Microsoft Word - MSR June 2014 Final.docx

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June 2014

Forward Markets: Macro Strategy Review Macro Factors and Their Impact on Monetary Policy, the

Economy and Financial Markets

U.S. Economy

According to Congress’s Joint Economic Committee, average gross

domestic product (GDP) growth over the 19 quarters of our current

economic recovery has been 2.2%, with total growth of 11.1%. The

average for the seven post-1960 recoveries is 4.1%, with total

growth of 21.1%. The 10% spread between the average recovery

and the current recovery represents almost

$1.6 trillion in unrealized GDP and $300 billion in lost federal tax

revenue. Overall job growth has been well below the historical

average since the recovery began in June 2009, and the quality of the

jobs created has also not been good. According to analysis by the

National Employment Law Project published in April,

22% of the jobs lost during the Great Recession were in low- wage

sectors such as food service and retail. However, those low-wage

sectors accounted for 44% of all new jobs during the

recovery. Mid-wage jobs accounted for 37% of the job losses, but

only 26% of recovery jobs. Higher wage jobs have represented 30%

of the increase in jobs, but were 44% of the losses. This analysis

suggests the entire wage structure has dropped a notch during the

recovery. The downshift in wages is corroborated

by Department of Labor data, which shows employee compensation

as a percentage of national income has fallen to 66%, the lowest

since 1951.

In April, 288,000 jobs were created, raising the 12-month average to

197,000 from 185,000 and the best one-month increase since January

2012. Average hourly earnings though were flat and have only

increased 1.9% over the past year. More importantly, average hourly

earnings have been stuck at 2% annual growth for four years—well

below the 3.5% to 4.0% experienced

during the average post-World War II recovery. Meanwhile, the

Consumer Price Index has risen 2% over the last year, effectively

wiping out any increase in purchasing power for most workers.

12-Month Exponential Moving Average (Monthly

Change in Nonfarm Payrolls)

210K

190K

170K

150K

130K

110K

90K

70K

Source: Bureau of Labor Statistics, period ending 04/30/14

Weak Income Growth Suggests No Acceleration in GDP

(Average Hourly Earnings Year-Over-Year)

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

Source: Bureau of Labor Statistics, period ending 04/30/14



2 Macro Strategy Review www.forwardinvesting.com

U.S. Personal Savings Rate

9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%

Source: Bureau of Economic Analysis, period ending 03/31/14

The lack of real income growth caused consumers to maintain

spending by dipping into their savings, with the savings rate falling

to 3.8% in April, the lowest in six years. Food prices rose 0.4% in

April and have risen four consecutive months. Just in time for the

barbeque season, meat prices posted their largest jump since 2003.

GDP growth will likely pick up markedly in the second quarter,

after an especially weak weather-induced first quarter. The

consensus is that GDP will continue to grow by more than 3% inthe third and fourth quarters. Unless income growth really picks up

soon, our expectation is that growth is more likely to moderate in

the second half of the year, after bouncing back in the second

quarter.

Economic Enervation

We discussed the state of our nation’s bridges in our November

2013 Macro Strategy Review (MSR), in a section entitled, “The

Clues to a Future Crisis Are Usually Hiding in Plain Sight.” Bridgesare an important part of our transportation system, since they make

it possible to travel in a straight line, rather than wasting millions of

hours and incurring additional transportation costs in circumventing

rivers, canyons and other natural obstructions.

Bridges help lower the cost of shipping goods anywhere in the

country, and save valuable time for millions of commuters every

day. According to the U.S. Department of Transportation and its

2013 National Bridge Inventory database, there are 607,000

bridges in the United States and more than 10% of them are

deemed “structurally deficient” or “fracture critical.” The

Department of Transportation estimates that cars, trucks and

school buses cross the 63,000 structurally compromised bridges

250 million times each day. At least 20% of the bridges in

Pennsylvania, Rhode Island, Iowa and South Dakota are

structurally deficient. The Laborers’ International Union of North

America recently launched a $1 million campaign in Pennsylvania,

Ohio and Michigan for radio ads and billboards to highlight the costs

and safety perils of deteriorating highways and bridges.

The AAA Automobile Club has estimated that poorly maintained roads

cost each motorist an extra $324 annually for repairs and operating

costs.

