So this latest number is probably some weather payback and not enough to change any outlook on QE.

Over the longer term, we must still worry about what jobs are on offer. In the recession, two thirds of job losses were in five industries, three of which were high wage sectors (construction, manufacturing, and business and professional services) and two in low wage sectors (retail and leisure). But in the recovery, two thirds of the job gains have come from three low wage sectors: retail, education and health services, and leisure. This is part of a longer trend. Here's manufacturing jobs as part of all workers. It has been in decline for years but arrested recently, which is part of the manufacturing recovery story. Still, this is a net exchange of higher for lower paid jobs.

And here's its corollary, leisure and hospitality workers as a total of all employees. It's clear, then, that the recession hit high-wage earners hard and the recovery is mostly in low-wage alternatives.

So why the drift? Many reasons including the great off-shoring, education, skill mismatch, etc. But one reason is this, which shows private non-residential investments over GNP.

It has bounced from the bottom but still way below the 1970s when businesses were truly scared. You can also see the flattening in the early 2000s. That's when investment moved into residences rather than plant and equipment. At that time, government incentives to pull investment into housing completely overwhelmed business investment. It should get better but it partly explains the slow and erratic jobs recovery.

Yes, Still No Inflation: The inflation gang usually respond to the "no inflation" facts with the "Aha, but expectations are high and they count more" theory. Well they're not. A study from the Atlanta Fed last week showed 74% of businesses expect unit costs to rise only 2% in the next year. For the next 10 years, 82% expect labor, input, productivity, margin adjustments or sales to have no material effect on unit labor costs. So if they don't see any price inflation then they must expect only low demand. And here it is:

The DPI per capita declined by 0.1% in March and hasn't moved for years. That puts a cap on wage and price inflation.

Bottom Line: The market did not like the employment number because it rules out QE3. But that was ruled out at the recent FOMC meeting. We're seeing very little directional trade. Yes, there's support at the 1350 levels for the S&P but we don't see much push beyond 1400. The themes we like are i) companies with cash flows, dividend growth and high margins and ii) trading GTs, often on intraday levels. Fund managers (not us) get bored with investment themes quickly. But the best ones can run for years.

Sources: "Pourquoi un chapeau ferait-il peur?", Le Petit Prince, Antoine de Saint-Exupery, European Central Bank, Bloomberg, VOXEU, Peterson Institute for International Economics, Federal Reserve Bank of Atlanta, HSBC, Federal Reserve Bank of St Louis, Bureau of Labor Statistics, Sentinel Asset Management, Inc.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

In March 1925 Lord Beaverbrook held a dinner with Chancellor Winston Churchill, Keynes and a number of pro-gold standard Treasury men. The debate centered on whether a return to gold would:

Keynes, of course, was in the second camp. He knew of the "paradox of unemployment amidst dearth," when an economy can not clear wages and prices, and falls into a liquidity funk. No matter how much rates are pushed, the desire to delever and withhold purchases prevents growth.

The Treasury position prevailed and reluctantly Churchill went along. One month later, Britain restored the gold standard. It lasted seven lean years. Everything Churchill and Keynes feared came true. Not one of the alleged benefits materialized. Churchill called it the worst decision of his career.

Sounds Familiar: Since the first Greek drama started two years ago, we have had much of the same debate: downsize from prosperity and embrace successive austerity programs in a race to the bottom. Last one standing collects the spoils. But there were none to be had. Rentiers may have garnered a few points on bond holdings but the core economic data deteriorated and, most of all, in the most socially costly sectors: unemployment, youth unemployment, declining asset values and wealth. After five governments lost their mandates, enough people are saying enough. About time.

We had some of that this week starting in Europe, where the Netherlands, with one of the largest current account surpluses in the world, proved unable to deliver concretionary programs that would have shaved about 1 point off the Debt/GDP ratio. The bonds barely moved and remain at the same level of a year ago. Which suggests investors would prefer a systematic program for growth than the water torture of fiscal tightening. Expect Spain next. Then France if there's a government change. And if Germany is the last one to defend the austerity plans, it's going to find itself increasingly isolated.

Two Observations on Europe:

• One, the ECB has a curious one-and-a-bit mandate. Its objective is to maintain price stability and "support...Article 2 of the European Treaty." Scoot over to said Article which says "promote social progress and a high level of employment." So pass on the first and fail on the second. Draghi seems to take the second more seriously than his predecessor and is grinding his Bundesbank partners into attrition. Good.
• Two: Europe has a demographic problem. Plenty of elder and soon-to-retire workers. Fewer entering the workforce. When this happens, creditors, which tend to be the first group, obsess about the purchasing power of nominal debt. And if they see low rates and inflation, they throw out the "Help, we're being repressed" line. Policies that engender growth may well lead to employment, demand, price increases and reductions in real debt burdens (which the elder group had in spades in the 1980s and 1990s). It really can lead to a division between creditors and producers. To date, creditors have won. That's why many banks are still standing. But the wins must start accruing to the producers and workers. That may be starting in Europe.

Two steps forward, some back. US GDP releases last week showed lower growth, at 2.2%, than Q4's 3.0%. Mind you, revisions in Q1 can be high. Last year we started at 1.8% and ended up, two revisions later, at 0.4%. Personal Consumption, the 70% of GDP that really matters, rose 2.9% but defense spending fell 8.0% annualized. The government sector, federal, state and local, continues to contract. This is the era of diminishing economic force of the government. Here's Government Consumption, Expenditures and Investment (although the last one is less in nominal terms than it was two years ago) against GNP. At this rate there won't be much to argue about for a smaller government.

Wages and salaries rose 4.6% but taxes rose nearly double that so disposable income growth is still under stress.

Regional Fed surveys: from Kansas and Richmond showed similar trends to the Empire and Philadelphia last week. Business conditions and shipments down but orders and employment up. This should be good for the next few months. This time last year many of these indicators were pointing down and we saw a subsequent roll off in activity. Another number that wasn't as bad as it looked was durable goods. The headline was down 4.2% annualized but still 9.0% up on last year and the unfilled order books remain high. Here are the two: very spiky on the orders, less so on the unfilled, which is what you would expect, but the ratio between the two is 4.6 vs. 4.3 a year ago. That means a pipeline of activity that should spell good news.

Bottom Line: Markets seem to be taking the broader economic news in their stride. The FOMC confirmed its policy, so no new buying but also no unwind on the balance sheet. That was enough to keep GT10s below 1.98% for much of the week. The demand for safe assets remains very high and that leads us straight to MBS where we maintain a very over-weight position. Equities are drifting higher, which we like as we increased the position some weeks ago. It helps that positive surprises outnumber negative surprises by 3:1 so far this earnings season. We continue to put new money to work in equities. The market tends to overreact to news which suggests there's lack of conviction. But at least there's no over-valuation. We're at the same multiples as a year ago.

Sources: "Depression is a choice," Steve Waldman; Martin Gilbert, Winston S. Churchill, Vol. 5, 1976; European Central Bank; Federal Reserve Bank of Kansas; Federal Reserve Bank of Richmond; Federal Reserve Bank of New York; Federal Reserve Bank of Philadelphia; Federal Reserve Bank of St. Louis; Bloomberg; US Census Bureau; US Bureau of Commerce; Bureau of Economic Analysis; US Department of Commerce; Sentinel Asset Management, Inc.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

First quarter markets flirted with euphoria. Jobs numbers were good, the Fed kept its head and confirmed a stable policy, Europe was quieted through the LTRO feedstock and corporate earnings looked good with the bank stress tests and a California fruit company powering ahead. But, understandably, and as with any attention disorder patient, markets need caring support. The catalyst for the recent drops was surprisingly benign: Spain and Italy are finding it tough to implement austerity, the Fed is not promising QE and earnings are going to be spotty as world growth prospects dim. Nothing much to worry about and we haven't changed our positions or outlook.

All in a line: Three Fed Governors, Raskin, Yellen and Dudley, said similar things this week. That we're not out of the woods...and there's still downside risk, that a more accommodative stance...helps the wealth effect and future easing could be warranted if recovery slows. All of which seems clear that the economic marks do not require any acceleration or change in policy but that, yes, it will come if needed. None of them believes inflation is a concern. This seems sensible (see below). The Fed understands the difference between relative price movements, that is prices reacting to market forces, like gasoline and refinery capacity, and across the board cost-of-living changes. There remains histrionic commentary on the inflation front. But it is not showing up in the wider stats or in capital markets...

Latest Inflation: both Consumer and Producer prices showed very little activity. Core inflation was 2.3% and 2.7% respectively. Commodity costs benefitted from favorable YOY comparisons rising 2.1% compared to 4.2% in December. The single largest component of CPI is OER. This is what it looks like:

It used to run systematically higher than core inflation. The reverse is now true. Both metrics are significantly below historic levels.

And of course this helps too. This shows earnings growth barreling along at, whoa, less than 2%.

We're of the school that monetary growth can not cause inflation on its own. The money must be dispersed. If it sits in excess reserves, it is not dispersed so it can't feed into the real economy. And if it can't feed into the real economy, then demand doesn't grow much and labor can not push for higher wages.

Exports: continue their multi-year growth and it's one reason we favor companies in the automation, capital goods and industrial sectors. Here's a simple measure of annualized exports over GNP. Its a bit lagged because we have February exports, at $181bn or 25% above the levels of two years ago, but only Q4 GNP. But...read and weep: if you're competing against the US, because these are moving to be a significant driver to growth and are worth about 0.2% to Q1 2012 GDP.

There are three main reasons for this (HT Tyler Cowen):

1. Robotics and automation are defining how modern assembly processes work and that means that labor is a less important cost input.
2. Shale oil and gas have led to significantly lower costs. US gas costs are around $2.00 MM/BTU or 12% of Japan's and 20% of Europe's. The US also has a greater capacity to monitor environmental concerns which is not the case in Europe.
3. Emerging market demand. As economies move up the living standard scale, the nature of imports changes from raw materials and infrastructure to higher quality goods in aircraft, semiconductors, pharmaceuticals and machinery-in which the US excels.

Please, let's do this: Reform Money Market funds. Both Bernanke and Rosengren from the Boston Fed outlined their concerns about this giant shadow banking playground. The reforms on the table are modest: provide capital, float the NAV and restrict liquidity. This all started years ago when fund companies set up liquid investments to compete against Reg Q. They were sold as a security with a $1 NAV...not guaranteed, mind you, but the fund sponsor would "strive but not guarantee..." as the prospectus said. They were then pretty much sweep accounts at the wirehouses and fund families.

In the early 90s, several funds got into trouble and the ICI decided a broken NAV was unacceptable and several fund companies made up the difference. The SEC said "righto" and tightened up asset quality metrics (Rule 2a-7).

Then in the next decade, the funds i) opened up to corporate treasury markets ii) became a shadow banking system iii) became large and iv) systemic. The SEC said "righto...just make sure you put that not-guaranteed bit up-front on the prospectus". And the fund companies said, "no prob" but "no thanks" to putting up capital in case of a NAV break. Then the Reserve Fund came along and messed up the party. Now they're all in a tizzy because the money fund concept really breaks down if there are liquidity restrictions, NAV adjustments or capital requirements. Profitability plummets and the product may just as well be a bank account with a nice FDIC guarantee.

Fund companies continued to support their NAVs in the last few years (i.e. put dollars into funds to prevent a break) and held defaulted securities. The Fed's position is merely to control potential losses and a run on the system. The industry opposes it. I'm not sure where this will end but welcome any changes which prevent these assets coming into the taxpayer domain again.

Seems like a digression? Well, back to the opening. The markets remain very skittish on credit events, especially ones that are not contained. We're not going to eliminate the risks but mitigation makes sense.

Bottom Line: The new range of 1380-1420 is a good place to consolidate but 1390 seems to show some resistance. We're still buyers. Treasuries are in a good trade pattern and we would lighten up on IGs given the spread gains in March.

Sources: US Census Bureau, US Bureau or Economic Analysis, Bureau of Labor Statistics Federal Reserve Bank of New York, Federal Reserve, Bloomberg, Federal Reserve Bank of St Louis, "What Export Oriented America Means" Tyler Cowen, "Money Market Mutual Funds and Financial Stability" Eric Rosenberg, Federal Reserve Bank of Boston, Sentinel Asset Management, Inc.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Where did we come from? Most commentary continues to use pre-2008 data as a baseline, whether for economic data, policy, household behavior or corporate prosperity. This is a mistake. Orthodoxy is almost irrelevant. But history is not. We remain in a liquidity trap. As a reminder, this happens i) when asset prices fall ii) the private sector delevers iii) credit demand becomes inelastic, i.e. immune to price iv) savings increase v) income balances between the private, corporate, net export and government sectors distort and vi) the reluctant leakages destroy aggregate demand. Throw in higher credit standards and necessary re-regulation and you can see why austerity economics is the final, stunning bullet.

This is what households look like in a liquidity trap...assets fall, deleveraging increases and the sector pulls back on demand.

The correct monetary response is to drive to the zero bound (ZIRP). Anything else is viciously pro-cyclical. To the monetarist school, this reeks of debasement, incipient inflation and devaluation. To pragmatists, it's the only way to restore balance to aggregate demand and the increase in the money base means nothing. And it means nothing because excess reserves and bank balance sheets simply do not move. In the jargon, velocity declines. The trap is complete. Nominal rates are low. Real rates lower. And more money drives up the demand for safe assets. The way to score this game is deflation. If deflation is avoided, with all its pernicious effect on collateral, wage stickiness and weird math (think Japan where nominal declines in GDP translate into real gains as prices adjust down), then policy has succeeded. So what you want in this situation is low rates, an expanding money base and a government sector to fill the void. Meanwhile prices barely move except for some commodity adjustments and inflation expectations plummet. Here's what happens when the government is able to borrow at negative rates and when leading inflation indicators, like trimmed PCE, are at 1.8% and falling:

The final question from believers in orthodoxy is, "Ah ha...but what happens when the CB has to unwind?" To which there are three responses: i) the balance sheet remains high for there is no rule that says CBs must reduce their asset purchases ii) assets are held to maturity, thus there's no open market selling or iii) demand for risk assets increases as real activity increases and that demand is only likely to come from fiscal policy. In the absence of that, it's going to be lumpy. Which is why....

That one big statistic: NFPs came in lower than recent claims predicted. The unemployment rate improved, participation fell a bit and underemployment fell by 0.5% to 14.5%. Revisions were fewer than they have been but still upward. The way to make sense of these is to look at trends over the last year. We have 2.12m more people at work than a year ago, 254,000 of those in manufacturing (remember the multiplier effect for these jobs is probably twice those of service sectors) and 180,000 people fewer in government jobs. So the theme remains: slow but incremental manufacturing and industrial growth and job creation, cautious hiring in the private sector and a government sector determined to administer austerity and pain. Although to be fair, that's no one's stated policy. It just happens because of orthodoxy fighting the inflation enemy of two wars ago. Think of it as Napoleonic tactics in a guerilla war.

But other employment data remains solid. Claims came in at 357k and a 4-week MA at 361k...on a solid down trend. Compare to 392k last November, put together with better consumer confidence, solid manufacturing numbers from ISM, good employment indicators from ISM Service and Manufacturing, plus regional Fed surveys showing calm expansion and we have a nice underpin. Job creation is likely to show an upside bias. Why? The GDI/GDP dispersion suggests growth is better than headline and the "birth/death" cycle of new businesses from BLS underestimates new business creation from 2009 low.

FOMC minutes: were better than the market gave them credit. There's still slack in the economy; inflation pressures are temporary (and by implication deflation remains a risk); employment is better, but not where members consider it solved; and all options remain open. What could be better? Other regional Fed comments support the policies...some just think changes could come sooner than 2014. This may have led some of the hawks on:

But it's highly unlikely that costs are pulling away, especially as these are not necessarily wage costs but associated benefits and pension costs. Neither of which is remotely inflationary. So the interpretation was that QE is off the table. Unlikely. Wait until we see another set of employment numbers and any sign of a roll off in production, regional Fed and manufacturing numbers.

Equities: The new range of 1380-1420 is a good place to consolidate. One broad metric we continue to like is the earnings yield of around 7%. Compared to bonds at 2% this represents a nominal risk premium of nearly 5%. And let's look at other drivers:

Bottom Line: Remain in large cap equities and IG corporates. GTs look rich again following the NFPs. Closer to 2.00% and we'll put in the shorts again. And again, high to MBS.

Fantasy Tax Plans: Because it's April. Some tax plans put an awful lot of faith in low top-rate marginal tax rates as a job creation tool. Another way I think about it is to create a picture: say, a doing-well I-banker paying a 40% vs. 35% rate. Does the difference really mean that they're not going to hire that additional gardener? Of course not. It may change whether little Aphrodite gets a Chris-Craft to go with the Cayenne. But offering a full-time paying job?

Because I suspect there's a big difference between highly paids and job creators. They're not the same person. Highly paids are in corporations and (as we know) overwhelmingly in financial services, etc. I have never met a manager or CEO who makes hiring decisions based on compensation or tax rate. Job creators are typically small entrepreneurs and their income tax rate, especially after all the deductions, probably has very little to do with their desire to hire.

[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Sources: "Does Central Bank Independence Frustrate the Optimal Fiscal-Monetary Policy Mix in a Liquidity Trap?" McCulley and Pozsar, Federal Reserve Bank of St Louis, Institute for Supply Management, Bureau of Labor Statistics, Federal Reserve Bank of Dallas, FT Alphaville, Tim Duy's Fed Watch, Sentinel Asset Management, Inc.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Good week ending an even better quarter. We like this rally because i) large cap stocks were in line with small and mid, that means less speculative juice and more reality investing ii) GTs came unglued fast but iii) Baa[1] spreads came in thanks to low net issuance and high demand, again crushing the crowding out theorists but, no matter, iv) Europe came back from the brink and fewer daily catastrophe headlines and v) the Fed gave plenty of information to not expect a policy reversal. This is solid stuff and markets feel better than this time in 2010 and 2011 when we saw spring sell offs. So what's behind all this? Start with:

GDP Data: We did not get the expected upward revision but, instead, confirmation of 3% growth. It was the only quarter in 2011 when final numbers exceeded initial estimates. There were three big things going on here:

Personal income: held no surprises. We continue to see very low increases in compensation and wages, up 4%, and big hits on the outlays, like taxes paid (17%). The real story here is that, yep, again, real DPI per capita is stuck, thus tempering demand.

And without pull demand, you don't get much inflation. Here's the PCE core and the GDP deflator running on empty. More people are coming out of the woodwork complaining about suppressed rates, Fed buying and inflation. But if you worry about this, you must jump over: i) better performance across the economy ii) a housing recovery iii) real DPI increase iv) capacity constraints v) a messy unwind of the Fed balance sheet and vi) core CPI increasing to a solid, consistent 4%. Meh...not going to happen.

So there is really nothing to see on the inflation side, which means that there's no reason for the Fed to turn hawkish but still leaves open the easing window. That's a nice combination.

Bonds: There's a new range in town. So don't expect a big move from 210 to 240 or so. The risk/reward trade off is out of balance with a duration of nearly 9 on the GT10. At today's yield of 2.22%, a fall to 2.10% in a week would return 1.1% and an increase to 240, would lose 1.5%, or over half coupon. So it pays to be opportunistic and very aware of downside exposure. Corporate bonds are a different matter. There's limited supply and excess demand. Last year, net corporate bond issuance was $24bn. This year, net supply after coupons may be as low as $9bn. Yet, demand from long liability managers like insurance companies and underfunded pension plans is probably twenty times that.

Which explains why Russia was able to tap bond markets for $7bn this week at spreads as low as 230bp over treasuries. The same Russia that in 1998 had 40% lending rates, an IMF austerity program, lost around $11bn defending and then floating the ruble and defaulted on its debt. Which makes a nice playbook for Greece should it run into problems.

Stocks: We remain net buyers of equities and particularly large caps. The P/E ratio on the SPX[2] is about 14 and FCF yields around 7.5% compared to Baa of 5.2%. Back in 2007 it was 6% for Baa and 2% FCF yields. A quick round of other economic stats for equities:

Put all that together and we can see why banks passed the earnings season well and the stress tests better and companies have started to raise dividends and repurchases...these are now running ahead of earnings.

Bottom Line: Trading into large cap equities and corporate IGs. Waiting for the lower quality rally in RTY[3] (up 37% since October) to peter out. Then we'll buy. Zero allocation to GTs but high to MBS.

Sources: Federal Reserve, Federal Reserve Bank of Chicago, Federal Reserve Bank of Kansas, Federal Reserve Bank of Richmond, Federal Reserve Bank of St. Louis, Bureau of Economic Analysis, US Department of Commerce, Tim Duy, FT Alphaville, Merril Lynch, "A Case Study of a Currency Crisis: The Russian Default of 1998" by Chiodo and Owyang, US Census Bureau, US Bureau of Commerce, Bloomberg, Sentinel Asset Management, Inc.

