Change is Coming
Nowhere To Hide As Stocks, Bonds Fall
Equity markets moved lower for the third time in four weeks, shedding approximately 2%. Bonds also lost money, with the Barclays Aggregate Bond index declining 1.1%. Rates moved higher last week on additional taper talk; the yield on the 10 year US Treasury rose from 2.57% to 2.84% during the week.
Economic data was generally positive last week, outside of a few underwhelming manufacturing reports. The relative health of retail and housing data offset this source of disappointment.
On Tuesday, the Census Bureau reported that retail sales rose 0.2% in July. While this was a tenth below expectations, the prior month was revised higher by 0.2% to 0.6%. Additionally, after stripping out the impact of automobiles, retail sales surpassed estimates with a 0.5% increase.
Improvement in the retail report was spread across categories, including food & beverage stores, clothing & accessories, and general merchandise. The only categories to decline by a substantial amount outside of motor vehicles were furniture and build materials stores. At least one outlet attributed this decline to abnormally wet weather conditions on the East Coast.
Inflation data also arrived via the producer and consumer price indices. These measures continue to indicate a complete lack of pricing pressure for US goods. In July, the PPI was flat at a headline level and increased just 0.1% at the core, which strips out more volatile food and energy components. Meanwhile, the CPI rose 0.2% at both the headline and core levels. This was in line with expectations.
The recent inflation data would appear to suggest that the Fed still has continued room to execute its program of accommodation. However, expectations have coalesced around a consensus that the Fed will begin reducing its current pace of $85 billion per month in asset purchases.
Thursday’s initial jobless claims report did nothing to deter those expectations, as the series fell to the lowest level of the economic recovery. The measure declined 15,000 to 320,000, which also pushed the four-week moving average to 332,000. The series has been under the 400,000 mark for almost two years now, which is generally the level at which economists believe job growth occurs.
Housing starts also showed a bit of life last week, increasing by 50,000 to a seasonally adjusted annual rate of 896,000. This was a hair under expectations, but as we noted there were some weather-related issues in July. Continued forward momentum appears promising, as building permits increased to a pace of 943,000.
On the manufacturing front, there were three important reports last week that revealed a sector that is still trying to find its footing.
Two regional manufacturing surveys – the Empire State and Philadelphia Fed reports – weakened in August. Still, the reports indicated growth, albeit slower than the previous month and below market expectations. More concerning is the marked weakness in new orders, which often portends future strength for the sector.
Industrial production was also disappointing, coming in flat and 0.3% below consensus. The series was held back by the all-important manufacturing component, which contracted in July. The measure’s mining and utilities components were mixed.
Although the housing sector took over the reins from manufacturing as the economic leader over the past year, the recent back up in mortgage rates could cause that trend to slow. This could leave the US economy more vulnerable to the vicissitudes of the manufacturing sector. Investors will learn more with the Flash PMI this week and the ISM manufacturing index due for release on September 3.
Change is Coming
The summer months brought a period of calm to global markets and economies. Nearing the move to autumn, it is time to look ahead and see what resides on the horizon. Investors could be due for a renewed bout of volatility based on any number of events set to happen before year-end.
The U.S. is likely to be one of the biggest volatility contributors this fall. Not only does the debt ceiling look likely to run out by the end of October, but the FOMC is also widely expected to announce a slowdown of its asset purchase program at its next meeting on September 18.
Recent data suggests the Fed should in fact follow through with its reduced asset purchase program. Retail sales for July, for instance, gave one of the strongest indications yet that consumers are spending and no longer in need of as much accommodation as the Fed has been willing to provide.
At the same time, the debate between Larry Summers or Janet Yellen as the next Federal Reserve Chairman will heat up given the pending end of Ben Bernanke’s term in January. The Wall Street Journal’s Jon Hilsenrath wrote over the weekend that an informal poll of economists showed Janet Yellen would be the best consensus builder at the Fed. Only one economist felt the same way about Larry Summers, suggesting a more volatile path forward if he becomes the next Chairman.
This week will provide additional insight on current Fed thinking as minutes from the most recent meeting are released. Economists are looking for further clarity on the pace of asset purchase reductions and any issues that may prohibit the Fed from slowing purchases.
All the while, politicians will look for common ground on the budget. Congress returns from recess on September 9 and top of mind will be the end of the fiscal year and the debt ceiling. Reaching a budget agreement will be difficult as Republicans and Democrats are estimated to be $100 billion apart. In the event a deal is not reached by October 1, the possibility of a government shutdown exists. It is unlikely either party will want to take the blame for that, so at the very least a short-term deal should be in place prior. Any number of issues will be on the table during negotiations, including higher taxes, repeal of the sequester, and cuts to discretionary spending.
Internationally, the news flow is likely to be just as important. Germany holds federal elections on September 22. Angela Merkel and the Christian Democratic Union are the likely favorites to win. One theory suggests other European nations stayed quiet in the run-up to the election, understanding the need to keep Merkel in power. Once the election is over, there is the potential for Europeans to go back to the drawing board for new ways to fix their problems. Economic growth across the Eurozone is improving, but that is mostly the result of Germany and France. Countries like Portugal continue to face austerity measures and fiscal reforms, raising the specter of ongoing intervention.
Source: Thomson Reuters
Several economists from Stanford and University of Chicago created an Economic Policy Uncertainty index to measure the number of instances of reported uncertainty in the media. During June and July, the index reached its lowest level since prior to the financial crisis. In the last few weeks, though, the index is turning higher, a possible harbinger of things to come.
Source: Economic Policy Uncertainty
Investors should understand that despite a seemingly quiet summer, traders and markets are ready to climb back to life in the next few weeks. Markets could move in either direction depending on the decisions reached in any of the aforementioned events. At the very least, investors should make sure they are properly diversified heading into the fall and prepared for a return of macro driven markets.
The Week Ahead
Although economic data is fairly limited this week, minutes from the July 31 FOMC meeting are released on Wednesday. There will likely be volatility in financial markets surrounding this publication, as the transcript is expected to reveal committee members planning an imminent reduction of asset purchases.
Data this week is mostly housing related, with new and existing home sales topping the list. The street expects existing home sales to rebound from a slight slip last month, while the opposite is true for new home sales.
Central bank activity is limited this week, with only Turkey and Thailand meeting. Neither is expected to modify current policy.
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