Funding to maintain our roads and bridges comes from the federal

government via gasoline taxes of $0.183 per gallon for unleaded

fuel and $0.244 for diesel fuel. However, since cars are gettingmuch better mileage (a good thing), the amount of

revenue has been declining in recent years. The Federal Highway

Administration estimates that the national annual bridge and road repair

would cost $21 billion. The longer Congress fails to address our

infrastructure problem the more likely it is that costs are going to rise,

since it is more expensive to replace or rebuild a bridge than maintain it.

According to the American Society of Civil Engineers, inadequate

surface transportation is projected to cost U.S. businesses $430 billion

in operating expenses by 2020 and cause

$1.7 trillion in lost sales opportunities. Given election politics, it is

unlikely that funding for this long-term need will be addressed.

Unfortunately, funding for road and bridge repairs and maintenance may

run out by fall unless Congress acts soon. The U.S. Highway Trust

Fund’s account balance will fall to $2 billion by September 30, and theMass Transit Account to only $1 billion, according to the Congressional

Budget Office (CBO). Without congressional action there will be no

Highway Trust Fund support for any new or existing road, bridge or

public transportation projects in any state during the fiscal year starting

on October 1, 2014. U.S. Transportation Secretary Anthony Foxx told a

Senate panel in early May that congressional inaction could force states

to delay or halt projects already underway, costing up to 700,000 jobs.

The CBO estimates

$18 billion is needed to maintain current funding through the fiscal year

2015, which ends on September 30, 2015, and $100 billion to fund the

traditional six-year transportation bill.

Even if members of Congress were able to agree on fundinginfrastructure fully, there is another problem. When Congress passed

the $830 billion stimulus package in 2009, a portion of the funds

were to go to “shovel ready projects.” But few projects were actually

started, since many projects were mired in the approval process.

According to the Regional Plan Association, regulatory approval for

infrastructure projects can take up to a

decade or longer. For instance, the expansion of the Panama Canal will

allow larger container ships to pass through the canal, so it

is important for U.S. ports to be able to handle the larger ships. If a

port is unable to handle the larger ships, it will lose business and jobs

to ports on each coast that are capable. Savannah, Georgia, is the

fourth largest container ship port in the U.S. and the fastest growing port over the last decade. In order to handle large container ships, the

Savannah River needs to be dredged to

increase its depth to 48 feet from its current depth of 42 feet. The original

application to deepen the port was submitted in 1999.

The environmental review statement for dredging the Savannah River

has taken 15 years to complete. New Jersey’s Port Newark Container

Terminal wanted to be able to accommodate a new generation of

efficient large ships, and submitted an application to raise the Bayonne

Bridge almost five years ago. This project has been bogged down by

environmental litigation, even though it requires no new foundations

or right of way.




Regulatory review is supposed to serve and protect a free society, not

paralyze it. Part of the problem is that regulatory approval

is spread among federal, state and local agencies. No single authority

possesses the power to decide when there has been enough review.

Since coordination between federal, state and local agencies is at times

poor, duplication of environmental requirements adds to delays and

costs. Ironically, environmental groups often work at cross purposes,

delaying projects that advance the green agenda they proclaim to

support. The Cape Wind project, located off the coast of

Massachusetts, has been reviewed by 17 agencies over the last 12

years. The Gateway West Transmission Line project will carry

electricity from Wyoming wind farms to the Pacific Northwest. The

approval process began in 2007, and must be approved by each county

in Idaho that the power line will traverse, which is why the approval

process has not

yet been completed. All it takes to halt a project of this scope is one

lawsuit in one county. Can you imagine how people would react if the

Internet or cell phones worked like this?

In 1835, French political thinker Alexis de Tocqueville warned that

the real threat to American democracy wasn’t forceful tyranny, but anew kind of challenge; he claimed that society would develop a new

kind of servitude that “covers the surface of society with a network of

complicated rules, minute and uniform, through which the most

original minds and the most energetic characters cannot penetrate…it

does not tyrannize but it compresses, enervates, extinguishes, and

stupefies a people, till each nation is reduced to be nothing better than

a flock of timid and industrious animals, of which the government is

the shepherd.”1 Enervates means to weaken or destroy the strength

and vitality of something. The cumulative impact of a network of

complicated rules over time certainly has the potential to weigh on

economic growth and sap its vitality.