[1] Moody's Seasoned Baa Corporate Bond Yield, source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis, Economic Research
[2] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
[3] The Russell 2000 Index is an unmanaged index that measures the performance of 2000 small-cap companies within the US equity universe.

Jason Doiron
FRM, PRM, SVP - Head of Fixed Income & Derivatives
Sentinel Asset Management, Inc.

I estimate that I inadvertently watch 12 hours of financial news programming per day. Too much television? perhaps, but for a portfolio manager it has become an occupational necessity. One of the greatest benefits to watching this much television is that I can recite verbatim every commercial that plays on CNBC with no clue which company is sponsoring the ad - pig on a skateboard anyone? The other benefit is that I am provided with a front row seat to a rogues gallery of pundits who describe the complexities of the financial markets through sound bites.

After a close contest with "kick the can down the road" and "tail risk," the undisputed champion of sound bites since 2008 has been "risk-on / risk-off." Both terms accurately describe the market sentiment for certain periods over the past 3.5 years. But as with all good sound bites, the useful life span of these terms is quickly coming to an end. Before we bid farewell to these terms, let me explain my reasoning for predicting the demise of risk-on / risk-off.

1) Irrelevance:
No other term more accurately described the market sentiment in 4Q08 and 1Q09 than risk-off. During the summer of 2011, the term risk-off accurately described the sentiment in certain sectors of the fixed income market such as CMBS. But the term risk-off does not accurately describe a 2 point sell-off in the SPX [1] on a Thursday afternoon before a 3 day weekend in July. That is simply called a pull back.

2) Professional:
I can assure you that the terms risk-on and risk-off did not originate from anyone in the risk management profession. Risk management professionals do not reduce an opportunity set down to a binary outcome such as on/off. If a true risk management professional were trying to describe the risk on/off phenomenon, they would use a term like homoscedasticity.

3) Fundamentals:
The demise of the term risk-on / risk-off should be a welcomed event by investors. Over the past three years, the only question that investors have needed to get right is risk-on or risk-off. Investing became a binary outcome where the instruments that you utilized to express either of these views mattered little as long as you got the on / off call correct. This seems easy enough but in a homoscedastic world, the benefits of diversification will prove to be futile in your fight against the risk on / off mentality.

We are starting to see an investment landscape where fundamentals matter again. A landscape where securities derive their value from the fundamental underpinnings rather than from a headline on failed votes regarding debt ceiling limits or sovereign default write-downs. The pundits will need a new sound bite to succinctly describe this landscape so I offer up. Heteroscedasticity!

Sources: Sentinel Asset Management

[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Last week was the week things started to turn. Most important, the GT10 spiked to 2.27%, a loss of around two points. This was a break from the tight 1.90% to 2.10% which we saw from November. Meanwhile equities continued to gain. Why?

FOMC: Sometimes it takes a while for Fed policy to sink in and the monthly statements are mini art forms. Parsing reveals much. This one said that expansion is solid, employment conditions improved and inflation subdued. So far so good. Then they threw in that financial markets pose much less of a risk (ok, some freedom of interpretation), which was a hat tip to the euro LTRO programs, and that gasoline price hikes are probably not going to drive broader inflation. Finally, the commitment to keep rates in place through 2014 restates the intent to maintain loose policy until all the major indicators turn more. The one data point that is throwing mixed signals is the GDP/employment trade off. Unemployment has fallen faster than growth would suggest. This is probably due to changes in the labor force and that productivity growth has fallen off. Either way, we have a clear path to additional easing if needed but no imminent QE3.

Testing the Stresses: The Fed also announced results of new stress tests. The majority of banks passed. This was only for complex bank holding companies (BHCs) but they are the ones that matter. There was a lot of rigour in setting the tests: 25 tests, ranging from a peak unemployment level, losses on bonds and mortgages, overseas recessions, falls in commercial and housing real estate prices. Ten plagues. And all with the proposed post-Q1 2012 capital actions. This led to projected losses of $534bn and a Tier 1 capital ratio of 6.3%, which is higher than the pre-TARP 5.5% level of 2008. Why so good? Put it down to deleveraging, equity raises and lower trading and counterparty losses than were in the system five years ago. Only one firm (ALLY[1]) failed outright. One insurance company, that only signed up as a bank holding company in 2008 for, ahem, welfare, and is giving up its banking subsidiary anyway (so there), was denied its dividend plans. The results now open the way to more distribution of capital by the banks.

And deleveraging goes on: The Flow of Funds report makes interesting reading. First, total debt (excluding financial sectors because that throws up unnecessary distortions like money market mutual funds usage) as a proportion of GDP is declining. This is mostly in the household and business sectors, with government filling some of the gap, which is what you want to maintain some order to aggregate demand.

Second, here's household net worth as a multiple of disposable personal income. Falling house prices did most of the damage here and, as we've discussed, real DPI has been under pressure for years. What we would like to see is a continuation of 5:1 ratio. That should be enough, along with higher employment, to build consumer confidence.

And third, here are corporate profits as a ratio of wages. It's never been higher. This explains the productivity gains in business and the ability to repair balance sheets. That's all good but we would prefer to see this number track sideways for a while because it would suggest wider employment gains, real earnings increase and broader demand. Stay tuned.

Finally, we saw treasury securities net issuance down over the year from $1.5tr to $1.0tr, and $222bn of corporate bonds and equities withdrawal (i.e. capital shrink). This means there was no crowding out or problem with the supply of financial instruments (although a negative 10-year TIPS yield would tell you the same thing). But that there is a demand problem. The economy is deleveraging, growth slow and quality assets in demand.

Economic Stats: Fairly light this week but what we saw was good. Job openings from the JOLTS survey remained unchanged. Retail sales increased 6.3% YOY. Recently some of that has been gasoline and autos, which sometimes go hand in hand (higher gas prices, more purchases of fuel-efficient cars). And the NFIB showed a small gain in overall confidence. Their job numbers and capital spending plans were much better.

So:

1. put a Fed message that no balance sheet action looks necessary, together with...
2. a clean bill of health on the BHCs,
3. better economic stats,
4. but an economy still deleveraging and with capacity...

and you are left with the conclusion that QE3, at least in the form of buying long-term assets, is off the table. For now. And that sent bonds sharply lower.

Bottom Line: Bonds are now outside of the recent range, especially in the 30-year. We could see another 10bp retrace to 3.50%. Equities have had a good run but still have reasonable valuations. New money goes to IG bonds. Spreads are approaching their long-term mean but demand from natural buyers is high.

Sources: Federal Reserve Board, Bureau of Labor Statistics, US Census Bureau, US Bureau of Commerce, National Federation of Independent Business, Federal Reserve Bank of St. Louis, Sentinel Asset Management, Inc.

[1] No Sentinel Fund held a position in Ally Financial, Inc. (ALLY) as of March 16, 2012.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Some confusing signals on whether QE3 will come. Mr. Bernanke did not mention it in his congressional testimonies. Then the idea of sterilized QE surfaced. "Sterilized" just means the Fed buys long-term bonds, probably mortgages, and borrows the money back in open market operations. It's not much different from regular QE but calms the inflationistas somewhat. The window for a new QE round opens in April-June, when Operation Twist ends. Beyond that, politics gets in the way.

The following matter to the Fed: job creation, commodity prices, the dollar and consumption. Those indications are fair but could reverse. So it makes sense to keep policy unambiguously expansionary, which, again, goes back to the 2004 playbook of as much transparency and communication as possible...even if it is by proxy.

Will oil prices hurt the economy? No. Recent good news on the economy has come with warnings of possible demand destruction from higher oil. This is overdone. First, let's stress that QE does not cause higher oil prices. There are too many iterations between increasing bank reserves and the trading firepower needed to drive spot oil prices sharply higher. And while we have seen a sharp increase since September, we're no higher than a year ago. During that time economic prospects dimmed then brightened, MENA troubles flared, receded and then grew, and Asian demand steadily rose. So prices increased. But there are reasons to be sanguine:

Put all this together and risks to the US economy look manageable. A big price shock further into the driving season could change things. But not yet.

Repression Part...lost count: Another Fed Governor, Sarah Raskin, reminded us that households invest only 7% of their assets in transaction accounts, CDs and savings bonds and much more wealth in economically sensitive instruments like real estate, equities and retirement accounts. And it is these assets that the Fed wants to improve. So any complaints on low yields for savers receives short shrift. This reflects the recent Flow of Funds report, which shows continued deleveraging, and net worth still $6.7 trillion below its peak. She recognizes the only way to rebuild this will be through jobs, confidence and output. So she must be encouraged by....

Employment: where we saw NFPs rise by 227,000 and another revision upwards of the prior two months. In the last six months, we have seen employment revised up by 240,000 to a total of 1.2m. The government sector continues to shed jobs, 226,000 in the last year, while the private sector added 2.2m.

Participation rates ticked up slightly but the long-term trend is that fewer people are choosing to work and the demographics of new entrants are flat.

It's becoming increasingly clear that, no, we do not need 400,000 new jobs per month to lower unemployment; we need more like 150,000. That reflects the workforce changes underway as we a) limit immigration and b) adjust to the retiring baby boomers. Finally, the underemployment numbers improved again to 14.9% and the median duration of unemployment fell to about two weeks less than it was a year ago.

Overall a strong report with every chance that we will see more of the same next month. Other good signs this week were ISM Non-manufacturing and Productivity and Costs reports which suggest that real hourly compensation is increasing more than productivity: good for confidence and consumption but less so for corporate profits, at least in the short term.

Bottom Line: Bonds remain in high-risk territory. The GT10 carries a duration of 9.0 and a yield of 2.02%. Corporates offer better value but the spreads are tight and in recent years have tended to widen out post earnings season. Domestic equities get the new money.

Sources: Empirical Research; Jim Hamilton, Econbrowser; FT Alphaville; "Conducting Monetary Policy at Very Low Interest Rates" by Bernanke/Reinhart; Federal Reserve Board; Bureau of Labor Statistics; Institute for Supply Management; Federal Reserve Bank of St. Louis; Sentinel Asset Management. Inc.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

No So Risk On: The highly anticipated second round of LTRO turned out a damp squib. The amount and the number of participating banks were up on the December round but there was no immediate push on the euro or risk assets. That's as it should be. The program is much more about providing vital finance to the banks and preventing a financing crisis.

Part of that financing crisis: started in the US with money market mutual funds in 2010-2011. It worked like this: i) many funds went in search of yield through quality commercial paper but ii) many non-financial companies reduced their funding needs and issuance, contracting 10% YOY; meanwhile iii) European financials needed access to wholesale funding and the money funds obliged but then iv) financials started to suffer asset deterioration as the spring/summer/ fall crisis hit their ratings, so v) US money funds withdrew financing to comply with their own rating requirements. That left European banks short on funding which opened the door for the ECB to create its own long-term repo program. So that's what is meant by systemic risk. Many market participants don't see that. So many are hostile to Dodd-Frank which specifically addresses systemic risk. But they're wrong.

LTRO-2 allows relief on bank capital: and has led to tightening in sovereign spreads...primarily because banks use sovereigns to rebuild capital ratios. It could lead to more C&I loans but demand is flat because the economic stats are not encouraging. Eurozone unemployment notched up to 10.7% and inflation to 2.7%. It is this tug-of-war that the ECB is trying to solve: austerity economics, slow growth, bad credit against barely resolved sovereign problems. The Germans contributed to the debate by saying the ECB should never have lowered rates last December.

Markets like to have it both ways: back in January, the FOMC said the economy was weak, hinted at QE and the market went up. Last week, Mr. Bernanke said that some things were positive, like employment and household spending, but that risks, like gas prices and slower than forecast growth, remained and, no, there was no need to change monetary policy...so no QE. And the market went up. Therefore, you would conclude that QE is good for asset prices and so is growth. But we will get one or the other. Not both. Ultimately, growth must underpin market appreciation. And some of last week's stats supported this:

1. GDP revisions: were broadly positive. There was higher growth in personal consumption, exports and investment but the government sector reduced growth by nearly 20%. Government expenditures' contribution to GDP fell in six out of the last nine quarters. Here it is and you can see the mid-1980s peak, a drastic fall off in the 90s, a big gain in the 2000s, and then a fall since 2009.

   
   
   Source: Federal Reserve Bank of St. Louis, Economic Research
   
   

   This is not to say that government expenditure as a driver to the economy rises in Republican years and falls in Democratic years. I'm not saying that. But the data is.

2. Two More Points: First, deflation still looks like a potential threat. Here's the GDP deflator. That's a hook down over on the right. Nominal GDP grew at a slower rate in 2011 than 2010.

   
   
   Source: Federal Reserve Bank of St. Louis, Economic Research
   
   

   And slow growth in nominal GDP continues to put downward pressure on real disposable income per capita, which came out last week and shows, again, just how slow is the consumption side of the economy.

   
   
   Source: Federal Reserve Bank of St. Louis, Economic Research
   
   

   Put all this together, and you can see how uneven is the recovery and that the role of government, post the 2009 Recovery and Reinvestment Act, has been irrelevant as a growth driver.

3. Two regionals: again pointed to slow but steady growth. The Richmond Fed has a good record on employment and showed a large gain on the manufacturing and services side. Similarly, the Chicago Business Barometer reported its highest employment level since 1984. This should be good for this week's employment report. The market will like anything above 150,000 for NFPs.

Bottom Line:

1. Volume: There's still no major conviction in the rally. Too many cautious investors out there keeping a wary eye on their gains.
2. Russell 2000: has broken down recently; the mega caps have overshadowed it.
3. Employment: Still the most sensitive number. Anything above 150,000 is fine but confidence will be shaken if it's much below.
4. AAPL[1]: The most over-owned stock in the market (reminds us of QCOM[2]) and accounted for about 20% of February gains. Watch for the 3/7 product launch because it has a very "buy the rumor, sell the news" following.
5. The Fed is sticking to its script: and with the growth numbers, this means that GT10s are likely to remain exactly where they are today, around 1.80% to 2.10%. Lots of backing and filling.

Sources: CLSA, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Richmond, Federal Reserve Bank of Chicago, Federal Reserve Bank of St. Louis, Federal Reserve Board, Institute for Supply Management, Sentinel Asset Management, Inc.

[1] Apple, Inc. (AAPL) was 4.8% of total net assets of the Sentinel Capital Growth Fund and 6.5% of total net assets of the Sentinel Growth Leaders Fund as of March 2, 2012.
[2] Qualcomm, Inc. (QCOM) was 1.5% of total net assets of the Sentinel Capital Growth Fund and 2.8% of total net assets of the Sentinel Growth Leaders Fund as of March 2, 2012.

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Do we have a deal? Up to a point. The headline on Greece is that the PSI will accept i) new bonds with a face amount of around €31(the current 10-year trades around €22) ii) EFSF notes with an even stiffer haircut and iii) some GDP-linked securities which allow for additional coupon payments if Greece meets specific growth targets. In return, Greece undertakes labor and pension reform, some privatizations, etc. All standard. Read any way it's an austerity deal for Greece that may result in the debt-ratio falling from around 160% to 130% by 2020. It's all going to lead to more unemployment and a painful internal devaluation. And it is not at all certain that Greek authorities can deliver. But all this is known and much of what we hear about Greece is noise. The worst may be over.

LTRO: Full marks for Draghi executing some deft monetary policy. The ECB, having sat on the sidelines and repeated the inflation mantra for most of the last two years, offered the three-year LTRO in December that took much of the funding pressure off banks. The LOIS-EUR spread fell from a December high of 104bps to 65bp and risk assets took off. The ones that matter are European bonds. Since December, Bunds, OATs, Spanish, Italian and Portuguese bonds appreciated by 3% to 15%. Some of that is banks buying their own sovereigns to ease liquidity. But this is no simple carry trade. Some will find its way into companies and households. The second of the LTROs hits on Wednesday. Estimates are all over the place but somewhere between €500bn and €1 trillion looks likely.

Inflation: Regular readers know we have a tough time seeing inflation anywhere in the economy. We get the printing press, monetary argument. And gasoline. It's just that for the first, money still has to flow into the real economy to hit CPI (asset price inflation is another subject) and the M2 multipliers are nowhere near where they need to be to kick start inflation. And for the second, it's daft to base monetary policy on a refinery shortage. There are some good signals ahead:

1. Increased Grain Production: Farmers will grow 94m acres of corn this year, up 2.3% from 2011 and the most since 1944. Coupled with a slowdown in ethanol use (finally), average corn prices look set to fall 19% this year.
2. Medical: We have seen alarmist estimates for increased healthcare costs. Medicaid and Medicare represent 42% of government social benefits so this produces some worrying projections about costs and deficits. But here's what is happening:

Increases in medical care services, about 5% of the CPI basket, are slowly coming down and have shown remarkably steady growth for the last two years. They are not growing any faster than the general inflation rate. If this continues, the myth of escalating healthcare costs may need a re-think.

Put these two together and join it with no real increase in disposable income or earnings and the inflation outlook looks benign. This was probably the thinking behind the FOMC projections of low inflation...and they have a good record on inflation forecasting.

US Economic Stats: The U. of Michigan consumer confidence index rose to its highest level in a year. It's heavily influenced by employment numbers at this stage so it ties in with the recent improvement in unemployment and initial jobless claims. Two more Fed surveys, from Chicago and Kansas City, showed improvement in manufacturing and production. We saw a big build up in inventories in 4Q. This is beginning to work its way through the distribution chain. But as the inventory to sales ratio shows, we should not see a big halt in production...businesses are still running lean.

We are still fighting: worldwide fiscal drag (aka the dogma of expansionary austerity) with accommodative money polices. The PBOC joined in with some RRR cuts, although these do not mean much in the Chinese loan-quota system. And the BOJ took steps to weaken the yen. CBs are in control. Government fiscal policies remain ineffectual.

Bottom Line: US government bonds remain in a tight band of 190-210. The New Issue Market is strong with low end investment grade names trading at less than 314 over GT10s. We continue to like US equities.

Sources: Hellenic Republic, Ministry of Finance; European Central Bank; JP Morgan; Bloomberg; Peter Tillman, VOX EU; Bureau of Labor Statistics; Federal Reserve Bank of St. Louis; Federal Reserve Bank of Kansas City; Federal Reserve Bank of Chicago; Sentinel Asset Management, Inc.

Thought of the Week: Brute Force and Two Serious Problems, 02.21.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The brute force of liquidity driven markets is waning. Earnings season draws in and there were enough negative surprises, about 30% of reporting companies, to take the edge off the rally. As of writing, we're up over 6% YTD on SPX [1] but with little decisive break out in the last three weeks. Why? Well, the culprits are:

Greece: Greece has been punching well above its weight as a pain for some time. The reason is not i) contagion for most of the back exposure has transferred to the ECB and internal pension funds, ii) nor default for the total amount of loans is about the same as the expected bank profits stemming from the LTRO, iii) nor bank insolvency as recent write downs from banks like BNP [2] suggest the mark to book accounting myth is over and iv) not from stock market worries; at the current levels of capitalization, AAPL [3] could buy the entire stock market four times over with its cash pile.

So it's about precedent. The economy shrunk another 7% last year and in nominal terms is 12% below its peak. That is a depression. Instead of allowing an orderly exit and devaluation, the sinisterly name Troika, demands more austerity. This is dangerous territory, where bad economics meets inflammatory politics. Greece is new to democracy. In the 236 years of America's history, Greece has been part of the Ottoman Empire, had a German appointed monarch, a weak constitutional monarchy, three civil wars and military dictatorship. Democracy as it stands today is around 30 years old. Hence, the ratcheting up of political rhetoric in Greece could easily escalate into demagoguery or worse. So these are high stakes and a solution greatly to be desired.

China: After a pretty awful 2011, when stocks fell 20% and remain at about half the 2007 peak, inflation, housing and net exports remain a problem. A "hard" landing for China is a slowing of growth from around 9% to below 7% and while Party manipulation guidance can probably deal with the first two, the volatility from Europe is a much bigger problem for exports. A quarter of exports go to Europe. Lower demand would feed back to corporate and financial balance sheets, impair the performance of companies in the tradable sector and, in the absence of domestic policy response, curb growth by around 4%.

Follow this through to the latest TIC numbers, which showed China holding fewer treasuries last month than they had for two years. This is a direct reflection of China's declining current account balance from a peak of 10% of GDP to around 3%. China's purchases of US treasuries are not a discretionary choice. As long as they run a surplus, want a competitive exchange rate, do not float the renminbi and maintain capital controls, then any excess must be recycled into treasuries. This is why the Chinese pledge this week to hold more EU sovereign debt is posture. They must continue to buy treasuries as a natural recycling of cash receivables from exports. The holdings might fall but it will be a result of lower export growth not a geo-political decision to support Europe.

