Economic Notes – April 14, 2014


Written by: Jon McGraw

It was a light week for economic data. The few releases that did appear were positive on the employment front; however, a few showed some imported inflation. Equity markets struggled with momentum stocks (those that led the way last year) pulling back.

(-) The Producer Price Index came in higher than thought for March, much higher actually, gaining +0.5% for the month relative to tempered expectations of a +0.1% increase. Core PPI, removing food and energy prices, rose +0.6%, compared to an expected +0.2%. The primary reason was an unexpected contribution from ‘trade margins’ (measures the change in margins received by wholesalers and retailers) of +1.4% (following a -1% drop the prior month). From an industry standpoint, trade margin gains originated from flooring, chemicals, cleaning supplies and clothing—from highest to lowest. Higher commodity prices over the last several months no doubt had some impact on the carrythrough on the PPI. For the full year, both the headline and core are up +1.4%, which remains quite low despite the volatility in recent months.

(-) Import prices rose +0.6% for March, which surpassed forecast of +0.2%. Food and beverages gained +4% month-over-month (fruit +14%, notably that from Mexico), the largest increase in 3 years and as well as higher natural gas prices from Canada contributed to the combined figure. Removing the North American influences of food and energy, import prices gained +0.2% on the core side. For the trailing year, overall prices fell -0.6% while core dropped -1.2%.

(+) The NFIB Small Business Optimism survey rose from 91.4 in February to 93.4 for March, which outperformed the forecast of 92.5. The largest increases originated from sales expectations (now in the double-digits), as well as plans for increased inventories. Current job openings and plans to increase employment didn’t change much, however, there was some indication of some rising wages by a quarter of firms surveyed, which was a few percentage points higher than last month.

(+) The Univ. of Michigan consumer sentiment survey to 82.6 in April from 80.0 last month, surpassing the expected 81.0. Consumer assessments of current conditions and expectations for the future both improved—the future more than the current, which is encouraging. Inflation expectations ticked up a tenth, but remained right around 3% as they have for quite some time.

(0) Wholesale inventories for February came in roughly in line with expectations, up +0.5%. The driving factors were computers and pharma categories, up a few percent each, but tend to be volatile.

(+) The JOLTS job openings report for February showed stronger gains than expected, at 4,173k versus a forecasted 4,020k—this was a post-recession high point for the JOLTS. The 12-month moving average of this volatile series is up 7% from the moving avg. a year ago; however, the level of job openings is about 90% of the pre-recession peak level (although you wouldn’t think so from a sentiment standpoint). The hiring and quit rates, however, remained at the same respective levels of 3.3% and 1.7%.

(+) Initial jobless claims for the Apr. 5 ending week fell -32k to 300k, beating consensus calls for 320k and representing a new low last reached in May 2007. Continuing claims for the Mar. 29 week fell -62k down to 2,776k, also well below consensus forecast of 2,835, which in itself was the lowest level since Jan. 2008. No unusual factors surfaced to convolute the numbers, and haven’t for a while, so the ‘normalcy’ of these stats is perhaps better than we saw earlier in the year.

Claims certainly have performed better, and, on the basis of a year-over-year decline of -8% last year and -6% in Q1 2014, both was in line with the GDP growth experienced. Claim levels of 285k would be consistent with estimates of +4% GDP growth, which may seem high, but possible if winter weather effects dissipate in favor of better organic growth stemming from pent-up demand.

Market Notes

Stocks experienced more volatility last week over concerns of slowed global growth. Looking at the sectors, utilities outperformed with a half-percent gain, while financials and health care lost several percent more than the market. Momentum stocks (i.e. last year’s winners, such as biotech, social media and 3-D printing) stalled and have moved negative over the past month, with an especially poor day Thursday. Then again, their valuations were getting a bit rich.

We are in the now in the midst of another earnings season, with the first reports this week being mixed (Alcoa, the traditional first name to report, was positive, but their results have not been shown to be especially correlated with everyone else’s numbers). Expectations for Q1 earnings have been lowered, through downwardly revised earnings estimates, many of which are weather-related—trickle-downs from the effects of economic data we’ve been reporting on for so many months. Those weather effects have generally been a negative for consumer goods, but a positive for earnings in areas like utilities. Then again, it could be the usual Wall Street game of over-revise expectations lower and experience the higher positive surprise at earnings release time—and everyone is happy. Overall bottom-up S&P 500 estimates are calling for growth of 2% in earnings for the quarter and 5% in top-line revenue. For the rest of the year, naturally subject to change, earnings growth is expected to expand to 10% quarter-over-quarter while revenue growth consistent at 5%.