The Federal Register is a daily digest of proposed regulations fromagencies, notices, corrections and finalized rules. It was first

published in 1936 and contained 2,620 pages. By 1966, the Federal

Register had reached 16,850 pages and mushroomed to 87,012 pages

in 1980. Obviously, some rules and regulations are more costly to

implement than others, but the number of pages in the Federal

Register provides a fairly good representation of

Federal Register Pages Published Annually

90K

80K

70K 60K

50K

40K

30K

20K

10K

the regulatory burden being placed on our economy and the hurdles and

costs of doing business. Since 1993, the Federal Register has averaged

71,470 pages per year, which means 286 pages were added every single

work day for the past 20 years. In 2013, the Federal Register contained

3,659 final rules and 2,594 proposed rules, with another 3,305

regulations moving through the regulatory pipeline. Of these

regulations, 189 are “economically significant,” which means the

government estimates they will each have a cost of at least $100 million.

Frequently, the actual cost of

a new regulation often exceeds the government’s initial estimate.

Compiling reports of compliance costs from government agencies and

outside sources, the Competitive Enterprise Institute estimates

$1.86 trillion is now spent annually by individuals and companies in

pursuit of regulatory compliance. This amounts to more than 10% of

GDP, and since businesses must pass along at least a portion of this

regulatory compliance cost to consumers in the form of higher prices, it

represents an unseen regulatory “tax.”

It is also having an impact on the willingness of people to assume the

risk of starting a business. For the first time in the last 30 years, the

Brookings Institution has found that fewer businesses are beingformed than are closing their doors. This is significant since small

businesses are responsible for 60% of the new jobs created, and one of

the reasons why job growth during this recovery has been the weakest

of any recovery since World War

II. The Heritage Foundation has compiled its Index of Economic

Freedom since 1993, by evaluating 10 categories, such as property

rights, the size of government and fiscal soundness. After seven straight

years of decline, the U.S. has dropped out of the top

10 most economically free countries for the first time. As the

government assumes more of the role of a shepherd, economic freedom

and growth are receding.

In April, Toyota made big news when it announced it will move itsU.S. sales unit and more than 3,000 jobs from Southern California,

where it has been located since 1957, to Texas in 2016. In 2011,

workers in Texas paid 7.5% of their income in state and local taxes

compared to 11.4% for California workers. Those earning more than

$48,000 annually pay a top income tax rate of 9.3% in California,

which is more than what millionaires pay

in 47 other states. Between 2005 and 2012, almost 250,000 people

moved from California to Texas, according to the U.S. Census

Bureau. According to the Tax Foundation, the migration out of

California represents $15.8 billion in lost income and almost $1.5

billion in lost tax revenue annually. Businesses are leaving due to

regulatory burdens, high taxes and high costs. California has the 48th

worst business tax climate, and green energy mandates have driven up

electric utility costs to the level of being 50% higher than the national

average. In response to criticism of California’s regulatory, energy

costs and tax burdens, California Governor Jerry Brown offered this

assessment, “We’ve got a few problems, we have lots of little burdens

and regulations and taxes…But smart people figure out how to make

it.”2 Unless California is able to reverse current trends, at some point,

only “smart” people will be living in California.

Source: The Office of the Federal Register, period ending 01/01/12




Although private employment has exceeded its pre-recession level, total

employment, which includes federal, state and local jobs,

is still below its December 2007 high. In the 11 recessions since

World War II, all the jobs lost during the recession in nine of the

recoveries were recovered within 32 months. Total employment will

likely exceed its 2007 high in May, a mere 76 months after the

recession’s start. As noted earlier, since the recession ended in June

2009 the quality of jobs has been poor, and income growth has not

kept up with the cost of living for many hard working and industrious

Americans.