Put all this together and China looks a very difficult story. Yes, the growth of the world's second largest economy is impressive and the infrastructure, which wows so many visitors, years ahead of demand. But in a year of leadership change, dicing with bank loans and mortgage rates to induce domestic demand is a high-risk policy.

US Economic Stats: A reasonable set of good numbers although one had to dig a little. Industrial production and capacity utilization both rose. Here is overall capacity utilization and manufacturing utilization.

The latter continues to impress at 77 compared to a 40-year average of 79. Some parts of the economy saw utilization drop, mainly in utilities due to warm weather. Housing starts also had a good number at 699,000. The key development here is the "5-units or more" starts which are 25% of the total. In the housing boom, they were around 18%. Since the 2009 trough, housing starts are up 46% but the number of "new places to live" is up around 100%. This means more housing coming on stream and ongoing relief on inflation.

Other surveys point to non-accelerating growth, which is good considering the fiscal drag (i.e. insufficient government spending). The NFIB was unchanged. I always like this source. They tend not to hold back and are in front of their customers daily. Their biggest problem remains demand. Only 4% said access to credit was a problem. We saw first hints of February activity with the Philly and Empire Fed surveys. Shipments picked up and new orders declined which fits with the inventory rebuild we saw in Q4.

Finally, the claims number was at its lowest level since early 2008. Here's claims shown against an inverted JOLTS number.

They're tracking well which suggests that claims are falling as openings increase. If we had a large mismatch of skills in the workforce, as some think, these stats would diverge. What we have is a good old-fashioned lack of demand, private deleverage and insufficient fiscal spend.

Bottom Line: It feels as if the LTRO liquidity rally is losing momentum. We see the same tight trading ranges on GTs with less conviction all round. The 30 year TIPS auction was soft...it's a very distorted market but came at 77bps or nearly 2 price points lower than they traded late last week. Stocks seem well grounded at current levels. But no rush.

Sources: FT, FT Alphaville, David Blanchflower, Bloomberg, US Treasury Department, Michael Pettis, Federal Reserve Board, National Federation of Independent Business, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of New York, US Census Bureau, US Dept of Housing & Urban Development, International Monetary Fund, Sentinel Asset Management, Inc.

[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
[2] BNP Paribas (BNP/ BNPQY) was 0.5% of total net assets of the Sentinel International Equity Fund as of February 17, 2012.
[3] Apple, Inc. (AAPL) was 4.4% of total net assets of the Sentinel Capital Growth Fund and 6.0% of total net assets of the Sentinel Growth Leaders Fund as of February 17, 2012.

Thought of the Week: Savers are not a special class, 02.13.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The self-reinforcing struggles between risk appetite and liquidity continued this week. Since the FOMC meeting, LTRO kicking in, easier policies from the ECB and a run of good economic numbers, we're in rally territory for equities here and abroad. The good news is that this has not come at the expense of other asset classes...so gold, bonds, US$, commodities are all holding up well. The liquidity push cannot have come at a better time. Private sectors are still building precautionary savings and public deficits are closing...the US and euro area both decreased and cyclically adjusted deficits by around 1% in 2011. That leaves monetary policy working in the US and beginning to work in the EU. This has consequences of course:

Repression Part II: As mentioned before, I can't find much reference to this prior to 2008 except in a very specialized sense. It has become shorthand for disenfranchising savers through ruinously low interest rates, combined with favorable tax or regulatory treatments for sovereign bonds. But savers are just one part of the economy and, like every other constituent, they have a product (savings) for which there is little demand (investment). There is no immutable law that says rates need to be positive in nominal or real terms. So in answer to the question, "why would anyone buy long treasuries?", one response is "go look elsewhere." Here is personal income from dividends and interest over the last 50 years.

The two represent about 22% of employee compensation. And you can see the big spike in dividends from the end of the recession; they're now around 80% of interest income, closer to what they were in the 1960s. So dividend income is becoming more important in the mix than interest income. Which is what it should do in a liquidity-trapped economy. So the next time you hear repression, cough politely and mention "dividends."

And Bank Recapitalizations: The LTRO, similar to QE, allows banks to rebuild capital. The ECB reinforced this with i) no change to the main refinancing rate and ii) a spirited and wholly justified defense of the LTRO system by Mr. Draghi. He wants banks to recapitalize, but not at the expense of financing economic activity, and to keep liquidity freely available. This is remarkably clear language from a central banker, and similar in tone to his fellow MIT alum, Ben Bernanke. And a welcome relief from Greenspan's Delphic nonsense.

To complete the picture, the EBA said they would hold off on stress tests for European banks for another year and allow banks to meet new capital ratios by amending RWAs (i.e. more flexible collateral allowances). Put all this together and a major equity issuance from European banks looks less likely. That removes an overhang.

US Eco Stats: The manufacturing renaissance continues. Exports in 2011 grew 14%. Capital goods exports grew by 10% and industrial supplies by 27%. The trade balance came in at $40bn better than the BEA estimates released with the initial GDP numbers two weeks ago. So we should see the 4Q revised up. And this is good. We're exporting more finished goods while importing more basic materials like oil, fuels and petrol...all of which are primary inputs into the manufacturing economy. Here's the growth of cap goods exports...halftime in America.

Markets: We had two key bond auctions this week. The 10-year came at 2.02% with a 3.0 bid/cover. Nothing to write home about. And the 30-year bond went at 3.24%. It was soft, as was the bid/cover of 2.4, which compares to the 12-month average of 2.7. It mostly went to dealers. We don't think this is an inflation scare in the making. The quantity of money school gets concerned but inflation is benign everywhere. Bonds rallied to the close on Friday. We see liquidity easing and collateral expansion everywhere. In addition to the CB+s, the +CME reduced margin requirements for many commodities and will accept a wider range of collateral for swap trades.

Bottom Line: The move into risk assets continues with equities running ahead of a fairly dormant and narrow range bond market. This should continue. But watch for any narrowing in the leadership stakes. So far, it's broad enough but tends to close quickly.

Sources: Benoit Coeure, ECB, ECB Press Conference, IMF Fiscal Monitor, European Banking Authority, US Census Bureau, US Bureau or Economic Analysis, Federal Reserve Bank of St. Louis, Financial Times, Bloomberg, Sentinel Asset Management, Inc.

Thought of the Week: Fed Policies Pay Off, 02.06.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The forces of disillusion have glowed recently. We have had unsubtle debates on the Fed debasing money, the ECB providing unwarranted support and threats that the economy was going to lurch into a double dip (a reasonable but narrow view) or accelerate into hyperinflation (yes, really). So this was a week of unequivocal good news.

Unemployment: Spun any way, these were good numbers. As well as the headline number falling to its lowest level all year, we saw revisions of nearly 300,000 since June, or over a third higher than the first estimates. This had nothing to do with labor participation, which peaked over 12 years ago, or temporary courier services. Private sector employment rose by 2.2m over the last year while the government sector fell by 268,000. More importantly, manufacturing rose by 235,000 which points to i) the increased competiveness of US manufacturing and ii) the likely multiplier effect. Multipliers can be slippery to pin down but manufacturing tends to lead up to four times as many jobs in services, support and infrastructure. Here's the uptick in manufacturing:

The decline in the 1990s was the great off-shoring venture when anything not bolted down was outsourced to lower wage domiciles. It coincided with much lower inflation and wage suppression. The good news is that this is reversing. We hear plenty of news of companies relocating plants and production back to the US as productivity improvements close the competitiveness gap.

Economic Stats: A good week, telling the same story as GDP told us last week. The private sector growing slowly, fixed investment and exports robust but with the federal and state governments a net drag of around 1% in Q4. So ISM Manufacturing and Non-manufacturing (i.e. mostly services) both rose,reflecting thirty consecutive months of expansion yet with very moderate price increases. Productivity grew. It's now 2.8% better than a year ago. And the Chicago Midwest and Dallas Fed regional surveys all showed clear upticks. We like some of the survey comments:

We heard similar comments from Honeywell[1], Airgas[2], Kirby[3] and Union Pacific[4]...some of the many quoted industrial companies who reported this week.

Personal income: has taken the brunt of the post-2008 period. Disposable personal income barely rose in 2011 and real DPI per capita has been stuck at around $32,400 for nearly seven years. We saw more frugality last month as the savings ratio increased to 4.0% and a big hike in personal current taxes. They were up 18% last year compared to a rise in personal income of 4.7%. Time was when corporations paid more of the total tax bill. Here it is going back fifty years:

Corporations pay 20% to 25% of the combined corporate/personal tax assessments. This has been going on for a while. If we want to reinvigorate the personal sector, it might be time to reassess tax policy on both corporate and corporal people.

Earnings: We're in the midst of the earnings season where companies are beating on revenues about 75% of the time. That's low. It's part of the game where analysts cluster around a guidance number which management tends to beat. But the revenue side is not surprising. The GDP deflator last quarter was 0.4% and we had slower growth in nominal GDP than in the prior two quarters. Companies need growth in nominal GDP to grow and there wasn't much of it late last year. But overall, we're seeing solid numbers with financials improving their costs and capital.

Bottom Line: Equities, bond yields and the dollar all climbed last week on the better numbers. Europe was mercifully crisis-free. This rally has some legs to it and a good time to buy into selected financials and small cap stocks which can get some growth out of a still slow economy.

Sources: Federal Reserve Bank of St. Louis, Federal Reserve Bank of Chicago, Federal Reserve Bank of Dallas, Bureau of Economic Analysis, US Department of Commerce, Bureau of Labor Statistics, Institute for Supply Management, Sentinel Asset Management, Inc. Institute of Supply Management

[1] Honeywell International (HON) was 1.7% of total net assets of the Sentinel Common Stock Fund, 1.15% of total net assets of the Sentinel Balanced Fund, and 0.3% of total net assets of the Sentinel Conservative Strategies Fund as of February 3, 2012.
[2] Airgas, Inc. (ARG) was 1.1% of total net assets of the Sentinel Sustainable Growth Opportunities Fund and 0.2% of the total net assets of the Sentinel Capital Growth Fund as of February 3, 2012.
[3] Kirby Corp. (KEX) was 1.2% of total net assets of the Sentinel Sustainable Growth Opportunities Fund as of February 3, 2012.
[4] Union Pacific Corp. (UNP) was 2.6% of total net assets of the Sentinel Capital Growth Fund, 0.8% of total net assets of the Sentinel Common Stock Fund, 0.7% of total net assets of the Sentinel Balanced Fund, and 0.2% of total net assets of the Sentinel Conservative Strategies Fund as of February 3, 2012.

Thought of the Week: When Two Percent is Good, 1.30.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

FOMC marked new ground by placing a date on any change in the fed funds rate out to 2014, a full year beyond the date put out last year. This is exactly the playbook described by the Fed Chairman nearly ten years ago. He is shaping interest conditions as obviously as he can. He would prefer a policy of conditionality, say to unemployment or inflation (the case for nominal GDP is probably too radical for now) but, if nothing, he is a pragmatist and knows he would not carry all the board with him. So the next best thing is a fixed period. This:

1. confirms our view that interest rates will continue to be range bound for the near future (call it 1.75% to 2.25% on the 10-yr note);
2. provides trading opportunities;
3. turns the light green to move out the curve for additional returns; and
4. fixes target inflation at 2% which is way above what we have now and probably represents a mild starting point for rate changes.

Wait there's more: they include this chart, which has each FOMC member's forecast for what they think should happen not will happen. Each blob is a FOMC member and you can see that individually there are more hawks than the collective whole. Two people think the FF rate should be 1% by year-end, six that it should be above 0.5% in 2013 and all think it should be 4% after 2014. Of course, that assumes that the economy or employment takes off...

Liquidity Rally: While the LTRO is not technically QE because i) it uses repos where the collateral risk remains with the banks and ii) does not specify any amount that they will buy or at what target (sorry that's the pedant in us)...it does provide liquidity for markets. Whether it's a relief rally or the start of something bigger is tough to tell but so far we have about a 5% return in European markets with more to come. Of course, the Eurozone economies are tripping up. The German export machine is bound to come under pressure and recent stats suggest that many companies are working on back orders. That can't last. Somehow, it all feels as if the euro is sleep walking to the edge. We're in a sit back and enjoy it period right now.

Economic stats: continue to encourage on the capital side with i) durable goods up 8% YOY, ii) the Chicago National Activity Index up to its highest since July, mostly because of production and manufacturing, and iii) the Richmond Manufacturing Index rebounding strongly especially in shipments and orders. The consumer side was the same torpid story with home sales at their lowest level all year and at lower prices: 43% of houses now sell for less than $200,000. Three years ago, it was 38%.

GDP numbers: were generally as expected. The big change was the inventory rebuild, with about 1.9% of the 2.8% growth. It's a volatile series and was bound to happen after the Q3 run down but encouraging given the backdrop. As with all of the data from last year, the government sector weakened, with federal expenditures at 6.8% of GDP down from 8.3% a year ago. Quite why we think government expenditure is bad for the economy or crowds out the private sector in the midst of a liquidity trap is muddled thinking.

Bottom Line: We will trade the GTs aggressively within the new lower bands. Built up cash after the run-ups in Europe and domestic markets. There will be better entry points.

Sources: Federal Reserve Board, US Census Bureau, US Bureau of Commerce, Federal Reserve Bank of Richmond, Federal Reserve Bank of Chicago, Federal Reserve Bank of St. Louis, Bureau of Economic Analysis, US Department of Commerce, Sentinel Asset Management, Inc.

Thought of the Week: Animate and Repress, 01.23.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Europe is in a state of suspended animation, neither moving nor acting on policy. After weeks of spurious deadlines, the markets settled into quiet acceptance that Greece is a hopeless case but that, for now, imminent collapse is not in the cards. Some of the best performing bond markets this week have been the worst of the worst...Ireland, Italy and Greece long bonds are up over 5%. It's not all good. Greek CDS have virtually ceased to exist and notional amounts on the peripherals have shrunk. No one wants to stand behind a restructuring, posing as PSI haircut, masquerading as default.

So why now? Liquidity. The ECB has taken a pragmatic twist and refinanced €683bn of bank collateral since December 23rd. Money is cheap, confidence building and bonds attractive. At the same time, the IMF put in for $500bn in additional assets to stand behind more restructuring needs. They won't get it. The US is not about to contribute. But it's a potential backing for further problems and, at the least, puts the IMF back in the game. They have played virtually no role in the last six months and the markets would welcome their management. Real economic data in the Eurozone is in the "getting-worse-more-slowly" stage. And that's not going to be good enough to solve the credit conditions.

Finally on Europe: The EBA is about to impose a new 9% capital rule on banks. There are two ways for a bank to improve ratios: increase equity through rights issues or retained earnings, or shrink assets through loan sales or not rolling over maturities. In Europe's case, there is no access to new capital. All the major suspects, pension plans, insurance companies, each other, SWF, etc. have been exhausted. So asset shrinkage is the only game. Japan faced the same problem in 1997 when the stock market had already fallen 47% and new BIS rules came into effect. Result? Another round of credit contraction and equities fell another 55%. So watch carefully to see the EBA repeat the mistake.

Help, we're being repressed: Bond hawks and inflationistas are fond of sounding the bell of "financial repression." I haven't been able to find a reference to it in any economic textbooks prior to 2008 so it's a new term. It sounds so medieval that you really have to listen to their story (cue sad eyes and suppressed outrage). It goes something like this:

1. bond yields are low in nominal terms, therefore
2. savers are unduly punished and made worse because
3. CBs are providing cheap money that
4. increases inflation and
5. reduces real returns to bond holders.

The dark days of "repression" are therefore the Bretton Woods period when governments monetized debt through interest rate caps, preferential tax treatment for government bonds, capital controls, etc. There are countless sob stories. And, so it goes. Some countries are doing it now: Italy exempted government bonds from capital gains and France required state pension funds to increase their bond holdings. But bondholders have no right to expect a real rate of return or demand that savers receive preference over consumers, government, business or any other component of GDP. Here's CPI and the GT10 yields. Sometimes bonds yield more than inflation. Sometimes they don't. Right now they don't. But there's no golden age of real returns from bonds and the vigilantes should not expect one now.

Next time you hear about "repression" check the size of their long bond position and what solution they propose (hint, it will be tighter money).

De-equitization: an ugly word for an interesting problem. In 2010 and 2011, SPX [1] returned 15% and 2.1% yet stock market capitalization fell 5%. How? Companies repurchased $200bn a year of stock, thus reducing the equity base and increasing EPS. But this does not change overall earnings. It just spreads it over a smaller denominator. The reasons companies do this are quite complicated: cash flows and confidence are solid, debt is cheap and new investment cautious. Throw in companies' EPS targets and there is a thriving carry trade in issuing debt and repurchasing equities. The combined "return to shareholder" rate of 5% (dividends at 2% and buyback of 3%) make for an attractive yield. This all sounds good except there's a potential trap. Buybacks can lead to lower reinvestment rates and over leveraged companies.

That's why we look more at 1) dividend growers with 2) lower payout ratios and 3) strong management that knows how to use 4) judicial buy backs. We're finding them in tech and some financials, both of which have had a very good run this year.

And speaking of financials: last year's earnings had ephemeral factors working for them: 1) asset quality improved so loss reserves could be released and 2) DVA, which allowed widening spreads on their own debt to be taken as income. This time around, we see expense controls, asset and deposit growth (European banks' contraction helps here) and better capital formation. We have avoided financials for years. But they're beginning to look more attractive now.

US Economy: We saw very subdued inflation. Headline CPI fell to 3.0% down from a September high of 3.9% and core CPI was at 2.2%. We also saw the notoriously volatile gas price index fall. Many pointed to this in the spring as the result of QE.

Luckily, the Fed paid no attention. There is no material inflation in the economy. The 10-year TIPS trades at negative and record low yields. Industrial production grew 3%, capacity utilization edged up and the Philly and Empire outlooks improved. It's more of the same. Slow growth, consumer caution and steady progress. Enough to add $300bn a year to the economy but not enough to spike unemployment down.

Bottom Line: We continue to see GT10s trade in a range. IGs are in strong demand but that might be seasonal because we may have zero net new issuance in corporate debt this year. For the longer-term accounts, MBS provide more price stability. In equities, financials and tech are attractive.

Sources: FT Alphaville, Citigroup Capital Markets, Nomura, European Central Bank, Federal Reserve Bank of St. Louis, Bloomberg, US Census Bureau, US Dept of Housing & Urban Development, Federal Reserve, Bureau of Labor Statistics, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Sentinel Asset Management, Inc.

[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: In Praise of Radhanath Sikdar, 01.17.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

In 1854, the surveyor general of India asked Radhanath Sikdar to calculate the height of Mount Everest using station observations 108 miles from the peak. Given the distance of the sightings and atmospheric distortions, the challenges were enormous. Using pencil, paper and trigonometry, he determined the height at 29,002 feet. The latest satellite technology today measures it at 29,035 feet. But the mountain grows by one centimeter a year so in 1854, the height was 29,030 feet. Thus, Sikdar was off by only 28 feet. Quite an accomplishment.

Now the point for Europe (yes, again) is that we do not have to wait for the latest data to confirm what we already know:

1. the economies cannot make expansionary austerity work;
2. households cannot pay for the banking mess; and
3. Germany cannot continue to export to impoverished customers.

So the time for growth and easier money is now. Not when the stats are so awful and degrading that political risk (see Hungary) trumps economic failure.

This week we saw: France and Austria downgraded, Greece take a step closer to default, new bond auctions from Spain and Italy that, while below last month's, had pitifully low bid/cover ratios and Hungary lurch again in its bond prices and currency...down 11% and 22% in last three months. On the other side of the trade, Germany auctioned 6-month paper at a negative 0.012%. So this is what happens: fiscal consolidation hits private consumption and investment without (because of a pegged exchange rate system) a rise in net exports or higher lending. Mr. Sikdar would have figured this out long ago.

The ECB meanwhile: is a very different animal under Draghi than Trichet. There was no interest rate cut but that is undoubtedly coming. The 3-year LTRO liquidity function from December is working. It's a form of QE lite, using repos rather that outright purchases. But the result has seen banks use new money to help the bond markets. The next step could be to start lending. Keep watching the ECB because it may well force the politicians into something more pragmatic than the current stand off.

US Bonds had a good week: including a successful GT10 auction at 1.90%, the lowest ever. The market has mostly ignored good economic news, probably because of the low growth hazards and run on the euro. We also saw new numbers for money velocity, or the rate of turnover of money, fall again. So, put the lower 10-year rate together with M2 velocity, as in the chart, along with low inflation and growth, and you can see that many of the old models are simply breaking down. More money is neither stimulatory nor inflationary. It's the same story that we've told for most of the last year.

