Weekly Update: Spring is coming
Anyone who has watched HBO’s “Game of Thrones” is familiar with the warning "Winter is coming." Well guess what ... spring is coming! I got a head start on the workweek, with a scheduled early morning flight on Sunday to Dallas, where meetings were to be held Monday afternoon and Tuesday. After being stranded twice in the last four weeks, I thought I would outsmart the weather which called for ice storms in Dallas on Sunday and a foot of snow by Monday morning in Pittsburgh. Well, many planes were cancelled that day, including mine, and I arrived in Dallas around 11 p.m. There I learned that one can drive on the ice, although my cab passed quite a few crashed cars, cars in ditches and police vehicles. It was 15 degrees in Dallas on Monday, for only the seventh time on that calendar day since 1898. I met several advisers who described how worried their clients were; one said his fears a 50% market decline. (That wall of worry is still really high!) What are we worried about? The Q&A wanted my thoughts on how Crimea will affect U.S. investors. Given the market’s reaction so far, even to the prospect of a possible Russia takeover of the Crimea region, not much—at least, not yet.
Credit and fear gauges remain muted, Ukrainian sovereign yields and credit default swaps have not blown out and stocks have rallied, with the S&P 500 reaching new highs almost five years to the day (March 9) it set a cycle low 666. The direct U.S. economic exposure to the region is negligible. Trade with Russia is less than 1% of total exports and imports, while trade with the Ukraine is virtually zero. The main risk is through the financial market—an increase in risk aversion and corresponding tightening in interbank funding markets. At present, this risk is low. Europe has larger financial and economic ties to the region. Of the top 50 underwriters in the Russian loan market since 2010, European banks underwrote 63% of all deals, followed by Japan with only a 13% share and U.S. banks with a 12% share. The country with potentially the most to lose is Russia itself. Its government seemed to have been surprised by the extent of sharp declines in the ruble and Russian equities—a reminder that as in 2008, its economy may not be as insulated against international pressures as previously believed (indeed, Russian banks have greater exposure to Ukraine than Western banks). The threat of targeted elite sanctions along with actions that would diminish access to low-cost foreign capital may be proving more effective than widely recognized. Russia has much to lose from a deepening confrontation, but without Ukraine or large parts of it in Russia’s orbit Putin’s dream of a Russian-led Eurasian Union will be greatly diminished.
Cornerstone Macro considers Russia the biggest risk to global markets. Its economy already was in a weak position before this crisis, with a continuing decline in investment, capital outflows and sticky inflation. A mild recession is likely, with real GDP declining 1%, and if sanctions are imposed a recovering eurozone could get hit hard. Still, the market doesn’t seem to be preoccupied with Crimea, focusing instead on a rash of relatively positive economic data this week (more below) and a Fed Beige Book that described the pace of U.S. growth as “modest to moderate” despite the brutal winter—the word “weather’’ was mentioned 119 times in the report. I hope we don’t see a melt-up, which will then be punished. But it does look as if our call for the release of pent-up demand in 2014 has a good chance of being accurate, which will be bullish for earnings and stocks. I finished my week with my third annual presentation to the Bedford Chamber of Commerce in the charming Bedford Springs Resort in my home state. What a warm reception. My travel problems are forgotten, spring is nearing (clocks change this weekend), my beloved daughters are home for spring break, and it will be 50 degrees in Pittsburgh on Saturday. I’m in a good mood! And I promise not to discuss the weather anymore.
All roads lead to jobs February nonfarm payrolls rose a better-than-expected 175K, with sizable gains in construction and manufacturing. The three-month average gain in construction payrolls is 15K, in line with pre-December trends and consistent with a pick-up in residential construction activity this spring. The highly volatile household survey rose only 42K after jumping 638K in January, but the two-month average was a solid 340K and the labor force expanded, positive signs even though the jobless rate ticked up a notch to 6.7%. This report built on this week’s further decline in jobless claims and a 24% drop in Challenger’s monthly layoffs tally that put layoffs the first two months of the year at their lowest level since 2000.
