A Lot Of Action In What Was Expected To Be A Quiet Week

Observations on the Capital Markets – Week Ended August 16, 2013

  • Most of the U.S. economic data released last week was rather ho-hum, consistent with continuing slow growth, but markets weren’t boring. Maybe markets are thin because it’s August, but the U.S. Treasury market had one of its worst weeks in a long time, and the selling spilled over into the U.S. stock market.
  • The Fed has signaled that employment will be what drives its policy, and employment-related data has been strong enough for the Fed to begin to taper in September. It’s not a done deal, but even the Fed “doves” seem open to the idea . . . so the big question is now becoming “how fast will the Fed taper?” Signs that Europe and China are strengthening gave no comfort to bond bulls.
  • Inflation remains restrained and growth remains muted, so we can’t blame “bond vigilantes” for last week’s sell-off. Instead, it seems increasingly apparent that Quantitative Easing (QE) did blow a bubble in the bond market (size unknown) and that bubble has now been punctured. (Note: this is not a market forecast: markets typically overshoot, so yields may well fall back after this sharp rise, but it’s hard to see how bond prices return to their prior highs.)

Executive Summary:

  • Last week in the capital markets: a Treasury sell-off takes U.S. stocks with it
  • Initial unemployment claims fell sharply 15k to a new cycle low of 320k
  • The National Federation of Independent Business (NFIB) Small Business Index, which measures the optimism of small business owners, rose 0.6 to 94.1
  • Somewhat soft data from the manufacturing sector
  • Business inventories were flat in June even as sales inched up.
  • Retail sales weren’t awful, but investors weren’t pleased
  • Consumer Sentiment (Reuters/University of Michigan) surprised on the downside
  • Good coincident housing data, but still cause for concern about the impact of rising interest rates
  • Inflation and unit labor costs ticked up, but remain low
  • U.S. consumers continue to deleverage
  • Detroit fallout
  • Washington watch
  • Fed watching: waiting for the September taper
  • Foreigners are selling Treasuries
  • The Eurozone posted positive Q2 GDP growth
  • Other Eurozone news was constructive
  • Japanese GDP grows…tax policy is in the headlines
  • China watch—New York Times watch
  • India tries (without success thus far) to stop the decline of the rupee
  • Mexico announces plans to open its petroleum sector
  • Egypt watch

Last week in the capital markets: a Treasury sell-off takes U.S. stocks with it

Currencies: The U.S. dollar was up against most currencies (consistent with rising higher interest rates); the Yen fell roughly 1.5% against the dollar; the Euro was marginally down. The British pound was notably strong as rising house prices, growing retail sales and stronger labor market data suggested that the UK economy is expanding.

Bonds: Ten-year Treasury yields rose 27 basis points, to 2.84%, the highest level in two years, producing a 1-week return of -2%. The 10-year TIP yield rose even more, up 35 basis points to 0.68%. The BoAML High Yield Master II Index HY measuring high yield bonds posted only a small loss as its spread over Treasuries narrowed 10 bps to 470; the BarCap Aggregate declined a bit more than 1%. The 10-year Japanese government bond (JGB) was unchanged. The German 10-year yield rose 20 bps to its highest yield since March 2012 while Italian, Spanish, and Portuguese yields fell (spreads narrowed) as confidence in the European economy rose.

Equities: The S&P 500 Index which measures the broad U.S. stock market was down 2%, lagging global equity markets. Regional MSCI indices MSCI Japan and MSCI Europe, which measure their respective stock markets, were barely positive. The MSCI Emerging Markets Index was up almost 2%. Within the S&P 500, stock in the Information Technology sector led, while Utilities lagged. Apple (up 10% for the week after Carl Icahn said he’d taken a position) boosted the index by almost 40 bps.

Commodities: Gold rallied $60 to $1,369. Oil was up about $2.50. The Agriculture Department’s Agricultural and Livestock Commodity index, a common measure of the commodity market performance, was down a bit.

Initial unemployment claims fell sharply 15k to a new cycle low of 320k

  • The four-week average also hit a cycle low, at 332k.

