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January 3, 2012

Investor Alert Beware of Rising Confidence!

For the first time in this recovery, general economic confidence seems poised to improve significantly a trend which will likely dominate major investment themes throughout 2012. Investors should therefore consider the potential rewards and risks associated with a meaningful improvement in confidence.

Rising Confidence Why Now?

While not a perfect relationship, Exhibit 1 shows change in the unemployment rate is a very important determinant of confidence. It overlays the Consumer Confidence Index (solid line) with the U.S. unemployment rate (dotted line, shown on an inverted scale). Confidence has not yet improved much in this recovery mostly because the unemployment rate remains stubbornly high.
Exhibit 1 Consumer Confidence vs. U.S. Unemployment Rate

This may finally be changing. Although still disappointingly slow, the pace of job creation is now sufficient to slowly but steadily lessen the unemployment rate. In 2010, private monthly job gains averaged slightly less than 100 thousand whereas in 2011 (through November) monthly job gains improved to 155 thousand. Following this slow progression, private monthly job gains during 2012 seem poised to average more than 200 thousand. For the unemployment rate, something magical happens once job gains persist in the 150 to 200 thousand rangelabor demand exceeds labor force growth producing a slow but steady fall in the unemployment rate. This may already be underway. In recent months, the unemployment rate has declined to its lowest level of the recovery at 8.6 percent. We expect the unemployment rate to decline further to between 7.5 and 8.0 percent by the end of this year. Using Exhibit 1 as a reference, such improvement in the labor market would be consistent with a Consumer Confidence Index (currently at about 65) of about 85! If economic confidence in the U.S. recovery does finally embark on a slow but steady rise, what are the implications for investors in 2012? Specifically, what would a revival in confidence imply for bond, commodity, and equity investors?

Economic & Market Perspective Update

Confidence and Treasury Yields?

Exhibit 2 overlays the Consumer Confidence Index with the real 10-year Treasury bond yield (10-year yield less the annual core consumer price inflation rate). Similar to the aftermath of the dot-com crisis, fear has proved the bond markets best friend since 2007. In the last recovery between 2003 and 2007, the real Treasury bond yield oscillated between 2 and 3 percent. However, as confidence collapsed to record lows in early 2009, the real bond yield declined briefly below 0.5 percent. Real bond yields were quick to recover, however, once confidence bounced from its record low reached during the darkest days of the crisis in March 2009. Indeed, even though confidence improved only marginally, by early 2010, the 10-year real bond yield surged higher by almost 2.5 percent! In 2011, the U.S. economic slowdown and escalating European contagion concerns produced another fear-based collapse in the real 10year Treasury bond yield. As we begin 2012, the dominance of fear is currently illustrated by Treasury investors willingly accepting a negative real 10-year Treasury yield. Exhibit 2 highlights a growing potential risk for Treasury investors. Even though the real bond yield remains at its lowest level since the crisis began, confidence has bounced again in recent months. Something seems likely to give in the next few months. Either renewed confidence in the economic recovery is about to fade or Treasury yields are likely to suffer a significant rise.
Exhibit 2 Consumer Confidence vs. REAL Treasury Bond Yield

Should economic confidence improve this year, the bond market is at risk for two reasonsdecaying calamity fears and rising inflation fears. If a consensus agrees the U.S. economic recovery is sustainable and risk of an imminent calamity has diminished, Treasury investors would likely reestablish a normal 2 percent real bond yield (and with a current core inflation rate of about 2 percent, a 2 percent real bond yield implies a 4 percent 10-year Treasury yieldouch!). However, if the economic recovery is perceived as sustainable, because both monetary and fiscal policies have been too accommodative in recent years, calamity fears would likely be quickly replaced by intensifying inflation fears. For these reasons, high-quality bond investors should be particularly concerned with the likelihood of a steady rise in economic confidence this year.

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January 3, 2012

Confidence and Gold Investors?

Rising economic confidence would certainly be good for commodity investors. A sustainable economic recovery would raise commodity price prospects and also heighten inflation expectations. However, as suggested by Exhibit 3, gold may lag other commodity investments (note, the relative price of gold is shown on an inverted scale). Since 2000, economic confidence and the relative price of gold have been closely related. Since 2007, fear has been the force behind the remarkable run in gold prices. Has this come to an end? As illustrated in Exhibit 3, movements in consumer confidence have typically led changes in the relative price of gold. For example, confidence began eroding in 2000 before the relative price of gold began rising. Likewise, confidence bottomed in early 2003 before the relative price of gold began declining in late-2003. Finally, confidence collapsed in 2007 before the relative price of gold began surging in 2008. Since 2009, the relationship between confidence and gold appears to be more coincident. However, should confidence continue to slowly improve this year, the gold run may be over for this recovery cycle. Although overall commodity prices, including the price of gold, may continue to rise during the balance of this recovery, if economic confidence has indeed begun a steady improvement, the price of gold going forward will probably consistently lag other commodity prices.

Confidence and Stock Market Sectors?

Exhibit 4 overlays the Consumer Confidence Index with the relative price performance of the stock markets most cyclical versus most stable economic sectors. Clearly, whether investors should overweight cyclicals or stables depends crucially on what happens with economic confidence in 2012. As shown in Exhibit 4, 2011 proved a great year for defensive/stable equity investments. As Eurocalamity fears intensified and as U.S. recession fears escalated, investors dumped economic sensitivity in favor of steady-eddy stocks. However, as suggested by this exhibit, should the recent improvement in economic confidence persist, investors which are currently comfortable in defensive stocks may suffer considerable underperformance while leadership shifts toward the recently revalued cyclical sectors.
Exhibit 4 Consumer Confidence vs. Cyclical/Stable Stock Price Performance** Exhibit 3 Consumer Confidence vs. Relative Price of Gold*
**Geo-Weighted relative stock price performance S&P 500 Cyclical Sectors (i.e., Consumer Discretionary, Industrials, Materials, and Technology) versus S&P 500 Stable Sectors (i.e., Consumer Staples, Health Care, and Utilities).

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Economic & Market Perspective Update

Summary
As we begin 2012, fears linger surrounding the European sovereign debt crisis and the potential for a U.S. or global recession. However, U.S. economic momentum has surprisingly accelerated in recent months and stands in direct contrast to the intensifying fears so prevalent since last fall. During the first quarter of this year, it will likely become obvious whether fallout from Europe will end the U.S. and global economic recoveries or whether recent evidence of U.S. economic acceleration is for real. And, if the U.S. economy continues to persevere, rising confidence in the economy and in the financial markets should increasingly prove a dominant theme for the year. The potential for steadily rising confidence this year suggest considerable risk for high-quality bond investors (will yields finally rise this year?), implies the great bull run in gold may be over, and advocates to equity investors that cyclicality should be preferred over the emotional comfort provided by defensive stocks. If economic confidence continues to broaden this year, it will indeed prove a Happy New Year!

Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. WELLS CAPITAL MANAGEMENT is a registered service mark of Wells Capital Management, Inc.

Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | 2012 Wells Capital Management