FOMC more dovish: a very forthright speech from John Williams of the San Francisco Fed and a new voting member. He's part of the Fed's desire to improve communication, and rightly points out that the Fed is not out of ammunition, that securities purchases can continue and that the fed funds rate should be negative. This should keep expectations extremely well anchored and may mean GT10s stay in the 185-220 range.

Growth: The NFIB has been a reliable indicator for the economy. This week they said for the umpteenth time that, no, credit is not a concern and that sales represent the single most important problem. They have reduced inventories but increased capital spending which is in line with small gains in confidence. Fourth quarter growth will probably show a solid 3% level up from 1.8% in Q3. Exports had two good months and the latest confidence levels have recovered from the battering they took from the debt ceiling nonsense in the summer.

Bottom Line: We're still seeing price volatility in treasuries. In the last five trading days, the GT30 has moved through a 4% price swing and yields 2.9%. So almost any intra-day move can eliminate a year's coupon. Stocks can wait a while. The earnings season is going to be temperamental.

Sources: Wade Davis, Bloomberg, Expansionary Austerity: New International Evidence (IMF), Federal Reserve Bank of San Francisco, Federal Reserve Bank of St. Louis, National Federation of Independent Business, US Census Bureau, US Bureau of Economic Analysis, University of Michigan, Sentinel Asset Management, Inc.

Thought of the Week: Bad Medicine, Bad Policies, 01.09.2012

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

"The certainties of one age are the problems of the next," wrote R.H. Tawney. He went on to censure anyone who felt that the poor were victims of their own "irregular courses" or businessmen who ascribed their own successes to "unaided efforts in bland unconsciousness of the social order." Grand words indeed. Unfortunately, the Germans replay the exact sentiments with their approach to the euro crisis: all noise and brimstone on the evils of deficits and over spending. Yet Germany remains a huge beneficiary of the euro, providing vendor finance to nearly every country and maximizing the low value of the € to boost exports. German exports more than tripled in nominal terms in the ten years of the euro and rose from 25% to 56% of GDP.

So now, the certainties of export-led growth, excess savings and protected exchange rates are visited on the euro economies. The big numbers, PMI manufacturing, new orders, etc., are falling, and banks have started the painful process of deleveraging, mostly through loan contraction, sometimes through deep-discount rights issues. The ECB won't buy sovereign bonds even though, as this chart shows, there is simply no link between reserve growth and inflation in a liquidity trap:

The only conclusion we can make from the policies and the results is either EU decision makers are 1) exercising a moral judgment on economically stressed countries or "cut and behave" or 2) providing gradual credit extensions that allow banks to recapitalize or "feed the zombies" or 3) they're making it up as they go along. And by the way, this has nothing to do with the "No Monetary Union without Fiscal Union" or NOMUWFU school. We shall return to this.

Oh, so very feint signs - Europe: The ECB has moved positively recently with the LTRO (i.e. 3-year liquidity facility that allows repos with collateral). It's not QE but it helps the immediate liquidity problems. The trouble is:

1. it's deflationary...the banks will not increase loans using these facilities;
2. it does not help bank profitability...the carry trade opportunities are too small;
3. it's part of a deleveraging by EU banks...so risks contracting the economies more; and
4. recent bond auctions have had pitifully low bid/cover rates (less than 1.5) and at rates which, in the case of France and Italy, are 30bps and 74bps higher than the last summit solution.

US Economy: We'll look back at this period and remark on just how steadfast performance was in the face of the global, national and fiscal pressures. This week we saw manufacturers' orders up 12% on the year and some very big gains in machinery and durable goods. This is all from companies with almost no debt so the growth, whilst modest by past standards, looks very sustainable. Both ISM numbers also rose for the 29th consecutive month. The recovery is there. Unbalanced. But there.

US Employment: 200,000 new NFPs last month with 8.5% unemployment and a 15.2% U-6 rate. These are strong. Why?

1. There are 1.03m less government workers from 2010 and the number has dropped every month in the last year
2. the private sector added 1.92m jobs in the last year and there are now 1.4m more people at work in the private sector and
3. the participation rate, falling from a peak of nearly 68% to 64%, is in secular decline as the following chart shows.

Participation is not falling because of despondent workers. It's falling because the growth in the 25-54 age range is ending, particularly among the younger group. Labor participation for 16-24 year olds has fallen from 67% to 55% within ten years. And that loss is because of lower birth rates, more willingness to pursue education (there is only 4.1% unemployment among degree holders, half that of the high-school only educated) and, probably, lower immigration. These will continue...we will probably be at 62% by 2013 and with unemployment at least another point lower.

So put these together and we can see the results of sensible monetary policy and not so sensible fiscal policy: slow recovery of manufacturing and service jobs, decline in all government jobs and gradually lower participation rates. Expect these trends to continue. They're far more powerful than whether FedEx [1] and UPS [2] added seasonal workers.

Bottom Line: We find 30-year bonds with a near 20-year duration very tradable. The YTD price swing is already over 4% and with a 3.0% yield; we must be careful that price changes not wipe out coupon returns. Stocks offer attractive entry points but we look at individual companies, balance sheets and management more than the overall asset class.

Sources: Federal Reserve Bank of New York, Federal Reserve Bank of St. Louis, Bureau of Labor Statistics, R.H. Tawney, Bloomberg, Capital Economics, Institute for Supply Management, US Census Bureau, US Bureau of Commerce

[1] FedEx Corp. (FDX) was 2.1% of total net assets of the Sentinel Sustainable Core Opportunities Fund as of January 6, 2012.
[2] No Sentinel Fund held a position in United Parcel Service (UPS) as of January 6, 2012.

Thought of the Week: Somali Sense of Humor, 12.19.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

At the beginning of the last century, the British fought a long forgotten war in Somalia, a nation, they quickly found, with tough-as-nails determination. A story carried that a wounded Somali staggered into a hospital, with bullet wounds in his legs and a spear stuck in his stomach. The doctors informed him that they would operate on the legs first because they were gangrenous. "No, no," said the man, "fix my stomach first. It hurts when I laugh." Europe may soon have to acquire some gallows humor because the news is not improving. Start first with:

IMF Report on Greece: The fifth review on the Greek financing package makes grim reading: 1) bank deposit outflows equivalent to 15% of GDP 2) privatization sales proceeds revised down to less than 3% of GDP 3) GDP to fall more in 2011 than estimated and again next year, bringing the cumulative shrinkage to 15% but 4) debt to remain at over 140% for most of the next decade, assuming a 4% paid rate not the 34% market rate and 5) labor productivity deteriorating. It's also strange because the IMF hints that PSI debts should be written down by over 50% and that there be more "universal" participation (they don't disclose what it is, just that it's "low"). And the IMF is only on the hook for €13bn of the €350bn of debt.

So the IMF, set up to manage balance of payment crises through subscriptions from member countries, is acting as factoring agent for private investors. And creating precedent for the inevitable rounds with other countries. Meanwhile, Greek spreads over Bunds, 33% for the record, no longer matter. The economy is in its own world, metastasizing into ruin. Hopefully maintaining a sense of humor.

And markets tremor: again. In another sign of euro dysfunction, the Bundesbank refused to participate in a general IMF trust for the eurozone. This immediately put pressure on the euro and equities into a 4% to 6% decline. The YTD fall in the core European markets reached nearly 20%. Economic stats look horrible: PMI down for the sixth straight month, unemployment up 2% and confidence down. All in line with a fall in Q4 GDP.

I try not to comment on gold: To most investors it's a panacea...good for inflation, deflation, political breakdown, risk off, fears of fiat money, etc. It just leads to arguments and, as they say in Alabama, never wrestle with a pig: you both get dirty and the pig likes it. So the 9% correction this week could be a) holders required to raise liquidity at any price b) year-end profit taking or c) the classic "in by the stairs and out by the window" story that goes for any commodity sell off. If the last one, expect more downside.

US economic stats: continue to show underlying strength. The Empire Manufacturing Index rose to its highest level since May; industrial production for business equipment is 10% above its level of a year ago, and for material and energy is +4%; the NFIB said 8 out of 10 of its index components rose but that sales remain the biggest problem; the current account deficit improved from 3.3% to 2.9% and the FOMC sounded dovish. Which they should because prices are moderating again at the headline, producer and core levels. It's not deflation but maybe enough to worry the Fed in the New Year. We may see less of an increase in OER, which carries a 25% weight in the CPI, because multi-family homes are coming on line quickly. They're now over 30% of housing starts and will probably reduce rent costs.

Aggregate demand continues to need help. This week the Treasury auctioned 10-year notes at 1.98% at 3.5x bid to cover and 5-year TIPS at negative rates of -0.9% at 3x. Federal interest payments have never been lower. Here they are at 1.4% of GDP. In nominal terms, debt-servicing cost more in 1996 than it does today. So with demand still low, Europe weaker and debt servicing costs never better, this at least provides some room to maneuver.

Bottom Line: We have been at high cash levels for some weeks. Bonds look very tradable between 180 and 220. Equities with flow yields remain attractive but we're wary of some of the traditional valuation guides, for example PEs.

Unless something breaks next week, this will be the last TOTW for 2011. Keep a sense of humor. It's worse in Mogadishu. See you in 2012.

Sources: Richard Dowden, IMF Country report No. 11/351, Federal Reserve Bank of New York, Federal Reserve, National Federation of Independent Business, Bureau of Economic Analysis, US Department of Commerce, Bureau of Labor Statistics, Federal Reserve Bank of St. Louis, Zentrum für Europäische Wirtschaftforschung, Sentinel Asset Management, Inc.

Thought of the Week: Teutoburg Forest Remembered, 12.12.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

A popular song in 19th c. Germany was "Als die Römer frech geworde" which roughly translates as "When the Romans were rude." It commemorates the annihilation of three of Augustus' legions at the Battle of the Teutoburg Forest in 9 CE. So complete was the victory that Rome never again tried to expand its boundaries and German independence firmly established itself. This week it did so anew. The European Council agreed to some startling actions to stem the crisis: 1) all fiscal deficits not to exceed 0.5% of GDP 2) excessive deficit rules to come into effect when they breach 3% of GDP 3) the Commission to sign off on national budgets and 4) enforce sanctions if debt exceeds 60% of GDP with 5) fiscal integration to follow and 6) EFSF and ESM capital to remain at around €500bn with another €200bn committed to the IMF.

The markets' reactions were generally favorable but I doubt any of this will hold. A quick look explains why:

Fiscal Deficits: Under the 0.5% rule, no economy would have qualified for the euro under the 1998 convergence criteria and none does so today. Same goes for the excessive deficit rule for 1998; only Germany squeaks by today with a deficit of 2%.

Commission sign offs: mean that a central authority must sign off on a sovereign state's national budget. This is constitutionally unconvincing with no resolution for non-compliance.

Fiscal integration: sounds impressive but I doubt it will lead to much more than some tax harmonization. More importantly, this would lead to some severe pro-cyclical cuts in expenditures and do nothing to address European competitive imbalances.

EFSF, etc: Capital stands until mid-2012 but European banks are on a massive deleveraging route, having lost $100bn of CP over the summer alone. So it's nowhere near enough to backfill bank refinancing needs.

What seems to have prevailed is the "austerity to growth/protect private lenders" policy which has been the motif for most of the last year. We have two great case studies on how this works. Ireland, which saw its unemployment climb 400% and economy shrink by 16% even while its debt to GDP rose from 12% to 120%. And Latvia, which pegged itself to the euro, saw its unemployment grow to 20% and its GDP shrink 24%. Yes, without a currency, interest rate and FX policy, the options are dire. And it's very hard to see anything but years of sub-optimal growth ahead.

Sort of Bright Spots: The ECB cut rates (although it was not a unanimous decision...makes one wonder what it takes to get these guys' attention) and there was a suggestion that ECB may consider "other elements" (read bond purchases) if there was a fiscal compact, which there now seems to be. So watch the space.

China Rate Cuts: RRR cut last week, which sounds good but doesn't mean the same as it does in the West. When China wants to affect credit, it does so by quota and administrative fiat not by reserve adjustments. So RRR changes don't really reflect easing. We saw China PMI decline below 50%...it's a diffusion index so that means they're headed to less activity. The important inflation number dipped. But two market indicators remain puzzling. First, stocks took another hit particularly in the "A" share market. This means that domestic investors are more bearish than foreign investors. Not a good sign. Second, the Renminbi Hong Kong delivered market (CNH) outperformed the official currency (CNY) by about 0.5%. This implies very low demand for the Renminbi generally and could mean bank funding pressures, export declines or investors wanting to buy dollars again. Or all three.

US Economy Stats: Same story. Progressively better. The ISM Non-Manufacturing sector grew for the 24th consecutive month with the Business Activity and Export sections showing good trends. This showed up in excellent trade numbers. Exports are up 15% YOY and the closing trade gap could be worth about 0.3% to GNP. We'll need it because of increasing savings and fiscal drag coming (see TOTW passim) along with an improving current account. If current accounts can be expressed as the difference between national savings and investment (and they can), then more saving and less demand is on the way. You can see the relationship between the two here. It's another indicator of low aggregate demand which has a decidedly uneven history.

Bottom Line: We have traded through GT30s and GT10s all week with a price swing of 3% on the benchmark 11/41. We're quite happy to sit on a high cash position and maintain the trade in large cap. All of the above reports make for interesting geo-political discussions but poor markets.

Sources: Center for Economic and Policy Research, Bloomberg, European Council, Suetonius, Financial Times, Michael Pettis, FT Alphaville/Deutsche Bank, Institute for Supply Management, Federal Reserve Bank of St. Louis, US Census Bureau, US Bureau of Economic Analysis, HSBC, Sentinel Asset Management, Inc.

Thought of the Week: Engines of Doctrine, 12.05.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

"Great nations," wrote John Ruskin, "write their autobiographies in three manuscripts, the book of their deeds, the book of their words and the book of their art. Not one of these books can be understood unless we read the two others, but of the three the only trustworthy one is the last." And he might have added, the least trustworthy is the book of words. European leaders have a tough time stringing together a coherent sentence but the words go roughly like this: 1) drive down deficits 2) pummel inflation 3) encourage companies to invest more and 4) households to spend more and, thus, fingers crossed, 5) create employment.

The problem with this is that output gaps (as measured by capacity utilization, unemployment and deviation from mean) drive down aggregate demand and prices. And no business executive will invest while demand is leaking. And so will not increase employment. This standard trap is exacerbated when there is no central bank that can do what central banks do: lend as last resort, react to bond auctions or drive an exchange rate policy.

An Embarrassing Moment: Added to this, European banks faced a classic Minsky moment. They ran into three problems: 1) forced to sell their best assets to offset declines in peripheral sovereigns they 2) bought as much high quality 3-month Bund paper as they could and promptly drove rates to below zero then 3) ran out of financing options in the inter-bank market. That's why the Fed and five other central banks opened up liquidity support on Wednesday. Markets like nothing more than an infusion of liquidity and risk assets promptly rose 5% or so. But not much changed. German bonds remained at the same level prior to last week's failed auction and Spanish and Italian bonds remained at the same level prior to their government changes. Which is a shame because there are...

Plenty of solutions: from eurozone bonds, more fiscal union, more ECB liquidity tenders to maturity restructuring, unsterilized bond purchases and building demand in Germany. But no one seems to want to take the lead. Meanwhile, we have their art.

I'm impressed by the Federal Reserve: They (probably) led the dollar liquidity facility decision, have kept a close watch on US financial institutions' funding and reiterated an intent to support stability through more "tools". We also heard two Fed governors, Yellen and the more hawkish Lockhart, talking about additional accommodation and not taking any option off the table. This may not presage any immediate QE3 but if we see a setback, it is clear they have more bullets. Of course, it would be nice if the politicians could provide a little more than small arms fire because:

US Economic stats: show two clear messages. One, there's about 1.5% of fiscal drag coming in 2012, about a third each from discretionary spending caps and expiration of payroll taxes and extended unemployment. It has already started as you can see here, which measures government expenditures in GDP. So it will be doubly hard to overcome these unless more government expenditure is forthcoming.

And I say that because the household sector is under extreme pressure with almost no growth in disposable income in the last few years. Here is DPI per capita. Even the recessionary spike is illusory because it shows only wage stickiness when the PCE deflator plummeted. There was no real gain to income.

But the second part of the US economy (two) is that manufacturing, industrial, export, capex and durable goods are holding up well. We saw this in the Dallas, Chicago and Richmond Fed surveys and the ISM Manufacturing Report, which showed its highest reading since June and with nearly all sub-series (orders, production, etc.) growing. Inventories declined which is usually a good indicator of rebuild in coming months. Put all this together and you can see why the US stock market is one of the best performers YTD.

Bottom Line: End of year positioning throws up some odd behavior. Wall Street firms shrink balance sheets, so it's not usually a good time for bonds. We have raised cash and would buy very selective equities on the weak days.

Sources: Federal Reserve Bank of Atlanta, Federal Reserve, Federal Reserve Bank of Chicago, Federal Reserve Bank of Dallas, Federal Reserve Bank of Richmond, Federal Reserve Bank of St Louis, Bureau of Economic Analysis, US Department of Commerce, Sentinel Asset Management, Inc.

Thought of the Week: No Direction Home, 11.21.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The conceit of Ancient Rome: In Imperial Rome, roads out of the city marked only the distance from the city, not to anywhere. All that counted was how far or near you were from it. The ECB adopts a similar centricity: all that matters is to keep prices stable. Nothing else. Which is why euro bonds continue to retreat with Italy and Spain hitting the 7% club for their 10-year paper. Unemployment can remain at 10% for three years. Growth can slow to 0.2%. (The German ZEW survey on economic conditions fell to its 2008 lows, barely above what it was in 1992 and 40 points below May of this year.) But while inflation stays above the 2% target, all bets are off to ease the pain.

And how hard would that be? The heart of the problem is that the ECB cannot buy government bonds without offsetting sterilization (i.e. lend as a last resort). Neither can it issue euro-wide bonds thus putting German credit risk behind Italy. Nor can it participate in auctions. That's the way the rules were set. And that's why the ECB holds only €175bn of crisis-country debt compared to the Fed's $2,800bn balance sheet. Italy has €307bn of bonds maturing in 2012. That could be refinanced at levels 200bp below the current 6.9% level if there was coordinated central bank action to counter a classic buyers' strike. It is likely to happen but not yet. And that begs...

Why is the euro not weaker? Because it's not as bad as it looks:

1. Europe as a whole does not have a balance of payment crisis, which is the normal trigger for a currency run. The three largest current account surplus countries of Germany, Netherlands and Austria have a combined surplus $40bn greater than the three weakest (France, Italy and Spain). So Europe is a capital exporter and has no trouble financing itself externally.
2. Capital flight has not taken hold and where it has, say in Greece, euro deposits are moving from one national bank into another, with no medium of exchange. The same goes for the high volume of inter-euro trade.
3. The latest fundamental equilibrium exchange rates (a nice cheat sheet that calculates the FX rate at which imbalances and capital flows are indefinitely sustainable) shows the euro overvalued by only 2%, compared to the US$ overvaluation of 10%. The Swiss have helped to support the euro through the CHF defense policy announced in September. However gloomy one is about the periphery, the euro is driven by the excess savings and surpluses of its successful core. Or more simply, there are plenty of flow buyers of euro and not enough speculative power to drive it down.

Odd then, that we have a series of solvency and economic crises without a currency crisis. But not unprecedented. Think to the US in 1984 and Japan, well, now.

US performance in the wings: Another week of improving performance and avoidance of the recession scare (which we never bought into). The Empire Manufacturing index had its best month since May and future business conditions shot up 32 points to 39 (that's 48% of businesses saying conditions will improve vs. 9% who say they won't). That's a nice move and came with a 7% increase in retail sales and 4% rise in industrial production. Inflation numbers came in lower than expected with core at 2.1%. This is what it looks like:

Quite why we all got worked up by 2% inflation is only because there are monetary hawks who see every twitch as a threat to bond investors. If we're to have higher levels of demand and economic activity, we should greatly desire more inflation. Meanwhile, inflation sensitive assets remain unconcerned:

Productivity Gains: We've mentioned in the past about the huge productivity gains in US manufacturing and industry. It shows up in high levels of corporate profitability, earnings, low real wages, etc. All a bit cerebral. So here's how one restaurant chain, Brinker (EAT) [1] does it. New ovens from Middleby (MIDD) [2] need less attention and cleaning yet cook multiple foods faster and more precisely. It is "conveyer-ized" technology. At a capital cost of $90,000, one oven recoups labor savings in less than 18 months and increases margins by 100bps. It's a microcosm of what is going on in the US economy. Innovation and tight management. Low labor needs. All that's missing is more aggregate demand.

