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Weekly Update: This is undeniable

As of 05-31-2013

I spent much of the week in Connecticut, home to the second wealthiest ZIP code in the country and to Greenwich Avenue, the “Rodeo Drive of the East.’’ We didn’t stop there—too rich for my blood. Although I was delighted when, before a talk in Westport, a gentleman (!) (whose wife is a collector of handbags) admired my designer purse. It is fabulous—shoes and handbags, that’s what we live for! Despite this state’s affluence, the overarching feeling from the people I met with was skepticism. They see the market is strong, but believe it is only because of all the central bank easing. Clearly, QE has had an impact. But the strength out there now seems to be more legit. Manufacturing is expanding (see italics below). Consumers are undeniably feeling better (see italics below). Housing is undeniably improving (see italics below). We keep getting back-to-back upside surprises that suggest it’s really quite premature to time the beginning of the next recession, even if the historical record would argue that the current recovery/expansion, which by next June will be entering its sixth year, is getting old. With the Fed’s efforts starting to really get the economy going, I find my presentations moving away from the theme of malaise.

It’s not just the U.S. where things are looking less grim. Even as the OECD cut eurozone growth forecasts for this year, there are signs the darkest days from austerity may be coming to an end. France, Spain, Slovenia and Poland will get two-year extensions to bring their budget deficits below 3% of GDP, and the Netherlands and Portugal will get one more year. Those changes could matter given the evidence that there are large multiplier effects across countries from changes in fiscal policies that are made during recessions. For a real turn to emerge, however, Empirical Research says Germany must stimulate its economy. Along those lines, German Finance Minister Wolfgang Schaeuble this week indicated such a move may be nearing. He warned that failure to win the battle against youth unemployment could tear Europe apart and that abandoning the Continent's welfare model in favor of tougher U.S. standards would cause "revolution." Helping matters, the ECB has been more willing to act, cutting the benchmark rate 25 basis points to a record low 0.5%. Inflation that is low and falling should allow it to maintain this accommodative stance. The big problem is the transmission channel of looser monetary policy remains dysfunctional—more needs to be done to improve credit availability.

Back home, bond yields have made a clear technical upside breakout. The next technical, according to ISI, is probably the 2011/12 peaks around 2.40% on the 10-year Treasury. After that, the next technical is close to 3.00%. Up to 3.00%, increasing bond yields are probably more of a positive signal than a negative, in part because inflation expectations have barely budged. This implies that the increase in yields is real; that is, bond market participants expect stronger growth ahead. If equity investors are taking cues from the bond market, then one would expect stocks to rally, which they have. A key reason inflation expectations are not moving higher is because actual inflation will probably not move much higher. That is because money velocity, although a lagging indicator, is likely to stay low and CPI rarely moves significantly with low velocity. The S&P 500 is 11.7% above its 200-day moving average—once an index gets more than 10% above this benchmark, a pullback should be expected, Dudack Research says. Oppenheimer expects a correction of 6% to 9%, and even market bulls believe a pullback is probably overdue and needed. But longer-term, the worries expressed by my Connecticut friends are indicative of much of the bearishness still out there. It’s just another flower on my beautiful wall of worry.

Positives

A confidence boost The respective Conference Board and Michigan consumer confidence and sentiment gauges surprised to the upside again in May, with the former reaching its highest level since February 2008 and the latter its highest level since July 2007. The 14.3-point rise in the confidence index over the past two months represented its biggest back-to-back monthly increase since December 2011—there have been only 14 other cases since 1967 with two-month gains of at least this magnitude. Meanwhile, the Michigan reading shows sentiment moving out of the recessionary zone where it’s been stuck since 2008—excellent news for stocks and the economy.

Manufacturing’s lower gear may not last The Chicago PMI surprised, jumping from slight contraction territory to a 14-month high of 58.7 in May, the biggest one-month jump since 1983. Every component contributed, led by surges in production and employment. Elsewhere, the Richmond Fed’s manufacturing survey improved but continued to point to contraction, consistent with the May prints of the Philly Fed and Empire surveys, both of which also remain in mildly contractionary territory but with positive longer-term outlooks. The Chicago PMI tends to be closely correlated with the national ISM Manufacturing index, which comes out next week. One sign of potential increases in activity comes from U.S. automakers, which are canceling some summer factory shutdowns to boost output to meet demand.