Given this backdrop, the U.S. State Department’s April 18 decision not

to proceed with the Keystone Pipeline System is surprising, and for true

environmentalists, perplexing. On January 31, the State Department

released its fifth environmental report on the pipeline and stated the

pipeline would have no marginal effect on the climate since the oil will

be used whether or not the pipeline is built. However, the State

Department also evaluated the climate impact if the pipeline was not

built. Greenhouse gas emissions will increase between 27.8% and 41.8%

if the oil is instead transported by tanker or rail to a myriad of existing

pipelines. Furthermore, they estimate the 830,000 barrels of oil a dayflowing through the Keystone Pipeline would likely result in 0.46

accidents (spills) annually, resulting in one injury and no deaths. In

comparison, transporting the oil by railroad would result in 383 annual

spills, causing six fatalities and 49 injuries. Last summer, a train

derailment in Lac- Mégantic, Quebec, killed 47 people. The State

Department also estimates rail transport will result in 1,335 barrels being

spilled annually, versus 518 barrels for the Keystone Pipeline. Based on

these statistics, the Keystone Pipeline would be a net benefit for the

environment and save lives. Economically, the State Department says the

pipeline would create 42,100 “direct, indirect, and

induced” jobs.3 The construction of the pipeline would create 2,000

construction jobs, with many of those jobs going to union workers.

Terry O’Sullivan runs Laborers’ International Union of North America,

which represents 500,000 construction workers. O’Sullivan and his

union supported candidate Barack Obama in 2008 and President

Obama in 2012, saying he is a leader “who will fight to create jobs.”4

O’Sullivan was understandably upset when the Obama administration

announced on April 18 it was delaying its decision on the Keystone

Pipeline until after the November election. In a public statement

O’Sullivan said:

This is once again politics at its worst…In another

gutless move, the Administration is delaying a finding

on whether the pipeline is in the national interest based

on months-old litigation in Nebraska regarding a statelevel challenge to a state process— and which has

nothing to do with the national interest. They waited

until Good Friday, believing no one would be paying

attention. The only surprise

is they didn’t wait to do it in the dark of night…It’s not

the oil that’s dirty, it’s the politics. Once again,

the Administration is making a political calculation

instead of doing what is right for the country. This

certainly is no example of profiles in courage. It’s clear

the Administration needs to grow a set of antlers, or

perhaps take a lesson from Popeye and eat some

spinach…This is another low blow to the working men

and women of our country for whom the Keystone XL

Pipeline is a lifeline to good jobs and energy security.5

The recovery that began in June 2009 has been the weakest of any

post-World War II recovery, despite unprecedented monetary

accommodation and fiscal stimulus. There are many reasons why this

recovery has been so disappointing and we are not suggesting that

regulation has been the largest contributor.

However, overlooking the progressive burden of regulation and its

effect on business formation, job growth and economic vibrancy is a

mistake. The slowdown in GDP growth began long before

the financial crisis in 2008 and the weak recovery that started in

June 2009. If you review the aforementioned chart regarding the

increase in the number of pages in the Federal Register, you

can see there was an enormous increase in regulations between 1966and 1980. Given the lag time as all these new regulations were

implemented and their cumulative drag on growth, it is not surprising

that the downtrend in the 20-year average of GDP growth reemerged

around 1980.

There is a demographic tsunami that has the potential of swamping our

fiscal finances over the next 10 to 20 years, as baby boomers leave the

labor force and government spending soars. Unless economic growth

accelerates and is sustained, it is likely there

will not be enough money for the government to make good on the

future liabilities embedded in the Medicare and Social

Security programs. The clock is ticking and a network of excessive

regulations, or using regulation for political gain, rather than a tool ofcommon sense for the common good, is an indulgence we may not

be able to afford. As Alexis de Tocqueville wrote in the nineteenth

century, “There are many men of principle in both

GDP Year-Over-Year Change (20-Year Average)

5.0%

4.5%

4.0%

3.5%

3.0%

2.5%

2.0%

Source: U.S. Bureau of Economic Analysis, period ending 03/31/14




parties in America, but there is no party of principle.”

Eurozone

Eurozone GDP grew 0.8% in the first quarter, with Germany and

Spain up 3.2% and 1.5%, respectively, while France was flat, Italy

was down 0.5%, and GDP in Portugal was off by -2.8%. We do not

expect GDP growth in the eurozone to exceed 1% by much in 2014,so the first quarter was in line. Since banks provide 80% of the credit

creation in the eurozone, a solid recovery is not likely until lending

and credit availability improves. A recent report by the European

Central Bank (ECB) noted that the credit squeeze throughout the

eurozone had eased modestly in recent months,

but has a long way to go. New bank loans are still only half of their pre-

crisis level. Since small- and medium-size businesses represent two-

thirds of all jobs, unemployment is not likely to come down quickly in

many eurozone countries until credit availability improves materially.