Bottom Line: Difficult to see real direction. A technocrat's bounce follows a credit or contagion warning. The markets are weary. We still trade the GT10s and quite happy to take ticks rather than points. And buy the high cash flow stocks.

Sources: Peter Jones, Zentrum für Europäische Wirtschaftforschung, Peterson Institute for International Economics, Federal Reserve, Federal Reserve Bank of New York, Federal Reserve Bank of St. Louis, Barclays Capital, US Census Bureau, US Bureau of Commerce, Bureau of Labor Statistics, Bloomberg, Der Spiegel, Sentinel Asset Management, Inc.

[1] No Sentinel Fund held a position in Brinker International, Inc. (EAT) as of November 18, 2011.
[2] Middleby Corp. (MIDD) was 1.5% of total net assets of the Sentinel Small Company Fund as of November 18, 2011.

Thought of the Week: Colditz and the Trevi Fountain, 11.14.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

All this and the Super Committee still to come.

You have to have a long-term plan: Among the exhibits at the Colditz museum is a row of moldy jam jars. Turns out a British officer secreted the jars under his bed and nurtured dry rot cultures for insertion into the wooden walls and joists of the castle. Once there, all he had to do was wait 25 years for the castle to come crashing down. Now if the euro designers had a slightly better plan than "there is no escape, ever" we wouldn't be spectators to one of the greatest financial disasters of our lifetime.

Not so dolce vita: The pressures in Italy are easily measurable. The Bund spread reached 550bp vs. 130 back in April. That's the Greek level from 2010 and represents a 12% loss in Italian bonds YTD. Not good if you have to refi your debt from around 4.5% in June to 7.3% now. Even 1-year bill auction today sold at 6.1%. It could have gone for less but the ECB is prohibited by law from intervening in the primary auction market...one of those planning oversights.

But Italy is a special case and not one of those sybaritic Mediterranean morality tales. It has a primary budget surplus (before interest payments), long debt maturity, low foreign liabilities and a self-funding deficit thanks to a high savings rate. Its problem is extremely low growth (GDP per capita below 2000) tied to a hopelessly uncompetitive exchange rate. Now couple this with a Bunds/OATs spread widening to 167. This is really worth looking at because for most of the decade, investors only needed a 30bp premium to hold French government paper. But now they need 146. Ouch.

The last quartet: And all this shows the paucity of thought from the EU. The austerity at any price crowd has no articulate opposition. Growth, employment, competitiveness are simply not mentioned by anyone in power. It's just cutting expenditure and fighting the inflation chimera. How does this end? 1) Someone calls the bluff and does an Iceland 2) a "core" Eurozone emerges of Germany, France, Netherlands and Austria or 3) austerity growth wins the day. If it's the last, I will be in the front row of Porcine Airlines.

US really better: The trade gap narrowed a lot more than expected. Exports are up 16% from last year and imports have been flat since March. You can put that down to the oil spike back then. Industrial and capital goods have done particularly well. If this keeps up, there should be a net gain of 0.3% to GDP. Not enough to offset the fiscal drag but better than most expectations. You can see some of the effects here, which measures the free fall in government vs. private job openings from this week's JOLTS:

And you can see the continuing success story of corporate profitability here in the measure of labor costs to profits where they are the lowest, well, ever. We'll spare the "share of labor in the recovery" story for another day.

Bottom Line: Keeping volatility down. Raising cash and using the trading opportunities in bonds. Trimming international especially Europe; DAX is 11% off October lows; but sentiment is very negative. This bond rally is all about the need to cover much higher margins on repos for European and Italian bonds but could have more to go.

Sources: Bloomberg, Matt Oxley, Zero Hedge, Federal Reserve Bank of St Louis, US Census Bureau, US Bureau of Economic Analysis, Bureau of Labor Statistics, Credit Suisse, Sentinel Asset Management, Inc.

Thought of the Week: Troubles Not Shrinking, 11.07.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Another week of when a simple headline can move markets 5%. But we're the better for it.

Time Ladies and Gentlemen, please: The Greeks wanted a referendum on the rescues but, given its likely "NO", caved into French/German demands to stick to a confidence vote. So the people do not get to choose on this one. The immediate response was to see Bund/everything-else spreads widen sickeningly. Italian spreads are now what Greek debt was 18 months ago. Greece, of course, is a proxy for the larger issue of deflationary northern forces set against inflationary southern preferences. And a feint to a ridiculous series of affirmations. In June, the EU committed to 3% budget deficits by 2013. Today it's 6.2%. No one expects a 3% fiscal contraction in a $12 trillion economy.

Two historical perspectives help: i) Germany made its final Treaty of Versailles (1919) reparation payment of $95m in 2010, so restructuring bonds to the longest possible maturities with the lowest possible coupons can, and has, been done ii) banks can recapitalize through asset shrinkage (the current strategy) or simply accept nationalization. It's not so long ago that most French banks were fully nationalized (Mitterrand in 1982 just as everyone else was privatizing) and Italian banks were extensions of the Christian Democrats for 50 years. That would stop a run in its tracks. So two proven ways to work through austerity. Neither made it into the G20 final communiquè.

Looking better every day: US employment was unequivocally better in October despite the headline NFP of 80,000. Revisions in recent months mean that since June, the economy created 466,000 new jobs against first estimates of 318,000. Since March in 2010, the private sector created 3.9m new jobs while the government sector lost 1m. The ratio of government to private jobs is back to where it was in 2002 (think about that). This is not a jobless recovery. It is a slow recovery with the private sector doing well under contorted and aimless fiscal drag. And it shows here...

Corporate Profits: Productivity rose again in Q3. Output per hour is now 1.1% better than a year ago and 4.6% better in manufacturing. It's showing up in the corporate sector, where we're at a cyclical and absolute record:

Headline politics have overshadowed a solid earnings season. Sales and earnings growth are around 11% and 16%, even better if we exclude financials. This puts the market on a forward P/E of around 12x. However, as always in headline driven times, correlations and volatility remain high. The market is not selecting companies but trading on contagion, growth and political stories. That does not allow for multiple expansion. Equity trading ranges will probably edge higher but there's no rush.

Answers to Bonds: GT30 yields have moved between 2.4% to 3.4% in less than a month. At an 18.5 duration, that's a $105 to $121 price move. There's a lot of trading opportunity around today's level of 3.1%. The economy is stronger and we know the answer to three critical questions:

1. Will the EU slow and cut rates? - Yes
2. Will China have a hard landing? - Yes
3. Will the Fed keep the QE3 option open? - Yes...well mostly yes

 

Bottom Line: So with that, we like spreads (IG, CMBS, High Yield) but not the interest rate risk. We would set up spread trades, reduce rate exposure and keep buying US some large cap stocks.

Sources: Bloomberg, Federal Reserve Bank of St Louis, Bureau of Labor Statistics, Sentinel Asset Management, Inc.

Thought of the Week: Separate Tables, 10.31.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Strong rally in the markets but not wholly convincing. The GT30 traded in a $104 to $112 price range, which means many holding periods are counted in hours not days.

Europe Saved: Or maybe not. The package looks roughly like this: i) 50% write down of Greek debt ii) recapitalize the banks and iii) leverage the EFSF. The first helps but Greece will still have a debt/GDP ratio of around 120%. They simply can't grow the economy fast enough to stay ahead of the debt overhang. The second also helps but the €106bn of recap would still fail any stress test that considers sovereign default. And the third is good but still requires 20% loss absorption by the private sector. Even that may be too much which is why we see European heads of state heading to Beijing to ask if they will help underwrite the deal. If successful, we would have the delightful irony of a non-welfare emerging market state propping up a welfare old economy. Could happen.

The immediate upside was a run in European equities and strengthening euro. Disconcertingly, Greek CDS prices evaporated, putting into question sovereign CDS as a reliable hedging instrument. Italian bond yields continue to climb to their highest level since 1997. So, crisis solved. Now for the next.

US Economy: Safely out of the double dip woods. GDP was at 2.5% in 3Q, which sounds good, but is still up only 1.6% YOY. Government expenditures grew precisely zero and have been a deflationary force for much of the year. Expect more of that:

Lower government spending in the form of transfer payments also shows up in the personal income stats. We saw the third straight month of negative real DPI, erasing all gains from the last year and putting per capita DPI $284 below last December. Spending exceeded income for the month, which meant the savings rate fell. Nothing disastrous but that cannot hold. Good news is that nominal GDP is around 5%, which is good for sales and earnings from corporate sector. Which explains...

Good Earnings Season: About two thirds of companies have beaten expectations and growth is around 16%. If the market holds at 1280 pixel-time level, we will have seen a 17% retracement of the 22% summer correction. Equities look well supported but NFLX, AMZN and GMCR [1] show how fragile is confidence. The ever-reliable Fed surveys from Richmond, Chicago and Kansas all showed improvements with very little sign of price increases.

Bottom Line: Some worry that the sell off in bonds may be too rapid but we're comfortable with domestic stocks and, increasingly, international.

[1] No Sentinel Fund holds a position in Netflix (NFLX), Amazon (AMZN), or Green Mountain Coffee Roasters (GMCR) as of 10/31/2011.

Sources: Bloomberg, Federal Reserve Bank of St Louis, Bureau of Economic Analysis, US Department of Commerce, Sentinel Asset Management, Inc.

Thought of the Week: A Matter of Sentiment, 10.24.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

In the 52 trading days since the beginning of August, 30 have seen moves of over 1.5%. Market cycles are compressed and trading prompted by political headlines...and not good ones.

Euro Tracking: Greece is no longer the issue. It's a proxy for how to manage the other sovereign debts and recapitalize the banks. In this, all roads lead to Germany. It is the only economy capable of leading or backstopping the various funding institutions (IMF, ECB or EFSF). In the last week, bond markets almost gave up on France as we saw Bund/OAT spreads widen to 113bp, the largest since the Euro was launched and compared to an average of around 35bp. Until Germany agrees to some sort of European-wide bond or bank recapitalization, expect more of the same. Meanwhile, banks will reduce their loans to replenish capital and the economy will teeter on recession. Back in the states...

Post Summer Blues: Economic stats were encouraging in the US. The Empire Survey was much better than its headline. Not surprising as the headline question is a separate question unlike the ISM number which is an aggregate of the sub-indicators. Orders, shipments and unfilled orders all bounced sharply from August and 83% of companies expect to increase or maintain employment levels. Good. Then the Philly Fed confirmed the bounce with an even stronger reading in nearly all categories. The Beige book completed the picture with ten of the twelve districts reporting stronger or unchanged activity.

Not much to see in prices: The headline number of 3.9% YOY is driven by fuel and energy prices, which are up over 25%. Core inflation remains at 2% and probably too low given the level of activity we should be seeing. It's unlikely we'll see much increase given the woeful state of per capita income growth:

Housing starts recovered by 10% but more important, multi-family housing increased nearly 60%. Multi-family properties are invariably rented so that should help clear the housing market and reduce the OER component of the CPI.

Reflections: Bernanke's speech gave several laudatory examples of inflation targeting by CBs around the world. He wants more transparency and provide "conditional forward guidance" i.e. we will do "this" until "that" happens. Or, in the real world, "we will keep rates at 25bp until inflation hits x%." At the moment, he has only put a date on the "this." He seems very comfortable with the idea of exercising more overt and structural tools yet realizes he faces internal dissent and external pressures. This is not a man out of bullets. In the debate on targeting nominal GDP, policy could move more expansionary post Twist.

Bottom Line: These are not markets given to reflection. SPX has gained 12% since the October 3rd lows...GT10s have lost nearly 4%. We're looking to reduce price volatility in bonds, which means we're in shorter duration MBS. We're comfortable with a higher cash position and jump on any news from the earnings season.

Sources: Federal Reserve, Bloomberg, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of St Louis, Bureau of Labor Statistics, US Census Bureau, Sentinel Asset Management, Inc.

Thought of the Week: Crossing and Recrossing, 10.17.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Heading into another G20 weekend meeting. There are plenty of ideas around: IMF backing, strategic defaults, broader EFSF guarantees and infusions of bank capital. We would put the probability of any breakthrough at less than 10%, which means more drift. Bond spreads narrowed and the 30-year auction bid-to-cover ratio was significantly better. So much for crowding out. The market rallied but does not feel particularly underpinned.

One more important, one less: The market glossed over the FOMC minutes. Mistakenly. Labor costs and inflation were subdued and loan demand "tepid". There is clearly more dissent on the board, between the hawks "we're done" and the rest rightly concerned about aggregate demand. Fisher's comment on the risk of "hoarding by savers" describes a classic liquidity trap. A "number" (i.e. majority) were in favor of "large scale asset purchases...[that avoided] longer term Treasuries" which sounds awfully like QE3. The less important number was retail sales. On the face of it, a 1.1% MOM growth looks healthy. But there was a mighty big seasonal adjustment and in nominal terms, sales were down 4%.

Where is that confidence? It's meant to appear when rates are low, the economy stabilizes and companies have cash to invest. Well, all those are in place. But we just saw the lowest readings for the U. of Michigan confidence survey since March 2009, and 92% of the NFIB (not a group to hold back their views) saying credit is "not a problem" and a third saying "poor sales" certainly was. Job openings are running about 3m a month. They should be around 4m at this stage. Perhaps this has something to do with it...

Government Redux: We've mentioned in the past about government pulling back much faster from the economy than the private sector can absorb. The drag in 2011 is around 0.4% of GDP and will increase to 1% in 2012. Here's one example: a near 35% fall in unemployment insurance against an essentially unchanged U6 rate(it's even worse for the official rate):

Relief Rallies: We have seen a nice 13% rally in SPX and GT10s correct about 4% from yields of 1.75%. That's all in the right direction. But to see this sustain, we will need to see positive guidance in the earnings season. It's a mixed story. Valuations remain attractive.

Bottom Line: Despite our palpable frustration with the economy (and by the way, that's only because it can do so much better), we're still trading GT10s in the 175 to 225 range and increasing allocation to US equities. At these dividend levels, we're paid to wait.

Sources: Federal Reserve; Federal Reserve Bank of St. Louis; Bloomberg; US Census Bureau; University of Michigan, Institute for Social Research; National Federation of Independent Business; Sentinel Asset Management, Inc.

Thought of the Week: The Mists Disperse, 10.10.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

In both bonds and equities, we're back to mid-August levels. It was not a pleasant ride. The trigger was the debt shenanigans (never good to threaten wage earners) and the European Spartans vs. Sybarites argument. It's quieter now, which gives us thinking time.

It was worse, then better: The annual GDP revisions were a shocker with $400bn of GDP removed from 2003 to 2010. That's 2.7% of GDP that was never there. Real DPI growth was less than half what we thought. It's easy to second-guess policy with hindsight but the new numbers showed how inadequate was the fiscal response back in 2009 and why growth has been so slow. Then the third estimate of 2Q GDP came in and revised growth from 1.0% to 1.3%, which is what we were told in the first place. But the underlying story is the same: government shrinking, corporate profits rising, net exports improving and PCE flattening. And that's why...

You don't see it: inflation. Not there. Nor is it likely. If you are from the freshwater school of economics, the collapse in money velocity should be enough evidence. If you live in the pragmatic world, the latest personal income numbers showed another decline with government and transfer receipts taking the biggest hit. Per capita DPI has fallen by $190 this year. All due to lower government spending. Fine, if you're into austerity at any price. Not so fine if you expect the economy to recover, hire and spend. Hence, TIPS breakevens have fallen by over a point since May, the CRB is at the same level as in 2008 and core inflation is at 1.6%.

But look: We never thought that a double dip was likely. Low and slow, yes. But not absolute declines. Recent numbers support that. Friday's NFP were up nicely but more importantly, so were the revisions. Three month cumulative job gains were 287,000 compared to the 105,000 we saw last month. We have now created roughly 1.5m private sector jobs in the last year and lost close to 300,000 government jobs. We also saw solid ISM Manufacturing and Services numbers with the important production, employment and new orders numbers all growing. Not bad given the fiscal headwinds and some brave Fed policy.

Valedictory nonsense: Trichet held his last ECB meeting and decided to keep rates unchanged. They now look like this:

And that, in one easy chart is why the Euro is holding up. It's down 9% on the month and a rate cut would have wakened it further. Matchsticks support the Euro right now: political risk is high, economies slowing, contagion spreading (Dexia in its death throws). So the only reason it's not plummeting is the rate differential.

Bottom Line: As Jason wrote here last week, we're not sanguine on rates. Bull market sell-offs are ugly affairs. GT10s could hit 2.25% without touching the sides. With earnings season coming up, we are on the hunt for equity bargains financed with long bonds.

Sources: Bureau of Economic Analysis, US Department of Commerce, Federal Reserve, ECB, Bloomberg, Institute for Supply Management

Thought of the Week: There's more to the truth than just the facts. 10.03.2011

Jason Doiron
FRM, PRM, SVP - Head of Fixed Income & Derivatives
Sentinel Asset Management, Inc.

Given the dramatic market moves over the past quarter, we would like to share our thoughts on the subtle differences between the truth and the facts. In our opinion, the "TRUTH" is represented by the actual risk premiums that we observe in the market place while the "FACTS" are represented by the underlying data that typically contribute to these premiums. In investment parlance, we typically refer to the facts as the fundamentals and over the long run, we expect the truth (i.e. market prices) to be based upon these facts (i.e. fundamentals).

The Truth: Over the past week, the yield on the 10-year US Treasury note traded as low as 1.710% and closed Friday with a yield of 1.91%. To put these levels in context, during the 2008 credit/liquidity crisis the low on the 10-year was 2.055%. Additionally, the 30-year US Treasury bond has traded as low as 2.73% over the past week and closed Friday with a yield of 2.91%.

The Facts: Inflation metrics continue to rise with the most recent readings for Core PCE (YOY) coming in at 1.6% and Core CPI (YOY) at 2.0%. Since December, these levels have risen from 0.9% and 0.8%, respectively. That is a substantial increase in inflationary pressures when one takes into consideration that over the same time period we have seen a dramatic decrease of 138 bps in 10-year treasury yields.

Bottom Line: It is typical for investors to develop a sanguine view on interest rate risk during market environments such as these. This point is compounded by the unprecedented involvement by the Federal Reserve in all tenors of the yield curve. Operation Twist has allowed the Fed to manipulate the entire term structure of interest rates in the hope of stimulating additional economic activity. Although the old adage of "don't fight the Fed" certainly holds true for now, we would caution investors on developing an overly sanguine view of interest rate risk.

Sources: Bloomberg, Sentinel Asset Management

Thought of the Week: Yield Ahead, 09.26.2011

Daniel J. Manion
CFA, Senior Vice President, Portfolio Manager, Director of Equity Research
Sentinel Asset Management, Inc.

In Praise of Yield: So far this month the equity strategy teams of both Morgan Stanley and Bank of America Merrill Lynch (there may well have been others) have published pieces in which they extolled the current attractiveness of dividend paying stocks. At Sentinel, we couldn't agree more with the timeliness of this sentiment, although the notion of "yield support" might offer little comfort to equity investors experiencing a daily decline in stock prices equivalent to a year's worth of dividend income. Prospects for global growth have become decidedly less certain of late and corporate earnings growth expectations for the back half of this year and 2012 are in the process of being tempered, but companies' ability and intent to raise dividend payouts to shareholders seems firm. As the stock market continues to discount a global slowdown, lowered equity market valuations result in yields available on stocks at record levels relative to the 10-year US Treasury yield. A widening of this gap, and diminished upside in bonds, may eventually cause investors at the margin to shift funds back into equities, reversing a multi-year flight from high quality large cap US stocks.

Large Cap vs. Mid and Small Cap: Although dividend income has historically provided almost 50% of the returns equity investors have earned over time, dividend focused equity strategies have not exactly been the market's "sweet spot" in recent years. From the overall stock market lows in early March of 2009 up until the end of this year's second quarter, the biggest gains have come from more volatile small and mid cap stocks, which tend to exhibit more rapid earnings growth during periods of economic expansion and rebound, but tend to offer lower yield. While still somewhat early to draw too may conclusions, note that thus far in the third quarter, losses in higher yielding large capitalization stocks have been modest compared to steep declines in mid and small capitalization stocks.

A Word on Growth: We also agree with the notion that in stock investing a focus on companies that are able to grow their dividend over time is a better long term strategy than simply emphasizing high yielding stock (which may have very high payout ratios, and in many instances limited growth prospects). Another item to note is that investors need not concentrate their portfolios in certain sectors to enhance overall portfolio yield. In fact, some "growthy" sectors like technology have many constituents that have the wherewithal to substantially boost dividend payouts.

Bottom Line: During recent bouts of stock market weakness, we've continued to put incremental dollars to work in high-quality large capitalization US stocks with attractive dividend yields in our asset allocation funds.

Thought of the Week: Diogenes in the Barrel, 09.19.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

It's a good time to sit tight and stay with cash. It's not uncertainty. We can live with that. It's the certainty of temporary impasse. Here's why.