Housing looks to be shifting from recovery laggard to leader The Case-Shiller price index jumped 3.9% in the first quarter, the most in eight years, and was up 10.2% from a year ago, the fastest pace since Q1 2006. Prices have recovered to levels last seen in Q4 2003, with all 20 cities in the gauge rising in March for a third straight month, half by 2% or more. April pending home sales rose less than consensus but still brought year-over-year growth to 13.9%. Inventory also rose, a positive given that a lack of supply has been blamed by Realtors for smaller-than-expected increases in sales.

Negatives

Rising sentiment not reflected in April consumer spending It unexpectedly slipped 0.2% last month, while March was revised down to just a 0.1% increase.  Falling gasoline prices played a role in the slippage, as did the weather—utility expenditures fell in April after March’s large cold weather-driven gain. Real consumer spending is on pace to rise just 1.5% this quarter, and has been rising only 2% annually during the recovery versus an historical 4% average during expansions. In other words, consumers appear to be remaining cautious about overspending even as their mood is improving.

When it comes to housing, recovery doesn’t mean cured King Securities notes that despite a recovery in prices, over a quarter of homeowners with mortgage loans still owe more than their homes are worth. While not technically underwater, another 18.2% of homeowners with mortgages likely do not have enough equity to afford to move. Nearly 44% of homeowners have less than 20% equity in their homes, making it hard to move or trade up, given the considerable costs involved in buying and selling a home, including the cost of a down payment for the next mortgage.

Downwardly revised GDP not so bad Real GDP growth for the first quarter was revised down a tick to 2.4%, but the pattern of revisions was consistent with a bit stronger consumer demand as retail inventories were lowered and consumption revised up on stronger real spending on motor fuels. Miller Tabak notes that the final Q1 GDP report is now rather dated, but in terms of the tapering debate, investors will likely take heart from the lesser likelihood of reduced Fed intervention given the weaker pace of growth and bigger impact from slowing government spending.

What else

Excess anything often creates trouble The Financial Times provides a stark reminder of the consequences of the global excess liquidity, noting the proportion of “covenant-lite” loans has soared to more than 50% of all leveraged loan issuance so far this year, twice the level seen during the last boom in 2007.  $129 billion of leveraged loans have been sold with covenant-lite features this year, up from $22 billion in the year-ago period and $96 billion for all of 2007, according to S&P Capital IQ data. On a related note, Bloomberg reports an increasing number of companies are tapping the loan market to pay dividends.

Rate risk looms over budget The Levy Institute’s blog had an interesting note on the U.S. budget outlook. Over the next 10 years, it is not health care, Social Security or defense that it is the primary risk to a favorable budget outlook. The institute noted that the repricing of U.S. Treasury debt is the primary culprit to raising the deficit in the out years.

It’s not just here where graduates struggle to find work Only 30% of June’s 7 million college graduates in China had found jobs by mid-April, down 10 percentage points from a year ago. A February survey conducted by the Ministry of Education also found hiring plans, measured by openings, among the 500 major employers (i.e. government agencies, foreign enterprises, state-owned enterprises and private corporations) were down 15% on average from a year ago. This is putting significant social and political pressure on the government to boost the pace of job creation.


 
 
 
 
 
 
 
 
 
 
 
Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.
Consumer Price Index (CPI): A measure of inflation at the retail level.
Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.
S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.
The Chicago Purchasing Managers Index, produced by the The National Association of Purchasing Management–Chicago, gauges factory health in the upper Midwest based on surveys of companies in that region.
The Conference Board's Consumer Confidence Index measures how optimistic or pessimistic consumers are about the economy.
The Empire State Manufacturing Index gauges the level of activity and expectations for the future among manufacturers in New York.
The Federal Reserve Bank of Philadelphia gauges the level of activity and expectations for the future among manufacturers in the Greater Philadelphia region every month.
The Federal Reserve Bank of Richmond Monthly Manufacturing Survey survey is a gauge of activity and expectations for the future among manufacturers in its district.
The Institute of Supply Management (ISM) manufacturing index is a composite, forward-looking derived from a monthly survey of U.S. businesses.
The pending home sales index, released monthly by the National Association of Realtors, is designed to be a leading indicator of housing activity.
The S&P/Case-Shiller Home Price Indices measure track changes in the value of the residential real estate market in major metropolitan regions.
The University of Michigan Consumer Sentiment Index is a measure of consumer confidence based on a monthly telephone survey by the University of Michigan that gathers information on consumer expectations regarding the overall economy.
Federated Equity Management Co. of Pennsylvania
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