The ECB report also noted that 60% of businesses in Greece, 52% in

Italy and 43% in Portugal still face a real problem

in gaining access to credit. When they can obtain a loan, they are

often paying rates two to three times higher than German

businesses. The lack of access and cost of credit will make it

especially difficult for businesses in Southern Europe to not fall

further behind Germany in terms of productivity.

Entering 2014, we expected the ECB to engineer a decline in the value

of the euro. As we discussed in the April MSR, the simplest way for

the ECB to lift inflation and further support growth would be to

communicate a desire for the euro to decline. The ECB has estimated

that the 15% rise in the euro over the last 18 months has shaved 0.4%

off eurozone inflation. Since imported goods will

cost more and add to inflation, a weaker euro should alleviate some

Eurozone Unemployment Rate

14.0%

13.0%

12.0%

11.0%

10.0%

9.0%

8.0%

7.0%

6.0%

Source: Bloomberg, period ending 03/31/14

Euro to USD

1.40

1.35

1.30

1.25

1.20

1.15

Source: Bloomberg, period ending 05/23/14

of the downward pressure on inflation. A weaker euro would also likely

make exports from every EU country cheaper for the rest of the world to

buy, which would likely lead to an increase in exports and GDP growth.

A cheaper euro would especially help Italy, Spain and France, which

have higher labor and production costs than Germany. After the ECB’s

meeting on May 8, ECB President Mario Draghi stated that the ECB’s

governing council is “comfortable with acting next time” and easing

policy at their meeting in early June. He also reiterated the connection

between the euro and the low rate of inflation. “The strengthening of the

exchange rate in the context of low inflation is a cause for serious

concern.”6

It appears currency traders have gotten the message since the euro

peaked on May 8 at 139.93. As we discussed in April, the 50%

retracement of the decline from the July 2008 high of 160.38 to the

low in June 2010 at 118.77 was 139.57. The May 8 peak was just 0.46

from a perfect 50% retracement, which technically is significant.

During the week of May 9, the euro posted a weekly key reversal

when it made a higher high, lower low than the previous week, and

closed lower. In fact, the May 9 weekly reversal encompassed the

three prior weeks, which adds to its importance.

This is another technical indication that the trend in the euro versus the

dollar has turned down. This is one of those times when the

fundamentals and the technicals are aligned, which should increase the

probabilities that our forecast of a decline in the euro is on target. As we

wrote in the May MSR, “Shorting the euro has the potential to result in a

profitable trade over the next year.” From a risk management point of

view, a stop on a short trade should be either just above the May 8 high

or pennies below it.

Stock Market

On March 7, the S&P 500 Index traded just over 1,883. On May 22

(10 weeks later) the S&P 500 closed at 1,892, about 0.5% from where

it traded on March 7. Basically, the S&P 500 has been sloshing

around in a 4% range. However, that benign description

belies what has been happening under the surface. Two days after the

S&P 500 made a new high on May 13 the Russell 2000 Index

was down more than 10% from its high, making a new low for the

year. This type of bifurcation within the market is fairly rare. When an

important sector like small cap stocks undergoes a meaningful

correction, more often than not, the rest of the market is tugged down

too, even if it’s to a lesser extent.

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S&P 500 Index

1,900

1,800

1,700

1,600

1,500

1,400

Source: Standard & Poor's, period ending 05/23/14

Past performance does not guarantee future results.

Major Trend Indicator

6

5

4

3

2

Source: Forward Proprietary Indicator, period ending 05/23/14


The pattern of higher price highs accompanied by less upside

momentum continues. Although the S&P 500 made a new intraday and

closing high on May 13, the Major Trend Indicator (MTI) only reached

2.50 on May 14. That’s quite a bit lower than the

4.38 it reached on January 2, when the S&P 500 was 3.3% lower.