When Europe gets it wrong, it gets it really wrong. The cycle of tighter budgets, lower growth, higher deficits and higher bond yields is so manifest that you would think some coordinated policy response would be front and center. Not a bit of it. Greece is fast approaching the point where a declining economy cannot support debt repayments. It does not matter if the country embraces frugality or not. There is simply not enough juice to pay off debt. There are plenty of solutions: Consol-type perpetuities, ECB purchases, Eurobonds. All rejected. So now, we have near runs on the banks. European bank stocks are down 37% this year. This week we saw furious denials from leading banks that they did not have funding problems. Euribor OIS spread tells a very different story. It's up 20% in two weeks.

Clash of Wills: We may not see any respite until one or more of the following happen: i) the ECB cutting rates, ii) a deliberate QE program, if only as a back door recapitalization of the banks as happened in QE1 in the US, iii) restructured fiscal policy or iv) currency depreciation. Even these will probably not avoid a Greek default and Euro exit, which we now put at a 20% probability. It's tough to sit through. But we're in the midst of a major policy divide: fiscal consolidation to allow some magical multiplier to work or demand management to step up spending. Heterodox views are not easily reconciled. Hence the market funk.

Come Together: Asset class correlations have reached very high levels. In SPX[1], industry correlations are 97%, compared to 82% a few months ago. Similarly, international and emerging markets, the AUS$ and high yield bonds all show readings of above 90%. Twenty years ago, it was around 40%. It's not new to see higher correlations when markets stress. What is new is the high level of market velocity and asset class trading, which bypasses stock research and valuation measures. We see that as a good time to pick up names where dividends and growth comfortably exceed GT10 yields and inflation.

Prices: It was mostly a week of price information. Producer prices fell rapidly in the last few months. Lower energy prices, down 5% YOY, were somewhat offset by higher food, up 1.7%. We saw the story of subdued inflation over in import prices, which fell for the fourth straight month. Consumer prices came in at +3.8% with core CPI at +2.0%. Some of this is food inflation but some is in the elusive OER, which was negative a few months ago and is now rising at 1.4%. This may be no more than a reflection of a tight rental market but, at 25% of the index, it's something we're looking at closely.

The Regional Surveys: Philadelphia improved from a miserable August with a very firm rebound in future growth expectations. The Empire index again had a large number of respondents saying there was no change in expectations. We put it down to the painful August headlines. Production was encouraging especially given a weather related drop in utilities output. Put all the data together and it's soft but heading better. Not a ringing endorsement but not recessionary.

And did you see: new census data, which showed 46m in poverty (defined as living on $30 a day) and a whopping 7% decline in HH income since 2000. Tough to see any discretionary income kicker with that.

Bottom Line: If inflation continues then GT10s at 2.07% and core inflation at 2.0% make no sense. We'll position for higher rates but trade both ways in the meantime. We continue to buy. But no hurry.

Sources: US Census Bureau, US Dept of Commerce, Bureau of Labor Statistics, ConvergEx, Federal Reserve Banks of New York, Philadelphia

[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: Confused Alarms, 09.12.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Analysts are revising earnings forecasts down. Savings are merely funding deficits. They're not headed into productive assets or consumption. Here's why.

Bruising in Europe: This is no vigilante raid. Markets are no more organized than your average riot. But they can still inflict damage. This week we saw Euribor inter-bank spreads climb to 73bp, extraordinarily aggressive language from the SNB to weaken the CHF and the flight to safety with German Bunds at 1.76%. European banks fell again; they're down 35% in the last month or so and CDS widened.

Why does all this Euro stuff matter so much? Generally because 1) of the US' financial and economic exposure in Europe and 2) banks continue to mark their Greek and other bonds to model (not market) and those assets equal up to 10% of their equity. Ouch. And specifically, there's a lack of confidence that Eurozone banks can fund themselves except at extreme cost. Currently it's at LIBOR +100bps or 90bps more than a month ago. Throw in an actual default and the slow burn financial crisis gets serious. Europe is desperately keeping up a semblance of unity. It's a good act.

Two Speeches, Two to Come: Both speeches were prelude. But they were consistent. The Fed Chairman's speech said that the fundamentals were fine (sort of), but that demand has been weaker than he expected. But his final kicker was that the US needs fiscal stimulus if there's any hope of breaking out of the cycle. Geithner said pretty much the same.

The President's speech acknowledged the Keynesian truism that when employment increases, aggregate real income increases. He couched it in some supply side guff but the core of it, to add some discretionary income and reduce long-term unemployment, is dead on. The net effect is about $335bn (because it's not all in one year) or 2.1% of GDP. Set that against fiscal drag coming in 2012 of -1.8% and you can see why the markets didn't react too much. You would think that with the opportunity to borrow at negative rates, we would get more investment pull. Still. Something. Diary the President and the next FOMC meeting around September 20th.

Quieter week on the economy: Probably most important was ISM Services where seven of the constituent indexes rose and where some 60% of companies are simply seeing no change. That's consistent with flat, not recessionary, activity. Similarly, over in trade we saw exports up 16% and imports up 13%. We're buying less from China, Europe and OPEC, which probably reflects lower US demand and improved terms of trade. Put it all together and we have net exports probably adding 1% to growth in Q3. Which is good because we need it to offset the oncoming fiscal drag. And we see this in places like JOLTS, where there are marginally more openings in the private sector but fewer and fewer in the public sector.

Bottom Line: Bearish sentiment prevails. We're stuck in a low yield curve environment, which means that quality assets will stabilize or rally. Eventually. We're liquid and picking up stocks in mid cap.

Sources: Institute for Supply Management, US Census Bureau, US Dept of Commerce, Bureau of Labor Statistics

Thought of the Week: Are we there yet? 09.06.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

A rogue summer. Markets fretted, politicos dissembled, bankers flinched. So that leads us to:

Growth Fears: 3Q is of course weaker but not enough to tip into recession. Why? i) there's no pressure in the economy and volatile measures like inventories and orders are holding up ii) personal and disposable income are barely moving; confidence is flat (there are some August distortions in the metrics) but that does not mean wholesale retrenchment iii) no inflation, either at the PCE, broad deflator, core or CPI level. The NFPs came in at 0% after three months of private job growth of 340,000. The government sector continues to shed jobs. The cumulative one year jobs story so far: private +1.7m and government -0.5m. The number is maybe, perhaps slightly better than it looks what with the Verizon and Minnesota shutdowns. It's a close run thing but look at...

Fed Surveys: We've had a string of them recently and the common theme is broadly positive: an improved outlook over next six months, manufacturing and production steady but sales and orders down. The Dallas Fed's this week was typical: twelve of fifteen forward indicators up, with prices down and some inventory rebuild. Put this down to seasonality (they never capture the full seasonal effect), production interruptions and biggest of all, the July-August self-made crisis on the debt. It's hard to overstate what damage that did but it's mercifully working its way out of the system.

And the Fed: We saw the speech, FOMC minutes and some very "easing" sentiments from Fed officials. Reps from Atlanta, Chicago and Minneapolis saying that growth is not fast enough, and that more Fed action is ready to go. Perhaps more explicit guidance on policy, balance sheet composition, cut in IOER...that sort of stuff.

And the consumer?: Hanging in. Real DPI fell last month and, per capita, it's a whopping $35 more than a year ago. Why? Government spending, in the form of transfer payments, is flat this year. Yes, with all the hype about spendthrift ways, there was zero growth in the social benefits line item (that's the one with Medicare, SS, unemployment, etc.). And at the same time, there was $150bn more paid in income taxes. So you can conclude that either i) government spending must continue to decline to let the private sector do its thing or ii) that getting people back to work is the best possible outcome for the national accounts and that you need sensible demand-side polices in place.

The case for MBS: There was a tape bomb this week with the risk that homeowners will receive a mortgage deal. Right now, i) a homeowner can't refi if they're over a 125% LTV and ii) they pay a fee if credit scores are in the 600s. That could change. But too liberal a policy would wipe out FNMA's and FHMLC's capital which would require Treasury infusion, which would require more funding. Not to mention the damage to bank capital as premium securities are marked to par. See where this is going? The MBS market does not see this as a threat and neither do we.

Here's a nice one: This week S&P gave a sub-prime CMO a AAA rating. Mind you, they don't have seigniorage, taxation privileges, full liquidity and a pristine credit history (Ed: That's enough S&P trash talk for now.)

Bottom Line: The asset class trade (all those ETFs and algos) are running the market right now. Good for fundamental investors to buy large and mid cap equities on the intraday volatility.

Sources: Federal Reserve Bank of Dallas, Bureau of Economic Analysis, US Department of Commerce

Thought of the Week: No Counter Stroke, 08.29.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

That Speech: Not the Jackson Hole one but one from Bernanke in 1999 where he recommended unorthodox solutions to Japan's deflation. In an almost play for play repeat of the US, he highlighted i) the collapse in the PCE deflator ii) how zero inflation can not coexist with prosperity iii) the bad practice of targeting asset prices and iv) the idiocy of defending an exchange rate. He proposed a commitment to zero rates, money financed transfers (basically, inducements to spend) and non-standard intervention or QE-turbo using corporate bonds and asset backed securities.

Fast forward to Friday and we can see the constraints under which he operates. It's clear he recognizes the lack of aggregate demand and a vast output gap. And he noted gradual economic improvements with the exception of employment...which is like a Confederate newspaper announcing "Apart from Pickett's Charge, the day went quite well." So he put the Fed in a holding pattern, acknowledged the fiscal drag that is about to worsen and asked policy makers to do more. It's hard not to feel for the man. He sees the issues clearly enough but must counter the hair-shirters who expect more out of this recovery. They should look at...

"When will the housing market stabilize?": from the Dallas Fed, which highlights the collapse of housing starts from 1.8m units per year to less than 400,000 and the higher LTV requirements in the current market. They see no let up. We're not advocating forgiveness and easy mortgages, which spooked the MBS market this week. But it's clear that despite the lowest levels of marginal taxes since 1931 and the lowest corporation taxes of any OECD country, we need some policy to pull the economy forward.

Meanwhile, manufacturing: improves slowly. The Chicago National Activity Index improved on production, employment, consumption but not sales. It's the best number this year and in line with what we saw over in Durable Good Orders, up 9% YOY and led with a big bounce in transport equipment (mostly aircraft). The Richmond Fed was weaker but all ten of its surveyed components expect better results in the next 6 months. This all ties in with the second stab at the GDP numbers which showed 1% growth (yep, revised down again), deteriorating federal and state and local government expenditures (again) and PCE up less than 0.4% in four years. Corporate profits soared but they're not doing much with the money.

Thread this all together and the markets' reactions make sense: TIPs spreads hitting daily lows, a GT10 rate that cannot break above 2.30% and a fear that equities face a double hit of lower inflation and demand. So we're going to have to wait for all this to sort itself out. Good news that the next FOMC meeting will be two days instead of one.

Bottom Line: Widening IG spreads point to concern on debt coverage and the risk trade...we don't like long duration bonds regardless of who issues them...corporate equities look settled in the macro turmoil. That's where we put incremental money.

Sources: Federal Reserve Banks of Dallas, Chicago, and Richmond; Ben Bernanke: Japanese Monetary Policy: A Case of Self-Induced Paralysis, Princeton 1999; Ben Bernanke: Federal Reserve Bank of Kansas City Symposium 2011; US Dept of Commerce; Bureau of Labor Statistics; Bloomberg

Thought of the Week: Canopy Jungle, 08.22.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Another week of big moves...VIX above 40, GT10s below 2.0%, SPX[1] back to pre-QE2 levels, GTII10 at negative rates. Why? Well, everything really. Euro banks, threat of a Tobin tax, no to Euro debts, weak US economic numbers, the Euro non-deal. But they boil down to two things: lack of US demand and European banks. Let's take a look:

US demand, weak but not out: Industrial production is up 3.7% over the year with some of the capex and resource industries showing double that but with consumer and housing industries at almost zero growth. It ties in with the Philly Fed numbers at their lowest level since March 2009... the same month, incidentally, the stock market bottomed. No surprise because we continue to see negative growth in real earnings. Yes, for nine out of the last thirteen months, wages fell. This economy will simply not give consumers a break and, while this is good for the corporate sector in the short-term and very good for inflation, it will not hold. We need relief for consumers and it will not come through tax cutting.

Fiscal drag is coming: which it need not. We have ample money to fund growth, and, yes, deficits. The total net worth of households exceeds $58 trillion, nearly six times the federal government's net debt. Household finances are improving; debt service payments are down to 11.5% of income compared to a 14% peak. And banks hold over $1.6 trillion in excess reserves. So the problem is not debt levels. Or money availability. We have full room to borrow more. But we have suppressed demand. We can remedy that easily without igniting inflation, which has mysteriously disappeared from the discussion after six straight months of core inflation below 0.2%. The latest LEI was hopeful but pointing, as with all recent stats, to modest pace. The solution to all this is fiscal demand creation. But we have to exhaust monetary policy debates first.

European Banks: Bank runs and funding problems are nothing new. Nor is the size of the problem that great. But investors are pole-axing European banks because they continue to hold their own sub-prime mess in the form of cross-border loans to weak Euro borrowers. They won't write them down and the Eurocrats are giving them every loophole to avoid doing so. Other banks then withdraw funding and capital ratios decline. The front-end damage commences and the notorious short sellers pick up the pieces at the back end. There are plenty of solutions, such as temporary credits and pan-European bonds (i.e. consolidate the debts). And don't forget nationalization could recur and may well if the stresses continue. Perhaps that's why Euro bank CDS increased 28% compared to an average 33% share price drop.

And the limits to Monetary Policy Part III: The FOMC dissenters were on the waves this week. Fisher objects to the "Bernanke put," Plosser to "protect[ing] traders" and Bullard says that no QE3 is coming. We agree any twist operation will have limited effect...heck the markets are doing a great job taking bond prices down without additional buying power. They probably all agree that traditional transmission mechanisms have weakened. Next week's speech from Jackson Hole will probably announce some measures but nothing like the scale of 2010.

The relentless news points to an economy performing below capacity with inadequate aggregate demand. This is troublesome but not tragic. Markets overreact in both directions and this is one of those times. The long trade out of bonds and into equities remains.

Bottom Line: Buying stocks with deliberate cash return strategies and growing dividends...avoid the high EPS dispersion and momentum plays. And enjoy a walk in the Salley gardens.

Source: Federal Reserve Banks of Philadelphia and St Louis, Bureau of Labor Statistics, The Conference Board, Bloomberg

1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: As the hordes go by, 08.15.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Another week of market paranoia. This is, of course, the result of uncertainty, confusion and seemingly contradictory news. The tales of economic slowdown, sovereign debts, Euro existentialist crises, rush to safety and manic trading are rampant. We've seen them before and, yes, they are full of sound and fury. Here's why.

Growth Fears: Now well and truly in the forefront. And in that environment, deflation is a fear and the only investment strategy for deflation is capital preservation. Negative rates in CHF (Swiss 3m paper selling at premiums), another gold rush and GT10s at 2.03% (for a nano second) all tell the same story: i) weak final demand, employment and world growth and ii) the reality that, unless there's some give on fiscal action, about 1.8% of US GDP rolls off at the end of the year. That's stuff like payroll taxes, accelerated depreciation allowances and unemployment extensions...not to mention state and local expenditures. And so...

Time for a macro refresher: The federal government accounts for about 8% of GDP; take out defense and it's less than 3%. The rest of the budget spending goes straight into the PCE line. Yes, it's all transfer payments going to consumers. Is that not what the fiscal hawks want? Money going to the most trustworthy, dispassionate and efficient part of the economy: the private sector. So, if that's cut and nothing replaces it, we are staring at some serious fiscal drag. Once again, jobs were never on the agenda in recent discussions. It was as if some fiscal, magic-pixie dust sprinkled over the economy will erase the output gap. Jus' sayin. So thank you...

FOMC: Made no change. The words in the first paragraph included: slower, deteriorations, flattened, weak, depressed, tragic. And one paragraph is new: the Fed said "conditions warrant exceptionally low levels... through 2013" but added a dissenting paragraph that said "conditions warrant exceptionally low levels...for an extended period." See the difference? The hawks don't want a date out there. But we're glad there is one.

And so is the bond market. Funny that with all the comments on how fiscally profligate we are Treasuries have rallied 5% (10% if you hung out at the 30 year mark), US CDS are back to 52bp from a high of 65 but US bank CDS have risen 35% to 190bp. Dollar fairly stable. That is not the pattern of a big sovereign debt crisis, which means that what we have in the US is a clean old growth problem. That's usually easier to deal with. And makes it different from 2008.

GT10s look rich...duration at 9.0 vs yield of 2.2% or a 4x risk/reward ratio. GTII10s traded negative yesterday, first time I can remember...5 years yes, they're stuck at negative 90bps! It's a very asymmetric return for GT10. That argues for bringing duration way in.

And over in the real economy: U. of Michigan number of 55 was a real clunker but what do you expect when politicians talk blithely about not sending social security checks or paying federal employees? There is always a negative feedback loop danger but we think this number will reverse soon. Elsewhere the trade deficit was slightly worse but again due to the average price of oil being well over $100 in 2Q. It's now $88, which should improve the terms. JOLTS was better. The unemployed to openings ratio was 4.4 against 5.6 a year ago. Leading indicators still point to growth.

Ok, calmer now but will it get cheaper? Yes, possibly. Markets are working with short horizons and at the asset class level. Fundamentals are not important to the market right now. SPX[1] earnings normally fall about 30% in a recession (more in 2008 but that was due to financials) and the market is down 15%...so half way there if we are headed towards recession. But we're not. The ROE of top companies is about 21%...exclude financials and it's about 5 points higher.

Bottom Line: Economy soft but recession fears overdone...and a very good performance from the private sector in the teeth of some vicious headwinds. Try to ignore the markets' St Vitus dance. It will pass.

Source: US Census Bureau, Bureau of Labor Statistics, Federal Reserve Bank of Dallas, Bloomberg

1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: A sudden sword, 08.08.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

No fury like a market scorned. This week saw the debt ceiling deal close. A Pyrrhic victory for all and disaster for the American worker (we will come back to this). Stocks fell in nine out of the last ten days.

What happened? It's always difficult to tell who pulled the trigger but it started with i) a run on Euro banks ii) to a safe haven but iii) Japan & Switzerland were having none of it and intervened heavily to iv) stop their currencies appreciating so v) money sought out US dollars which meant vi) short term rates fell to negative 0.5bp and so vii) banks announced a charge for customers which meant viii) negative rates that sent money looking for yield in duration assets which ix) rallied bonds and x) gave a built-in excuse for a "risk off" trade out of stocks, which really took it on the chin. Nothing to do with earnings. Nothing to do with companies. A fully-fledged anxiety attack.

But it had its roots in: a US growth problem and an EU debt problem. The trouble is that policy makers have treated the wrong ailment in each: the US fighting the chimera of debt and Europeans the illusion of currency unity. Europe can't even agree on the simple stuff. This week we saw four European financial companies use four different accounting standards to impair Greek bonds. And in the US, the weaker economy raised its head on Tuesday with the news that DPI has been stuck flat for three straight years. We have known this for months but recent political flack had camouflaged it.

Now back to me [1]: We hold to the soft patch position. The labor market is healing. NFPs rose 117,000. The private sector added 904,000 jobs in the last year. The government lost 717,000. The workforce shrunk and unemployment dropped a bit. Slow but steady. The ISM reports showed seven out of eleven industries growing and expansion for the 26th consecutive month. The Texas Manufacturing survey nearly doubled in July and the state gained an impressive 30,100 jobs. Those who raised the specter of inflation earlier this year have some explaining: the latest trimmed PCE annualized rate was -2%. That should put some discretionary income to work in the next few months.

Bottom Line: Buying large cap equities. We've been net buyers for most of the last week. It would take a lot to induce a double dip recession at this point. Recession drivers are a) bank and credit problems b) over extended inventories or c) inflation. Sure there are other exogenous shocks to trip an economy but none are present. We have weak demand and if there's one thing corporate America does really well, is adjust to lower demand.

Sources: Bureau of Economic Analysis, Institute for Supply Management, Federal Reserve Dallas, Bloomberg

[1] You are not a monster http://www.youtube.com/watch?v=zkd5dJIVjgM&feature=related

Thought of the Week: Waiting for the Barbarians, 08.03.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

So just when it seemed as if it couldn't get any worse, it didn't. We thought we would extend our normal deadline to comment on the debt (ahem...) discussion. We needn't have bothered.