One important reason as to why stock earnings have rebounded so strongly in the last cycle is the improvement in profit margins, which have moved from a low of just under 6% in 2009 to just under 9% today. Profit margins—being the simple fraction of net income (aka earnings) divided by sales revenue—represent one third of the classic ‘DuPont’ return on equity calculation. So, starting with sales, and removing cost of goods sold, R&D, administrative expenses, depreciation/amortization and other costs, as well as owed interest and taxes, you get a final ‘bottom line,’ which is net income.

Are net profits sustainable at such a high level? Probably not forever, but they could hover here for a while. We’ve seen a steady increase in margins since the 1970’s, which, when you think about trends towards automation and associated efficiencies, this isn’t entirely surprising. However, in the most recent business cycle recovery, there has been debate about how much cost-cutting can be accomplished without higher revenues on the other end. So, just like last quarter, eyes will be focused on top-line revenues and guidance commentary as well as bottom-line earnings. As the business cycle matures and firms become increasingly confident in their prospects for profitability, we may start to see increasing amounts of leverage used (from today’s much lower post-crisis levels), which may act as another lever to aid corporate returns.

In developed foreign equity markets, the U.K. fell by just over a half-percent, while the Eurozone fell -2%. Japan suffered a -5% loss following a BOJ announcement that rates/stimulus will remain unchanged, as policy appears to be on track for 2% inflation at present. The BRIC emerging market nations gained several percent, and have experienced a bit of a comeback in recent weeks, as EM equity is the leading equity group so far in 2014 (who would have guessed at the end of last year?) as sentiment is perhaps reaching a bottom.

Bonds generally performed well in a risk-off week, with yields falling about 10 bps across the curve—so, long bonds outperformed short bonds. Intermediate credit and MBS gained between one-half and one percent, while high yield bond indexes lost ground with widened spreads.

High yield bonds and bank loans have experienced strong cash inflows over the past year. There continues to appear to be some room to run here—spreads are just below long-term average levels, but aren’t near their all-time ‘tights.’ In high yield, default rates have remained below 1% (compared to a historical average of 4%) and have generally stayed at lower levels until a year or two after the Fed begins to raise rates. Relative to the fewer opportunities seen in intermediate-term investment grade debt, a spread that stays somewhat stable continues to provide ample absolute return for waiting by clipping the coupon. Floating rate bank loans are in a similar situation, although pricing is closer to ‘fair value.’ Then again, these types of securities have historically performed well when rates rise, due to their resetting nature—all other fundamental factors aside, continued economic improvement could be a technical positive for that market.

In broader foreign markets, a weaker dollar on the week created positive performance in both developed and emerging markets; otherwise, local currency returns appeared to be roughly flat. Non-U.S. markets were highlighted by the return of Greece for the first time in four years, raising €3 billion for a 5-year bond with a 4.75% coupon. Perhaps the amazing part is that the deal was eight times oversubscribed, implying huge interest in the paper. Conditions have certainly improved in Greece—their deficit-to-GDP ratio is only about a fifth of what it was in 2010 (on a lower GDP base than pre-crisis). No doubt this improvement added to the success of the bond offering, but the rate appears low considering the ongoing challenges.

With the exception of Europe, most real estate segments were negative on the week, along with general equity markets, but better than the financial sector as a whole. U.S. industrial/office lost a percent as the worst performing group; however, year-to-date numbers from the real estate sector are extremely strong (up in the 5-10% range), representing the best performance from any asset class and demonstrating its diversification characteristics.

Commodity indexes generally gained about a percent overall, with strength in coffee (worst drought in Brazilian history has affected this and other products), natural gas and some industrial metals such as nickel and aluminum. West Texas crude also gained a few percentage points from $100 to $103. On the negative side, sugar and cotton correct a few percent on the week.

Have a great week!