As I have stressed for quite a while, the technical deterioration that

has taken place in recent months only sets the stage for the market to

potentially experience a decline. A meaningful decline (greater than

7%) is not likely until investors have a reason to sell all stocks.

Currently, most investors are constructive on the economy,

especially for the second half of this year. With that

as the dominant outlook, most institutional investors are only interested

in identifying which groups to be invested in, rather than questioning

whether they should be fully invested in the market.

As small cap stocks were sold, the proceeds were used to buy large cap

stocks institutions viewed as having greater value. That’s why the

correction has been rotational in nature, rather than a true correction in

which the majority of stocks are sold. The S&P 500 should run into

resistance at the red trend line above the S&P 500, which is near the

range of 1,915-1,925 (see nearby chart). If the S&P 500 falls below

1,810, it would violate the mid-April low at 1,814 and the dark blue

trend line from the low in June of last year. This would indicate that a

test of the 1,737 low in early February and red trend line below the S&P

500 was likely.

Treasury Bonds

At the beginning of this year, the almost universal opinion was Treasury

bond yields were only going higher. This view was easy to embrace

since the Federal Reserve had decided at the December Federal Open

Market Committee meeting to begin tapering their debt security

purchases by $10 billion a month. With less demand coming from the

Fed, yields had to go up! However, from the

end of December, Treasury yields began a resolute march lower,

confounding most experts. In recent weeks, analysts have been

scrambling to explain why Treasury yields have been falling, since so

many had expected the opposite.

Since the January MSR, our view has been that Treasury yields were

likely to come down based solely on the chart pattern of the 10-year

Treasury bond. In the January MSR we said, “Our guess is

that the 10-year Treasury yield will come down, possibly to 2.5%-

2.7%.” In March we wrote, “The 10-year Treasury yield is likely to fall

below 2.58% and approach 2.46%, before any sustained rise in yield

occurs.” In the April and May MSR’s we stated, “The pattern of the

10-year Treasury yield suggests that it is likely to fall below 2.58% and

approach 2.46%.” On May 15, the 10-year Treasury yield dropped to

2.47%. Close enough.

So, where does the 10-year Treasury yield go from here? We don’t

know with any degree of confidence. The yield could dip below 2.40%,

but to drop appreciably further would take a geopolitical event resulting

in a flight to quality, or far weaker economic data than we expect. Our

guess is that the 10-year Treasury yield is more likely to just drift higher

in coming weeks.

Jim Welsh, David Martin, Jim O’Donnell Macro Strategy Team

May 23, 2014




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Definition of Terms

10-year Treasury is a debt obligation issued by the U.S. Treasury that has a term

of more than one year, but not more than 10 years.

Consumer Price Index (CPI) is an index number measuring the average price of

consumer goods and services purchased by households. The percent change in

the CPI is a measure of inflation.

Federal Open Market Committee (FOMC) is a branch of the Federal Reserve

Board that determines the direction of monetary policy.

Gross domestic product (GDP) is the total market value of all final goods and

services produced in a country in a given year, equal to total consumer,

investment and government spending, plus the value of exports, minus the value

of imports. The GDP of a country is one of the ways of measuring the size of its

economy.

Index of Economic Freedom is a ranking of countries or states based on the

number and intensity of government regulations on wealth-creating activities.

It compares countries to each other and compares overall levels of economic

freedom across time.

Russell 2000 Index measures the performance of the 2,000 smallest

companies in the Russell 3000 Index. The Russell 3000 Index represents

approximately 98% of the investable U.S. equity market.

S&P 500 Index is an unmanaged index of 500 common stocks chosen to

reflect the industries in the U.S. economy.

One cannot invest directly in an index.

1. De Tocqueville, Alexis. (2002). Democracy in America.

Chicago: University of Chicago Press.

2. The Wall Street Journal, “Jerry Brown’s ‘Little Burdens’,” May 2, 2014.

3. Forbes, “Even Obama’s State Department Knows Keystone XL Is Not An

Environmental Hazard,” July 23, 2013.

4. The Wall Street Journal, “Keystone Uncensored,” April 24, 2014.

5. Ibid.

6. The Wall Street Journal, “Draghi: ECB ‘Comfortable With Acting Next

Time’ -- 3rd Update,” May 8, 2014.



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