That Package: The CBO states it will reduce the deficit by $2.3tr over the next 10 years, of which discretionary spending caps account for $756bn and $1,200bn comes from, wait for it, decisions to come from the Joint Select Committee. Then there's the bi-decade balanced budget Constitutional amendment nonsense for good measure. The CBO takes as its baseline the March 2011 budget and economic numbers...the same ones the BLS just revised down by a whopping $400bn. So a smaller economy, growing at less that expected, needs to do the same amount of cutting. Could happen. But what is amazing is the almost total absence of discussion on employment and jobs. It's as if there is some unstated syllogism of "lower deficits mean more jobs." They don't.

AAA: S&P wanted $4tr in savings to avoid a downgrade. At pixel time they kept quiet on the issue. Fitch (the French one) said they would not downgrade but might if debt goes to 100% of GDP. So clear on that. There's no shortage of pundits calling for a downgrade. But it is hardly likely that any downgrade would have a material effect on US Treasuries. The GT10 trades nearly 90bp below February's level, a rally of 10% amidst the full fury of the debt negotiations, and the 2-year Treasury trades at 32bp. Not the stuff of Armageddon. Remember there are no forced sellers if a downgrade happens and there are no alternatives to the depth and liquidity of the US bond markets: not gold, not Swiss francs, not Bunds. The largest non-US bond markets are Japan and Italy. Want some? Thought not.

And in the real world: the squeeze on consumers continues. The BLS numbers again showed higher savings, low access to credit and concerns about household balance sheets. It's the corollary of record earnings and profitability of the S&P companies. And in line with the manufacturing and corporate led recovery we have discussed for months...years actually. It's a recovery measured in inches. The most recent Dallas, Richmond and Chicago surveys tell the story: 90% or so of companies reporting unchanged or improved prospects. As long as the unch number remains, the recovery will crawl on.

Bottom Line: Testing times; the bond market is overbought and due for a correction, but this is the consensus view and may take longer to play out. The S&P[1] is down nearly 7% but showing robust earnings growth and dividend yields. That's where we put our money.

Sources: Congressional Budget Office, Bureau of Labor Statistics, Federal Reserve Banks of Chicago, Richmond and Dallas, Bloomberg

[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: Unhurrying chase...Deliberate speed, 07.25.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

It was a week of overhangs some of which looked better at the end.

Shhhh...That Greek Deal: In a bizarre statement from the European Council (not to be confused with the Council of Europe) a deal landed that a) extended maturities b) lowers some coupons and c) wrote down some principals. Oh, and the IMF (that's us) kicks in. Basically, it tries to contain Greece with a lot of fluff about lower public deficits in the future. But it works for now and Greek bonds promptly rallied 15%. Expect this problem to resurface. Meanwhile...it's a tough case for European equities.

US Debt: Impasse, negotiations, taking it to the edge...all the descriptions fit. Worst case is a Guns of August scenario... the book JFK gave to his cabinet in the Cuban crisis with the advice not to let events run decisions ... no one wants it, but the machinery takes over. At pixel time, it's still "yes, we do...no, wait, we don't." But bonds are likely to remain stable because overseas buyers are willing to buy...and don't have to compete with the Fed. Corporate spreads look vulnerable. They're historically tight. Some AAA names are trading below Treasuries...it's happened before but it's usually a sign of a rich market.

A Mini Bounce: Yes, it's time for our favorite Fed surveys, this time from Philly. The index bounced but, as readers know, we look more at the "business unch" section, which is 46%, and the 50% who said business would grow by 1% to 6% (not annualized) in the next quarter. Unemployment claims fell only slightly but the Minnesota government shut down may have exasperated those in the short term.

Earnings Season: With about a quarter of S&P companies reporting we're seeing 75% beat estimates against an average of 65%. Some of the themes were high margins (AAPL, IBM, PM), lower loan provisions (BBT, AXP, WFC) and higher sales (CAT). Average sales growth for non-financials has been 15% and YOY earnings of 28%. All in line with our manufacturing, business recovery theme, then.

Bottom Line: Trading still in a clear range with a recent non-QE rally. Buying stocks.

Sources: Bureau of Labor Statistics, Federal Reserve Bank of Philadelphia, FT Alphaville, Bloomberg

Apple, Inc. (AAPL) is 3.44% of total net assets in the Sentinel Capital Growth Fund and is 4.18% of total net assets in the Sentinel Growth Leaders Fund as of July 22, 2011. International Business Machines Corp. (IBM) is 1.66% of Sentinel Balanced Fund, 2.77% of Sentinel Common Stock Fund, 3.23% of Sentinel Sustainable Core Opportunities Fund, 4.86% of Sentinel Capital Growth Fund, 5.41% of Sentinel Growth Leaders Fund, and 0.52% of Sentinel Conservative Strategies Fund. Phillip Morris International, Inc. (PM) is 0.75% of Sentinel Balanced Fund, 1.08% of Sentinel Common Stock Fund, and 0.31% of Sentinel Conservative Strategies Fund. American Express Co. (AXP) is 1.01% of Sentinel Balanced Fund, 0.89% of Sentinel Common Stock Fund, 1.04% of Sentinel Sustainable Core Opportunities Fund, and 0.44% of Sentinel Conservative Strategies Fund. Wells Fargo & Co. (WFC) is 0.61% of Sentinel Balanced Fund, 0.93% of Sentinel Common Stock Fund, 1.22% of Sentinel Sustainable Core Opportunities Fund, and 0.17% of Sentinel Conservative Strategies Fund.

No Sentinel Fund holds a position in BB & T Corp. (BBT) or Caterpillar, Inc.(CAT) as of July 22, 2011.

Thought of the Week: Traffic to Jacob's Ladder, 07.18.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Markets corrected this week and who could blame them? Regular readers know that we have tended to see recent economic stats as more robust than most...we stick to that view. But the political shenanigans are fast turning into a crisis, making these dangerous times.

US Debt: We all tend to like an honest, self-destruct story (step forward Sheen, Lohan and Brooks) but the US one is taking us to the edge. S&P placed us all on negative watch on the belief that there could be a late coupon or maturity payment in August. There are various ways to prioritize payments if there is no agreement but because Treasuries are a unique asset - the universal benchmark and deeply embedded in the financial system - it would be a disaster. A fire sale would follow.

Inflation and earnings: tell a slow growth story. The annual CPI rate climbed to 3.6% but that's because of the 18% weight in oil, transport, energy etc. Some pointed to the 0.2% rise in OER which has a 25% weight (and even more in the core inflation) but we don't see that as indicative of anything other than a short-term supply problem for rented accommodation. Real incomes, meanwhile, continue to fall...down 1.2% over the year and almost twice that for non-supervisory employees. No surprise, then, at the University of Michigan confidence indicator, down 7 points to 64 compared to a long-term average of 83.

Empire Manufacturing: Much better than it looked. Nearly all of the twelve forward-looking indicators improved. We're not a big fan of diffusion indexes so another way to think of it is that 80% of companies see their business improving or unchanged. That's in line with a slow patch.

Meanwhile, corporate earnings are coming in ahead of expectations and they're doing this with the highest level of gross cash on their balance sheets and one of the lowest net debt levels in history.

Bottom Line: Risk aversion for now and expect more sturm und drang but not much market direction.

Source: Bureau of Labor Statistics, Federal Reserve Bank of New York, Bloomberg

Thought of the Week: Enduring Through, 07.11.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

There's a lot of market activity lately but it's mostly noise. The S&P[1] rallied 5% in the last few weeks but breaks down as soon as confidence is dented. Bonds are caught in a good trading range with no desire to break out. It all feels very much like the doldrums. The economic numbers were testing to say the least.

Employment: Just when it looked as if the rate might stabilize at 9.0%, the latest number was 9.2%, marginally better than a year ago and particularly tough for the non-college educated where unemployment exceeds 14%. The basic story is that people are dropping out of the labor force; the private sector added 1.5m jobs in the last year but that the government shed 1.3m. The private sector simply cannot absorb the growth in labor and the government job losses. The seasonal adjustment is always aggressive in June...over 1.1m workers. Where did they go? We'll see how this plays out next month when June's hiring intentions (see ISM, Fed survey, etc.) are counted.

Other: Chain store sales had close to a blow out month...nearly 7%. And the ISM Manufacturing surveys show seven of the growth categories as growing and only one (supplier deliveries) slowing. The "employment intentions" index rose. The numbers are consistent with a soft patch. Not recession. Personal income remains stressed: DPI per capita is a mere $34 higher at $33,064 than last October. Blame higher taxes, social insurance (bad) and higher savings (good).

Chicago Fed Automotive Outlook Symposium: This news is rarely covered because, well, it's a soporific title. But they expect light vehicle sales to rise by 12% this year and note that Toyota's Prius outsold the entire Cadillac division in the first four months of the year. As the supply chain issues clear, there could be quite a rebound.

Don't mess with: Dallas Fed President Richard Fisher who said that 43% of all US jobs created since the trough were in Texas. Employment has grown at four times the national average for ten years. Some fiscal policies seem to work.

Bottom Line: It's going to be a long one. Best to keep on the side of the risk assets and buy on the dips. There will be plenty.

Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Institute for Supply Management, Bloomberg

1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: Standing Pillars, 06.27.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

After another week of ups and downs, the markets ended up where they started. It's the season for going into weekends with long positions covered...nothing enjoyable in markets happens on a Sunday. The news this week was good but you had to look for it.

GDP Data: All Q1 revisions so we'll not spend too much time looking back except to note that i) the numbers were revised up ii) the government sector, or fiscal drag as it's sometimes known, was down 8%, taking $60bn out of the economy and iii) disposable personal income clawed up 1%. And that's the pattern: government less, households on slow re-build, savings up and corporate profits up to a record 12% of GDP. Steady.

Chicago Fed NAI and Durable Goods: Also away from the housing and inflation stories, both reports were solid. The Chicago NAI is an interesting index, designed to show trends relative to capacity and much broader than other regional Fed surveys. It ticked up: April was revised down and half the indicators improved MOM. Production and manufacturing were up (good) and consumption and housing were down (which we knew). Durable Goods were also in reasonable shape with 16 of the 19 sectors up by an average of nearly 10% and defense (i.e. government) down 22%. All of which brings us back to...

The corporate sector providing the growth, which is good for capex and employment.

Oil: The decision to release 60m bbl from reserves (30m bbl for the US), was a cleverly designed damp squib. That's because it's a stimulus: if higher oil/gas was i) an important input to PPI and CPI and ii) a tax on spending, then its reverse is true. Don't get too carried away: it's equivalent to two days of US consumption. It's a signal that the government wants lower oil...this signaling can work in FX and bonds but usually doesn't for oil.

Finally, please note that markets are very twitchy. Margin debt is $315bn, its highest level for a number of years. It's at 2% of market cap, the same as its 2008 peak. Traders are running the show. As if to prove the point, late on Friday the 90-day T-Bill (i.e. US government) to Eurodollar LIBOR (i.e. European banks) spread doubled in less than 15 minutes and then closed up again. Watch for that kind of weird trading in the coming weeks.

Bottom line: The oil price break down gives great opportunity to buy some of the best managed companies in SPX;[1] fixed income markets look nervous.

Sources: Bureau of Economic Analysis, US Department of Commerce, Federal Reserve Bank of Chicago, NYSE, Bloomberg

1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: Grasping the Hem, 06.20.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Markets are trying to find traction but mostly crabbing...moving sideways with bravado. The Greece slow motion default rolls on. Five-year bonds and CDS both trade at 19% which means that to insure against default, investors' return will be zero. Don't expect any clear solution to this. Just more noise and muddling through. Meanwhile in the real world:

Manufacturing Surveys: Two of our favorite surveys (Empire and Philly) reported this week. Both disappointed but for the wrong reasons. These are diffusion indexes measuring those who say "better" minus those who say "worse". So "no change" doesn't get a vote. In the Empire, 18% of businesses said conditions were higher and 26% said lower. The result was an index of -8, which was the worst since November (cue gnashing of teeth). But 56% said conditions were the same and 41% said they expect to increase their workforce in the months ahead. It was a similar story with the Philly. This is not a Panglossian varnish to so-so news but brings us back to reality. Economic rebounds from 2008-like depths are neither swift nor smooth. Corporate America is showing solid productivity, strong cash generation and a sensible attitude to growth. Not glamorous perhaps but more sustainable in the long run.

Inflation fears: were all the rage a few months ago. This is fast becoming yesterday's story. The CPI rose 3.6% almost twice the amount of last December. But this is almost entirely due to a 13% rise in transportation and fuel costs, which are 18% of the index. Some food items also rose but probably due as much to their energy inputs (fertilizer, transport etc) as to supply shortages. Core inflation rose 1.5% but that's a long way from the TIPS break-even rate of 2.5% seen in May and which now trades at 1.9%. Low capacity utilization again points to disinflationary pressures. Inflation fears have given way to growth fears. Such is the near-sightedness of the market.

In the next few weeks, the important items are: i) some deal on deficit reduction...at this point almost anything with a trillion attached to it will work, regardless of time ii) earnings and announcements as we enter Q3 iii) signs of manufacturing numbers improving. What's less important is unemployment and consumer demand. There's no chance that either will move much.

Bottom line: In equities, we like stable growth and dividend strategies; fixed income markets look expensive...but in both cases, there's no rush.

Sources: Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Bureau of Labor Statistics, Bloomberg

Thought of the Week: Settled Gravity, 06.13.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Not a good week for risk assets but this has nothing to do with QE2. The reasons are both technical and fundamental. I try to stay away from technical issues but this one is important. Let's take a look:

Sound of the butterfly: The NY Fed sold $4bn of the worst type of MBS to the street. These were part of the $45bn Maiden Lane portfolio from AIG so, yes, mostly sub-prime, non-guaranteed and 100% LTV. Prices are notoriously opaque but hedging indices suggest the market required an enormous risk premium: the Markit CMBX Series 4 index [1] (the AAA tranche) fell 15% in three weeks. So triple that for the A tranche. The sale could not have come at a worse time. Sovereign risk fears, weak economic data and a whiff of higher capital requirements meant that dealers hedged using CDS where they could. The result was that risk assets fell like dominoes: first other CMBS, then high yield, non-agency MBS and equities.

Economy: The Beige Book and Bernanke's speech underlined what we knew already: a frustratingly slow recovery. The market is anxious for QE3 or some other monetary tool to boost asset prices. Doubtful. But there are unqualified positive trends: households are cutting debt at the rate of $100bn a month. Sure, this reduces spending power in the short term but it means less stress and higher savings. Non-financial corporations hold almost $2 trillion in cash, which surely underrates reported ROEs. Auto production will likely rise 25% in the next few months after the supply choke. Inflation will moderate as commodity prices ease. Not a bad list.

Technical issues evaporate. Meanwhile equities are at record levels of profitability, dividend growth and earnings. They can continue to cost cut and improve efficiency for a while yet. All with very little leverage. And that makes it very different from 2008.

Bottom line: Markets still want to shed risk assets but equity reentry is not far away.

Sources: Federal Reserve Bank of New York, Federal Reserve, Bloomberg

1. The Markit CMBX.NA.AAA.4 is a synthetic index referencing 25 commercial mortgage-backed securities. An investment cannot be made directly in an index.

Thought of the Week: Jewels in the Carcanet, 06.06.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

When we look back at these markets a few years from now, we will wonder at all the fuss. For several weeks, there have been corrections in SPX[1] while GT10s have rallied 6%. This is fine. There is no disaster pending and the next few months should present calmer re-entry opportunities. This is why:

Threading the data: Sure, the NFP numbers disappointed but this was always going to be stubborn. What is far more interesting is that we saw a) a rise in both manufacturing productivity and disposable personal income and b) Fed surveys pointing to higher employment in the months ahead. Productivity is the ultimate guarantor of higher living standards and very important for competitiveness. The US leads in this and that's why three German powerhouse manufacturing companies recently announced expansions in the US.

And what did you expect? We need to look at NFPs over the last year. We lost 1.3m government jobs. We created 1.2m private jobs. The labor force shrunk a little. Work moved from construction, finance and local government to goods production and manufacturing. It was never going to be frictionless. The labor force takes time to adapt. And it's all unequivocally good for inflation.

How 'bout those GT10s? At pixel time, the yield was settling in below 3%. We expect it go lower then higher. And you can quote us. Why? Because the end of QE2 will bring foreign buyers back. They're buying at an annualized rate of $640bn compared to nearly $1,000bn in 2010 and, unless they want their currencies to soar, they will buy. The higher rates won't come until economic numbers improve, probably in Q3, when we could see retracement to 3.40%.

So with productivity gains moving solidly ahead, 14 of the 18 ISM industries still in expansion mode, headline inflation cooling and US profitability at records levels, the outlook is fine.

Bottom line: Taking some duration risk off in MBS and corporates; equities defensive but not for too much longer.

Sources: Bureau of Economic Analysis; Bureau of Labor Statistics; ISM Chicago; Federal Reserve Banks of Chicago, Richmond, New York, Philadelphia; Institute for Supply Management

1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: A Vexing Eye, 05.23.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

There are neuroses in the markets but by Friday nothing much moved. The news is all over the place but this interests us.

Greece: The reason this $280bn economy (less than AAPL's market cap) keeps headlining is: what happens next? The (very) quick summary is: i) Greece has a 165% debt to GDP ratio that keeps deteriorating because ii) the economy contracted 5% and has 16% unemployment and iii) the government must run a 6% primary surplus for six years just to reduce the debt ratio to 130%. Could happen. But bond investors, a skittish lot at the best of times, marked up Greek 10-years to 16.5% or 1351bp above bunds. Sort of a weakest link, goodbye ranking.

So things are weird. There aren't many options for the Greeks: i) re-profile, which means extending bond maturities ii) withdraw from the Euro or iii) privatize more assets. The ECB shut off the first two by saying they would not accept Greek bonds as collateral if there was any restructuring. Why this matters is because the Euro could head south quickly if there are no agreements and German bunds come under pressure because they're the reluctant guarantor. Which, trust us, is not good for the US. Meanwhile back home...

Philly and Empire Surveys: came out this week and confirmed the weak patch in the economy that we knew about from the ISM surveys. But, from the glass half-full end of the bar, both show i) positive readings (these are diffusion indexes after all) and ii) expectations of expanding employment. Which is good for upcoming jobs numbers and again testimony to the remarkable productivity growth we've seen in the economy, so explaining...

Stock Buybacks: which continue to accelerate with $180bn announced this year, more than double last year. It's difficult enough to estimate corporate and SPX1-level EPS but analysts do not usually factor in share shrinkage. So if companies buy back up to 5% of the outstanding shares, earnings estimates may be too low.

All this leaves us feeling fine with current market levels...except for the crazies playing in the RENN and LNKD space.

Bottom line: Defensive and positioning for the post QE2 world.

Sources: Nomura, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, WJB Capital, Bloomberg and Sentinel Asset Management, Inc.

Apple Inc. is a 3.0% of total net assets in the Sentinel Capital Growth Fund and is a 3.6% of total net assets in the Sentinel Growth Leaders Fund as of May 23, 2011. No Sentinel Fund holds a position in Renren? (Ticker: RENN) or LinkedIn (LNKD) as of May 23, 2011.

1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: Counting Clocks, 05.16.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

In a week where Cassandras lined up, it turned out to be, well, pretty boring. There were a couple of releases that confirmed the meandering outlook for the markets.

Inflation (BLS): The headline was 3.2%, the highest for nearly three years. But nearly all of that was energy costs, up 32%, but because they're only 5% of the CPI weight, meant core inflation was only 1.3%. The bond market barely flinched which makes sense when you consider...

Real Earnings (BLS again): declined by 1.2% over the year and are down 1.7% from their peak. These have stagnated for years and there's no upward trend in sight. Which is why over at the NY Fed, we see...

Consumer deleveraging: household debt declined again to a level last seen in 2006. It's now at 76% of GDP vs. the 86% peak. Everything is down ( mortgages, HE loans, autos and credit cards) but so are delinquencies. This may explain why consumption was better than expected in Q1 GDP and why the U. of Michigan confidence numbers were up.

All a bit of a mixed bag which means that capital markets had nothing to chew on except the nonsense going on over at the silver market. We'll reserve comment on that for now.

Bottom line: We're travelling sideways but look soon for an end to EM tightening.

Source: U.S. Bureau of Labor Statistics, Federal Reserve Bank of New York, Bloomberg, Sentinel Asset Management, Inc.

Thought of the Week: Into the Din and the Glare, 05.09.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

What a week, starting with bin Laden and ending with a rumor of a Greek default...not for the first time and always a Friday. But this is what caught our attention.

Diving into BLS (again): The US jobs machine is not broken. Headline unemployment ticked up but NFPs popped to 244,000 with the last few months revised firmly up. So that's 1.1m new jobs since last September and all of that in the private sector. The diffusion index shows the gains broadly based, which is what we also see over at...

