Chart Toppers: Diversification, China and the Fed’s Dual Mandate

From time to time, instead of diving into a singular topic in these reports, I am going to do a“Chart Toppers” review, where I share some of the more interesting and relevant charts I’ve put together or seen on a variety of topics.

In this first installment, I am going to highlight the merits of diversification with a slightly different take on a popular visual used in the investment management business for quite some time. Next I’ll hone in on the relationship between the US and Chinese stock markets and economies. Finally, I’ll try to spin a slightly different tale on the Fed’s two mandates: inflation and jobs.

Diversification—an essential tool for investors’ financial (and emotional) well-being

The chart below, which I often refer to as the asset class “quilt” chart, is a popular one used by a variety of investment management firm over the years. The common structure of this visual is to show a variety of asset classes from year-to-year, highlighting how they move in and out of favor—often the best performer in one year falls toward the bottom in the next year, and so on.

What I thought would be interesting, given how volatile (and frustrating) the markets have been this year, would be to just look at 2015 to-date and rank a number of broad asset classes by monthly performance. As remarkable as these quilt charts look when ranking asset classes year-by-year, it’s even more remarkable what’s occurred this year.

As you can see at first glance, there is no discernible pattern. In fact, look at the first four months of the year. Commodities went from last place, to first place, to last place, and then back to first place…all just in the first four months of the year! Real estate investment trusts (REITs) had a similar pattern, but in the opposite direction. Commodities ranked at the top twice, while at the bottom four times; while REITs ranked at the top four times, but at the bottom twice. Small cap stocks also topped the rankings two months in a row; but during five of the other months, were toward the bottom.

One might say the question a chart like this begs is: “How do I gauge what will be, and invest in, the best asset classes, while avoiding the worse?” The honest answer to that question is you can’t, which is why being diversified across asset classes is your best option. Just about any moderate risk, diversified portfolio (among those asset classes) will generally fall in the middle of the rankings each period; but at the end of the “day” (or month, or year), the return will have been generated with less volatility than most of the asset classes individually.

China- a spike in market correlation, not in economic linkage

I often remark that I’m more intrigued by stories no one is telling vs. stories everyone are telling. The China economic slowdown story is one everyone is telling lately. And the question everyone is asking is: “Will China’s slowdown pull down the US and global economy with it?” A better question perhaps might be: “Can the US economy remain strong enough to keep the global economy afloat?” We believe the answer to the first question is “no” and the answer to the second question is “most likely.”

Nonetheless, the perceived implications for China’s slowdown on the US economy can be seen in the chart below, which shows a spike in correlation recently between the S&P 500 futures and the Shanghai stock market. One might infer that the economic linkages have equally spiked.

But the reality is that the relationship between the US and Chinese economies—via trade linkages—remains relatively small, especially when compared to China’s closer-in-proximity trading partners. As you can see below, only about 7% of US exports go to China; while exports account for less than 13% of the US economy. As such, exports to China represent less than 1% of US gross domestic product (GDP). US multinational corporations derive less than 2% of their net income from China. Finally, US banking exposure to China is less than 1% of total US banking system assets.

Fed’s dual mandate

As most know, the Fed is unique among global central banks in that it operates with two mandates: inflation (like other central banks) and employment. The final set of charts dives into the conundrum this dual mandate currently represents for the Fed. The net is that inflation is sending a message to the Fed that it should be in no rush to raise rates. On the other hand, most employment metrics are sending a different message. This will likely continue to contribute to market volatility; a key reason to maintain the aforementioned diversified approach.

Benign inflation risk

The recent consumer price index (CPI) release generated some attention because at 1.9% year-over-year it’s closing in on the Fed’s 2% inflation target, as you can see below. But not only is CPI not the inflation metric on which the Fed primarily focuses—that would be personal consumption expenditures (PCE)—a look under the hood of CPI is appropriate.

“Shelter” has a relatively hefty weight in the CPI via “owners’ equivalent rent.” As you can see below, CPI shelter is running at more than a 3% year-over-year pace. Excluding that single component, you see a much more benign trajectory for inflation—contributing to the Fed’s hesitancy to raise rates.

Strong employment trends

There are myriad employment statistics on which we and the Fed keep a close eye. Below are several, including the first showing initial unemployment claims—one of 10 subcomponents of the Conference Board’s Index of Leading Indicators. As you can see, claims are at their lowest level since the early 1970s.

Another jobs metric of note includes a report of job openings, via the Job Openings and Labor Turnover Survey (JOLTS), which shows job openings just off their 15-year record high. This measure has surged since the recession ended; with an even sharper upward trajectory since the beginning of 2014.

Related to the two data points above, we can also look at the number of unemployed as a ratio of job openings. As you can see, the low in this cycle matches the low of 2007. Employment slack has been shrinking sharply.

A relatively new problem in this economic cycle is a skills mismatch. Many of the jobs which are available require a set of skills that are lacking among the workforce. This can be seen in the chart below which comes from the monthly survey conducted by the National Federation of Independent Business (NFIB). One of the component questions it asks its members is about their “single most important problem.” Notice that “poor sales” has plunged as a plague on business; while “quality of labor” has surged as a problem—second only to taxes.

As always, we appreciate your feedback and if you have ideas you’d like us to address in the future, please speak with your financial consultant.