Manufacturing moving past weather The manufacturing ISM rose to a better-than-expected 53.2 as new orders improved and employment held steady in expansionary territory. Markit’s final read on February also rose above expectations to 57.1 on sizable gains in output and new orders, a good omen given January’s 0.7% decline in factory orders was larger than forecast. Still, nondefense capital goods shipments excluding aircraft were up an annualized 7.6% since October, and orders of these capital goods were up 12.2%.
All eyes on the consumer Nominal U.S. consumer spending is 15.4% above its 2008 peak, and even with the sequester, shutdown, tapering and bad weather, rose 3.5% year-over-year in January. On a monthly basis, the 0.4% increase in personal spending was double forecasts and was led by a surge in spending on services, primarily household energy. Goods spending actually fell 0.6% as the weather discouraged trips to the malls and auto dealer lots. An improving job market and rising net worth should act as a tailwind for consumption in coming quarters—the Fed reported rising stock and home values caused household net worth to jump by almost $3 trillion in Q4 to a record $80.7 trillion and that the ratio of net worth to disposable income is 639%, a post-recession high.
Disappointing ISM services—ACA a factor? February’s gauge surprisingly fell to 51.6, with the employment component plunging to 47.5, its biggest drop since 2008. Weather was a factor, but respondents indicated the Affordable Care Act also was to blame. Anecdotally, health-care and social-assistance firms said the ACA was “creating significant financial uncertainty to health-care organizations” and called the negative revenue effects “unprecedented.” Speaking of the ACA, the White House moved to let people keep their existing health plans into 2017, reducing the likelihood the exchanges will prosper as they are likely to disproportionately attract an older, sicker (and because of the subsidies, poorer) population while healthier people will keep their existing policies.
Productivity gains pared Q4 productivity growth was revised sharply down to 1.8% from an initial 3.2%, reflecting a similar revision to output growth. Compensation per hour also grew by more than initially estimated, causing a much smaller decline in unit labor costs (-0.1% vs. the initial estimate of -1.6%). On a year-over-year basis, output per hour was up 1.3%, the strongest since Q3 2012 but still consistent with a subpar pace of productivity growth. This suggests weaker potential output growth than in previous cycles.
All eyes on China Chinese growth continued to slow as February’s composite PMI dipped below 50%. The Chinese government is worried about weaker employment, helping explain its announcement of a 7.5% growth target at the annual week-long National People's Congress. This is the same target as in 2012 and 2013 even though the 5-year plan target (2011-15) is 7%. The 7.5% target and weaker PMI raise the odds of more easing by the Peoples Bank of China.
I don’t like old planes Following the budget deal at the end of last year that will finance government operations through the end of 2015, Ned Davis Research’s proprietary measure of economic policy uncertainty dropped in January to its lowest level since 2008. This index has a strong inverse relationship with capex, boding well for capex spending in 2014. Also, lending standards are easing in all loan categories except residential mortgages, the first such broad-based easing of standards in six years. Historically, easier bank lending standards and tighter credit spreads have been favorable for capex. The economy could use more capital spending. Ned notes the average age of private fixed assets reached 21.7 years in 2012, the most since 1958, with aircraft at a record 10.3 years (Gulp) and manufacturing facilities at a record 23 years, surpassing the 1946 peak.
A bullish take on tapering After borrowing roughly $1 trillion net short-term from banks in 2013, the Fed’s purchases will slow to roughly $500 billion this year and zero in 2015. This should force banks to undertake an aggressive search for new short-term borrowers, such as commercial & industrial loans to small businesses, Encima Global says. Perhaps this has started, as C&I lending jumped at a 20% annual rate over the last 13 weeks.
Why mom and dad may soon get their basement back Many seem to think the younger generation will never be able to afford a home and housing will not be able to gain traction as a result. In fact, employment in the 25-34 age bracket is doing very well and no other age group even comes close to matching the job gains in this bracket.