ISM: Data have been much better than headlines suggest. Manufacturing PMI has expanded for 21 straight months and the average through April (so bumping through the Q1 data) is equivalent to 6.1% GDP growth. Retailers' same store sales were at +8.5% for April, so, again, better direction post-GDP data. Some of it was Costco with its gas component but Limited, BJs, Saks all showed good numbers.

Commodities: What happens when a crowd heads for the exit. CRB down 8% and oil, NG, gasoline, silver down between 12% and 28%. Some of it is QE2 ending (from the money=prices school), or slower economic growth, or MENA. Take your pick. But a lot is because of ridiculously overbought and overleveraged positions...for a truly weird commodity ETF, check out UNG. Which is why we always invest in companies that add value to the commodity and not in the physicals or futures.

Bottom line: It's going to be rough for a while. Keep the powder dry.

No Sentinel Fund holds a position in Costco (Ticker: COST), BJs (Ticker: BJ), Saks (Ticker: SKS) or the United States Natural Gas Fund LP (Ticker: UNG) as of May 9, 2011.

Sources: U.S. Bureau of Labor Statistics, Institute for Supply Management, Bloomberg, Sentinel Asset Management, Inc.

Thought of the Week: Two By Two, 05.02.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

It's a quiet Friday and I'm homesick for tea and a wedding. So diving into the BEA (for GNP) and BLS (for employment costs), some thoughts:

Could do better: Difficult to spin the GDP numbers any way but disappointing. Growth slowed to 1.8% from 3.1% and about 2.3% up from last year. The personal and private side is doing well but government consumption was a net drag on growth of 1.09%. Say what you like about fiscal stimulus, but take $35bn of spending out every quarter and it's going to hurt.

One to keep an eye on: There's an interesting relationship emerging between inventories and imports. When imports increase (which depresses GDP), inventories also increase (which increases GDP). It makes sense because businesses tend to import, build, inventory and then sell. In Q4, they ran down inventories, imported a little and exported a lot. Net exports were a big growth driver. That broke down in Q1. Exports are way down and with the terms of trade very healthy, this is a puzzler. More to come.

Over to the BLS: Another economic stat that caught our eye...employment costs rose 0.6% over 3 months and 2.0% over 12 months. So far so good...ties in with the lack of wage pull we would expect from the employment numbers. But benefits increased much faster, 1.1% for 3 months and 3.0% for 12 months...and even more in the state/local government sector. If that kind of drag continues, employment recovery will be even slower than we thought.

With two thirds of companies reporting, we've seen 13% sales growth and 22% earnings growth. That's good but it's very focused in a few industries. Lack of dispersion is not a healthy sign.

Bottom line: May...time to back off.

Sources: BLS, BEA and hat tip to FT Alphaville. Sentinel Asset Management, Inc.

Thought of the Week: Quis custodiet*? 04.25.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Bond vigilantes play a special role. They are Cerberus to the inflation narcotic. They greet every twitch on the inflation thread as threat to being repaid in hard, non-depreciated dollars. Inflation is their nemesis in an asset class with finite returns.

They're also hysterics.

Take two investments that gained roughly 250% in 16 years. One came through deflation, contraction and lower living standards. The other through price appreciation, a doubling of the economy and higher per capita income. These happened between 1995 and April 2011. Japanese bonds returned about $24,000 on a $10,000 principal investment through lower rates, high real rates and flat nominal GNP growth. US stocks returned slightly more on growth, some inflation and productivity.

To a bond vigilante, Japan is the better: predictable, no monetary threat and real purchasing power maintained. But to an investor with broader sight, the US experience has more sustenance to prolonged economic health.

That's why the Fed is right to fear deflation and target some inflation. They may overshoot but investment returns from deflated, high real rates and negative nominal growth are a death knell.

Bottom line: Beware inflation radicals. We cannot measure growth and economic health by bond metrics only.

*Quis custodiet ipsos custodes? "Who will guard the guards themselves?" - Juvenal

Sources: Bloomberg, Sentinel Asset Management, Inc.

Thought of the Week: S&P - fashionably late...again, 04.19.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Here's the quick take on the 4/18 S&P announcement.

What they said:
Reaffirmed AAA/A-1+ for US with a change in outlook to negative from stable.

Why now:
Political differences in Congress. Both parties agree that savings need to be found...wildly different on the "how." Ryan Plan is to cut healthcare and entitlement...Obama about tax increases.

Rationale:

• Fiscal profile has steadily deteriorated
• Deficit of 11% of GDP noticeably bigger than other AAA sovereigns
• They like the fiscal consolidation plays in UK, Germany, Canada
• Political impasses
• Could cost another 3.5% of GDP to capitalize/relaunch Frannie
• Ongoing risks from financial sector that in a stress test could cost 34% of GDP (all those government guarantees)

What they didn't say:

• No problems of default
• No mention of higher rates
• Or changes in yield curve
• Or inflation

Other:

• 19 countries with AAA rating
• US only one with "negative" outlook

Market Reaction:

• DXY up on the day: +0.5%. Up sharply against Euro, AUS $
• Gold: rallied some $30 to close +0.6%
• GT10: unch. on the day. Fell initially from 3.38% to 3.44% and rallied back to 3.37%.
• SPX: fell 15pts to 1302 and rallied to 1305. Down 1.1%
• US CDS: up 7 pts to 49bps

Comment

1. It is an absurd notion that a sovereign nation with no foreign denominated debt cannot pay its debts. There is no, none, zero chance of default of any kind. They may pay it back in inflated dollars but S&P doesn't mention inflation.
2. Stocks were off in a lot of places...particularly in Europe. The markets are a lot more worried about peripheral Europe right now. We said last week markets were looking for an excuse to sell off. This gave them one but it has been pretty muted.
3. This is not news. Everyone knows the size of the deficit and state of public finances.
4. Putting a country on negative watch has had some salutary lessons, as when the UK was revised down in 2009...the subsequent fiscal retrenchment was rewarded with an upward revision late last year.
5. The fundamentals of the US have not changed. Rates will be governed by the Fed, what happens post QE2 and inflation and those are all pretty stable right now.
6. When S&P downgraded Japan in February, rates fell and stayed down.
7. S&P was part of the problem in the crisis. Not much has changed there. They may have wanted to get in front of an issue. That would be a first.

Bottom line: It may start the dialogue in DC so that would be good. S&P is not advancing the issues, merely explaining them. The markets quickly recovered and, no, this isn't the start of dominos crashing. The dogs barked, the caravan moved on.

Sources: Standard & Poor's, Bloomberg, Sentinel Asset Management, Inc.

Thought of the Week: Before the Echoes Fade, 04.18.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

In a quiet week, it's time to look at themes which are decidedly queasy, especially with the "sell in May" season approaching.

1. Earnings: The Q1 season started and immediately ran into headwinds. Top line is more important than EPS this time round. Why? Eventually cost cutting and margin squeeze run their course. Companies need revenue to grow. Annual sales growth will be around 8% this year compared to 14% last September. Demand is slacking both here and in the crucial overseas markets for S&P 500[1] stocks. A good rule of thumb is that a 1% change in revenue leads to a 3% increase in EPS. The pressure will be on this quarter.
2. Dollar: FX is easy to predict over the long term; it follows capital accounts and interest rate differentials. It's hazardous in the short term. Three broad measures of the dollar (DXY, for everyday trading; US trade-weighted, for the current and BOP accounts; and real adjusted rate, for long-term competitiveness) are all down about 5% since QE2 and 25% over 10 years. They are likely to stay that way for two reasons: the Fed is the most dovish of CBs these days and investment inflows are slowing. Political worries and risk aversion make the $ a tough call in the short term. In the long term, it seems a one-way bet.

And a thought: we're at peaks of output, operating margins and corporate profits, all with 8m fewer people in the workplace. That's why employment is the key measure for the market as well as the Fed.

Bottom line: No rush into equities and keep to the secular, stable growth areas. Maintain a healthy non-dollar correlated exposure.

Sources: Federal Reserve, Bloomberg, Sentinel Asset Management, Inc.

1. The Standard & Poor.s 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Thought of the Week: The jesters walk in the garden, 04.11.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

We're testing the market's patience. Last week we had oil blow through $110, the ECB rate hike, growth tremors, another Fed warning and to cap it all, the threat of a government shut down. This is our take:

1. Government: Making a crisis out of a problem (cue slow handclap). The budget is a non-issue...the sides agreed on a deal affecting less than 0.5% of the budget but the debt ceiling is much more problematic. Yes, the Treasury could print dollars to get past the technical default but that's unequivocally inflationary and a stopgap measure only.
2. ECB Hike: Aahh the pleasures of a single mandate. This takes some growth off the table...not especially good for US equities or the $ in the short term.
3. Market at inflection point: Earnings season is a couple of weeks away and we expect some consolidation from now until then. The year-on-year comps are definitely going to be tough.

So far, the markets are tending to indulge it all but it could get serious if the budget duels go on much longer.

Bottom line: There's some risk in the market short term. The equanimity may not hold.

Sources: Bloomberg, Sentinel Asset Management, Inc.

Thought of the Week: "They are not long, the days of wine and roses," 04.04.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Markets have held up extraordinarily well this quarter despite three lightning bolts (Japan, EU and Libya) aimed squarely at disrupting the fun. US domestic equities did best, returning some 6% to 7% for the SPX[1] and RTY[2]. Bonds, with the GT10 at +0.1%, and EMs at +0.9%, lagged. But it's the returns from the February peak that look more interesting with bonds and EMs at +3.5% and domestic equities down 0.8%.

That explanation for the lack of momentum since mid-February is:

1. Odd Leaders: The energy sector has been on a tear, up 20% this year. Strip out the 13% weighting of energy and the market return is less than 3%. When the energy sector leads, the rest of the market tends not to follow because of the inflationary input fear.
2. Outspoken Comments: From leading Fed luminaries (Plosser, Bullard and Fisher) all of whom stated concern at the "massive amount of accommodation." It would be hard to get a clearer message that the easy money days are ending.
3. Difficult to discern the health of corporate America: The New Issue Market has plenty of activity ($170bn in last four weeks) but a lot of this is tax arbitrage (borrow in the US against foreign cash assets) or refinancing. Not much for new capacity and business growth. And that puts a line under growth opportunities.

Bottom line: The trade into and around bonds looks good. We can sit out the next month or so for equities.

Sources: Bloomberg, Sentinel Asset Management, Inc.

1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
2. The Russell 2000 Index is an unmanaged index that measures the performance of 2000 small-cap companies within the U.S. equity universe.

Thought of the Week: The way we live now, 03.21.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Markets are uniformly bad at digesting exogenous events. They overreacted to the story in Japan, heartbreaking and confusing in equal measure, and the Middle East. But they are better at responding to economic numbers, such as jobless claims, trade, U. of Michigan confidence and inflation, all of which did not quite turn out as people wanted. So three quick points:

1. Wow and Flutter: There is a lot of noise in the economic series: oil prices, gasoline and winter activity all affected the numbers. But most of the upward trends remain intact, including the promising manufacturing numbers. Headline inflation was above expectations but as long as core inflation remains below the Fed's target, expect no policy change.
2. All very skittish: Since February, markets were looking for reasons to sell and last week, they did...quickly and indiscriminately. The major US and world equity markets were down 6% to 9% from February. US government bonds rallied with the bellwether GT10 at 3.23% or a 5% return since February. Expect more of this.
3. Looping back: Sorry we keep bringing the inflation line up but oil and CPI numbers reignite the debate. We're in the "no" camp and use this test to build our position: compare where we are today with any past inflation period (choose the 70s, early 90s or even post 2000) and ask:
   
   a. Did the economy have the slack/output gap then that it does now? I doubt it.
   b. Was wage push inflation a big deal then? Yes
   c. Is it now? No
   d. Is the substitution effect greater now? Yes
   e. Is the economy less dependant on energy inputs now than before? Yes
   f. Are all energy prices linked to oil, as they were then? No
   

And all that explains why inflation-protection assets have not performed (TIPS, gold) and inflation-vulnerable assets (GTs) have.

Bottom line: Market participants will continue to adjust risk appetite "out of equities" and into US GTs for a while.

Sources: Bureau of Labor Statistics, Bloomberg, Sentinel Asset Management, Inc.

Thought of the Week: I met a man who wasn't there, 03.14.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

In a week of major news, markets remain largely untroubled. Libya, a disappointing January trade deficit and higher jobless numbers and, on Friday, the sad news of the Japan earthquake, should have meant markets ran to close positions. There are two reasons why they didn't:

1. Tug of War: between the bull camp of a) better industrial production b) real economy and fixed investment numbers and c) earnings, and the bear camp of a) incipient inflation b) oil and c) lower consumer confidence. Neither side has a wining hand so the trade oscillates between the two camps on little real news.
2. Treasury as Debaser: some fixed income managers are imposing one-man (yes) buyer strikes, fearful that the Fed's monetary policy devalues government bonds. This creates a pull into equities but more as a "flight from" than a "rush to."

The first requires some confidence that the global economic cycle is intact. It is. That's why we're long equities and ready to step up EM exposure. The second is histrionic. Yes, we know the real trade-weighted value of the dollar fell 25% in the last eight years and by 52% since the mid 80s. That's a secular trend that is mostly benign (we'll return to this later). But the Fed is not about to let inflation rip. It's their most important metric. But if they act too early, they will surely choke the economy.

For a final thought on why GTs are still a good bet, remember that when the Fed stopped buying MBS in March 2010, GT10s returned 21% in the next 6 months. And when they started QE2, GT10s lost 6%. So the feared relationship simply does not exist.

Bottom line: GTs and equities still moving higher. But GTs have the edge for now.

Source: Bloomberg, Sentinel Asset Management, Inc.

Thought of the Week: Why inflation doesn't matter, 03.07.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The US economy is turning the corner. Inflation a chimera. We measure under utilization in an economy by three measures: the output gap, unemployment and capacity utilization. All three are at least two standard deviations away from their averages. None signals inflationary pressure. That is why the Fed has refused (rightly) to recant on QE2 and why they focus on the PCE deflator and unemployment. Until these move solidly and decisively, policy consistency makes admirable sense.

The inflation fear rests on flimsy evidence: the quantitative theory of money and recent commodity increases. Neither stands up to scrutiny - for two reasons.

1. This is not the place to deconstruct the Chicago school but the monetarist hawks refuse to acknowledge the downturn in money velocity (the V of the MV=PQ theory of inflation).
2. As for commodities, we have seen the CRB higher and with faster rates of growth before...with no subsequent lasting rise in inflation. In the US especially, i) raw commodities do not make up a large part of finished goods, ii) the substitution effect is far more prevalent today than the 70s and iii) supply in many commodities can quickly replenish. Want an example? Iran pumps 50% less oil than in 1979. Other suppliers quickly stepped in. And as one of the CEOs of one of our largest food manufacturing companies recently said, "managing inflation is nothing new to the food business."

Bond managers have outsized fears of inflation because, in an asset with limited upside, the mantra must be "repayment in real, non-depreciated dollars." But some, manageable inflation is welcome in most parts of the productive economy. It allows prices to move and promotes consumption.

Bottom line: Inflation should pick up some but the target has along way to go. For the ultimate inflation hedge, stay long in equities.

Source: Sentinel Asset Management, Inc.

Thought of the Week: Crawl to Quality, 02.28.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

What with the geopolitical risks and rising oil prices, the flight to quality has been very low key. In these times, bonds, gold and the dollar run and equities, currencies and credit take cover. There have been some movements in each of these but nothing like the levels we saw in past crises. So why so sanguine this time?

Part of the answer lies in the distortions to global and especially US monetary policy. Zero rates and QE2 push a lot of money into the system, most of which cannot be absorbed by the real economy...demand is still tenuous and indicators very unbalanced. What businesses and the consumer cannot take down, ends up in assets. Hence some very overbought and confused positions in commodities, credit spreads and even equities. This risk aversion won't last.

Bottom line: bonds and especially some government bonds no longer look expensive against equities.

Source: Sentinel Asset Management, Inc.

Thought of the Week: Beware Consensus, 02.22.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Two trades dominate world capital markets: bonds into equities and emerging (EM) into developed markets (DM). We're fine with the first but it's time to rethink the second.

Since September 2010, EMs¹ have returned 3.6% and the S&P² 18%. This is the biggest pullback since 2008. There are three reasons: inflation, growth and reallocations. All reasonable. Inflation has ticked up mainly because of food inflation and explicit programs to increase real wages; growth has come off the very high levels of 2010 and, finally, investors have reallocated back to the US as EMs grew to uncomfortably large positions.

China increased its reserve requirements again this week...second time this year and fifth in as many months. This is a serious intent to curb inflation and will probably work. Recent inflation numbers had a large dose of food inflation buried in them and that's unlikely to persist. This is a nerve-wracking game of cooling vs. choking but on balance, it's probably good to head off the risk of overheating.

EMs look attractive. Forward earnings multiple for the markets is 11x compared to 13x for the US. Growth is not about to fall off precipitously and policies are generally hawkish. Above all, the long term and global rebalancing is in the EMs' favor. If we set GDP to a 100 index starting in 2005, the US is at 105 in 2010, Europe 104, and China and India 147 and 169. That's a lot of headwind.

Bottom line: scope to increase exposure.

Source: Sentinel Asset Management, Inc.

[1] The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. You cannot make a direct investment into an index.

[2] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Inflation - - any winners? 02.14.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

There's much talk about incipient inflation. There are some important inflation data to be released this week so what's in store? The bear case is that agricultural and commodity prices feed into food inflation, which leads quickly to broader inflation. Throw in China, TIPS and the money illusion of QE2 and we have a problem. This is overdone.

The bigger picture is that capacity utilization, money velocity, and the wage and output gap will keep a lid on inflation. Some inflation is desirable especially with the specter of deflation only recently extinguished. The important number is the one Bernanke looks at: PCE. And that is at its lowest since 1959. The recent rise in GT10s and GT30s is a reaction to growth not inflation.

Inflation spooks bond investors especially. The risk of repayment in debased dollars overshadows all other fears. Their instinct is to describe inflation as the greatest and only risk to the economy. A single note symphony. Equity investors can take a more sanguine view. They tend to do well in moderate inflation and even, in nominal terms, high inflation. Only in Zimbabwe-type hyperinflation are all bets off. But any talk (and there is) of hyperinflation is reckless.

Bottom line: a mistake to fear inflation. Growth remains the driver...and the worry.

Source: Sentinel Asset Management, Inc.

Thought of the Week: What the unemployment numbers mean. 02.07.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Headline unemployment dropped to 9.0%. This was the number everyone was looking for in November...back then it was 9.8% and surprised everyone. This month is undeniably better but is mostly due to a drop in the participation rate and 500k fewer in the workforce. New business birth/death models and population growth hopelessly muddled the data.

Expectations for this politically sensitive number are always overblown. Yes, NFPs only rose 36,000 but that's on a workforce of 153m. It's bound to see swings and revisions. Meanwhile, note two things:

1. ISMs all have employment components and they have been positive for months. Just last week the ISM Services and Manufacturing recorded their best numbers since 2005 and 2004.
2. The trend counts. In the last 6 months, we've seen claims fall, manufacturing jobs increase and average weekly hours in the higher compensated industries increase. Corporate statements in this earnings season remain positive.

First reaction from the GT10 was to climb to 3.64%, highest since May 2010. Corporate spreads tightened, which they normally do if there's a run up in Treasury yields. We don't expect the GT10 to stay at this rate for long. SPX gained mainly because the employment number confirms much of the good reading from the last few weeks.

Bottom line: very encouraging.

Source: Bureau of Labor Statistics, U.S. Department of Labor; Sentinel Asset Management, Inc.

Thought of the Week: What do the GNP figures mean? 02.02.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

Came in at a record level of $14.87 trillion. Growth at 3.2% from 2.6% in Q3. The big changes were strong growth in personal consumption and investment with a big downturn in inventories, which fell a whopping $133 billion to $5 billion. This is a notoriously volatile number so don't read too much into it. The good news was that economic growth is intact and the major leading indicators in January confirm the upward momentum. Meanwhile we're seeing solid beats on earnings with earnings up 30% YOY. Not bad.

Source: U.S. Department of Commerce, Sentinel Asset Management, Inc.

Thought of the Week: What effect will unrest in Egypt have? 02.01.2011

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

In the past, major unrest in the Middle East had little lasting effect on the market: the Sadat and Rabin assassinations, Lebanon Marine bombing, the Iran-Iraq war and the first Gulf War all had 2%, or less, market corrections, followed by quick recoveries. Egypt is not a major oil producer, nor is Suez (1.1 million bpd) nearly as important as the Straits of Hormuz for carrying oil (17 million bpd). Global supply is about 89 million bpd. The story may dominate headlines but the economic and financial consequences are minor.

Source: Bloomberg, Sentinel Asset Management, Inc.