The NFIB Small Business Index rose 0.6 to 94.1

  • Hiring intentions rose to the second highest reading since the recovery began; the four-month average hit a new cycle high.
  • Credit availability was a “non-issue” lack of demand for loans, not bank unwillingness to lend, that is holding loan volumes down.

Somewhat soft data from the manufacturing sector

  • July Industrial production was flat (below expectations). A key July drag was a dip in motor vehicle production after June posted a 6-year high (10.98 million/year rate), up from a low of 3.56 million in January 2009. Still, the annual growth of Industrial production has fallen to below 2%.
  • The Empire State Index (the NY Fed’s monthly survey of NY state manufacturers) weakened modestly; most of the details (e.g. new orders and shipments) were consistent with very slow growth…but the employment growth and workweek components were strong and optimism in the six-month outlook were strong.
  • The Philly Federal Reserve’s report on manufacturing was softer than expected (after a big jump last month), but the new orders component was ok.
  • Comment: Despite headline weakness, the strength in the new orders and employment components is supportive of Fed tapering. Further, strength in the ISM Purchasing Managers Index, which compares prices paid with the prior month’s prices, suggests future strength.

Business inventories were flat in June even as sales inched up

  • Comment: inventory/sales ratios remain low; this bodes well for the second half (no excess inventories to be worked off means no production cuts are needed)

Retail sales weren’t awful, but investors weren’t pleased

  • Nominal retail sales rose for a fourth consecutive month, up 0.2% in July; June sales were revised up by 0.2%. Still, this was below expectations. Reports from Macy’s and Wal-Mart added to the gloom.
  • Excluding autos and gasoline, July sales rose 0.5%, the biggest gain in 7 months.
  • Comment: retail sales account for roughly half of total consumer spending and one-third of GDP.

Consumer Sentiment (Reuters/University of Michigan) surprised on the downside

  • The index, which measures how consumers feel about the economy, and had had hit a 6-year high last month, was pulled down by weakness in both the current conditions and expectations components.
  • Comment: The current conditions decline is surprising, given that jobless claims and gasoline prices have been falling and home prices have been rising. I’m inclined to view both last month’s strength and this month’s weakness as possible statistical noise (the survey is based on a sample of only 500 households), especially given the decent retail sales number.

Good coincident housing data, but still cause for concern about the impact of rising interest rates

  • Housing permits and starts rebounded, with the volatile multifamily component driving both June weakness and July strength. Starts and permits had/have stalled just below 1 million units/year.
  • The National Home Builders housing market index rose from 56 to 59, its highest reading since November 2005, with strength coming from both current sales activity and builders’ outlook.
  • Mortgage applications for purchases fell 5% in the week ending 8/9, continuing a 3-month trend, and refinancing applications fell 4% despite a 5bp decline in 30-year mortgage rates…and, of course, rates have risen since then.

Inflation and unit labor costs ticked up, but remain low

  • Both headline CPI (which measures inflation) and core CPI (which excludes food and gasoline) rose 0.2 percent in July. Year over year, headline rose from 1.8% to 2.0%; Core rose from 1.6% to 1.7%.
  • Import prices rose 0.2% on higher petroleum prices; ex- petroleum, import prices fell 0.5%. Year/year, ex-petroleum import prices were -0.5%.
  • Export prices fell 0.1% on lower agricultural product prices. Year-on-year, export prices are up 0.4%.
  • Labor productivity rose at a 0.9% annual rate in Q2; unit labor costs rose at a 1.4% rate. Year/year, productivity was unchanged; both hourly compensation and unit labor costs rose 1.6%

U.S. consumers continue to deleverage

  • Consumer debt declined 0.7% in the second quarter (Q2). The delinquency rate fell from 8.1% in Q1 to 7.6% in Q2.

Detroit fallout

  • Moody’s is inviting comment on a proposed methodology change which would raise the weight it gives to pension obligations from 10% to 20%.

Washington watch

  • Odds that Larry Summers will be the next FOMC chairman are rising. The Wall Street Journal says the White House has moved to quiet Senate Democrats from pressing the claims of Janet Yellen as the next Fed head, saying the President “will not be pressured” into an appointment. Comment: because Yellen is considered a major “dove,” the market may be pricing in a less accommodative Fed.
  • The Justice Department moved to block the American/USAir merger. Most commentators find the Justice Department’s reasoning/logic/arguments pretty weak . . . the only place the combined airline might seem to have excessive market share would be at Reagan (DCA) Airport . . .the one closest to DC.
  • Higher tax revenues continue to shrink the deficit.
  • No substantive progress on the budget or debt ceiling.

Fed watching: waiting for the September taper

  • Next Federal Open Market Committee (FOMC) meeting: September 17-18
  • Fed speakers continue to guide the markets to expect a September taper.
  • Chatter is now centering on the size/rate of the taper more than its start date: what is priced in?

Foreigners are selling Treasuries

  • The Treasury’s report has shown foreigners to be net sellers of Treasuries most of this year; net sales were quite large in June, hitting $67 billion. Both Chinese and Japanese accounts were large sellers in June.

The Eurozone posted positive Q2 GDP growth

  • Flash Q2 GDP was +0.3% (-0.7% year over year) after a -0.3% Q1
  • Germany (+0.7%) and France (+0.5%) drove growth. Portugal (+1.1%) was also solid. Spain (-0.1%) and Italy (-0.2%) remained in negative territory, but the rate of decline slowed (the trend is improving).
  • Comment : a positive Q2 number is a pleasant surprise—the end of the recession might have come a bit earlier than expected…but one positive quarter is not enough for a victory dance.

Other Eurozone news was constructive

  • German investor confidence (the ZEW report) and industrial production surprised on the upside.
  • Headline CPI was up 1.6% year over year; core was up 1.1%

Japanese GDP grows…tax policy is in the headlines

  • Q2 GDP rose for the third consecutive positive quarter, albeit more slowly than anticipated (0.6% quarter over quarter, 3.8% year over year).
  • Real consumer spending is outpacing overall GDP growth…but is that rising confidence or buying in anticipation of prices rising?
  • On the downside, machine tool orders (an important indicator for Japan) was weak
  • There’s lots of speculation/uncertainty about whether the government will seek to delay a rise in the consumption tax and/or cut corporate tax rates.

China watch—New York Times watch

  • Economic data was generally encouraging, notably rising factory output, electrical generation/consumption, and demand for copper…indications that growth is not collapsing.
  • The government said it would accelerate the cutback of excess industrial capacity.
  • A Friday New York Times article said that a credit crisis is spreading through China as the informal lending called “shadow banking” system dries up, causing “thousands of businesses to close, mass repossession of luxury cars and street protests.” Comment: it’s unclear whether this is just another “wall of worry” story (journalistic sensationalism… the New York Times is not a “China booster”) or a valid warning…there’s no independent verification of the story yet.

India tries (without success thus far) to stop the decline of the rupee

  • Facing a large current account deficit, and falling currency, India boosted import duties on gold and silver and banned the import of gold coins, while the Reserve Bank of India imposed new capital controls. It didn’t help last week: stocks fell and the rupee hit a new all-time low intraday Friday. Note: Indians were the world’s largest buyers of physical gold in Q2…given the decline of the rupee, gold doesn’t look bad in local currency terms.

Mexico announces plans to open its petroleum sector

  • Mexican President Enrique Peña Nieto proposed changes to the constitution that would allow private investment in the development of oil and gas resources (currently there’s a state-owned monopoly).

Egypt watch

  • The unrest is boosting both geopolitical fears and oil prices

The week ahead

  • New and existing home sales, FHFA house price index
  • Kansas City Fed survey
  • July FOMC meeting minutes…may shed some light on taper plans
  • Fed Jackson Hole meeting…Bernanke won’t attend: no notable Fed policy guidance expected
  • Eurozone and China PMI

Data Sources: The Wall Street Journal, Financial Times, Bloomberg

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