Economic Notes – August 19, 2013


Written by: Jon McGraw

(+) Retail sales for July rose for the fourth consecutive month, with a gain of +0.2%, which came in slightly below the forecasted +0.3%. While broadly stronger, the tempered headline result was based on a -1% decline in autos and auto parts sales. However, the more closely-watched ‘core’ number (removing auto-related items, gasoline and building materials) outperformed, gaining a tick better than forecast at +0.5%. Gains here were broad across a variety of categories, including restaurant meals/beverages with a particularly large increase, while electronics represented the only losing category group. While not large increases month-to-month, this indicator has served as a bright spot in recent months in terms of improved consumer behavior, as cash savings and paydowns of debt wane in line with generally improving conditions.

(-) The August Philadelphia Fed index reported results that were a little worse than expected, at +9.3 versus a +19.8 July level and an anticipated +15.0 this month. The details below the surface were also weaker, in the areas of shipments, new orders and employee additions. On the positive side, the level remained above zero, which pointed to expansion in the segment as opposed to contraction.

(-) Similarly, the New York Empire manufacturing index for August also disappointed, coming at a level of +8.2 versus the +9.5 July report and a forecast of +10.0. The underlying data was more mixed than that of the Philly survey, with new orders and shipments down, but employment and the average workweek improving somewhat. Capital expenditure expectations also improved for the six-month look-ahead period, which is a positive.

(+) Import prices in July broke a string of four straight declines by rising +0.2% for the month, but stopped short of the forecasted +0.8%. Higher petroleum prices (up +3%) were the primary factor, as the non-petroleum component of the report fell by roughly half a percent. Lower import price levels from Japan and China were noted specifically; the weaker Yen not being a particular surprise due to the efforts of the Japanese government to encourage this very thing.

(0) The producer price index came in unchanged for July, which undershot the expected +0.3% increase. Core PPI, which excludes food and energy, rose +0.05%, which itself came below expectations of +0.2%. Intermediate goods and finished goods for the month were unchanged as well on a net basis; the much of the increase in prices of food and energy were offset by weakness in other goods.

(0) Similarly sedate, the consumer price index gained +0.2% on a headline level (+2.0% year-over-year), which was on target with forecast. Removing food and energy, the core CPI figure rose +0.15%, which was slightly below the +0.2% expected, and brought the trailing 12-month core inflation number to +1.7%. In the underlying data, residential rents rose +0.2% in keeping with the same pace of the last few months, while a few ‘outliers’ consisted of tobacco and apparel prices moving at a faster rate than CPI. At the same time, personal computer prices declined.

From the combination of measures, inflationary pressures continue to be quite low—at least based on standard government measures. It seems at least some retirees may have a potential beef with the official CPI calculation based on the composition of their own expenses compared to the (usually lower) rate of increase in CPI-based social security income. So, we have a site for you ( ) that compares current methodologies used relative to those employed in the past. For the sake of space, we won’t delve into the intricacies of ‘hedonic’ and other adjustments, but some of the detail may make for an interesting read and/or conversation. The conclusion is that many retirees may need more of a nest-egg than they initially realized.

(-) Industrial production was flat in July, versus expected growth of +0.3%. As a component, manufacturing production lost ground by a tenth of a percent, while materials production bucked the trend with a small rise. The capacity utilization level was reported at 77.6%, which fell short of the forecasted 77.9%. Unit labor costs, which measures compensation relative to productivity, gained +1.4%. Nonfarm productivity rose +0.9% for the 2nd quarter, which surpassed a forecast of +0.6%, but the first quarter’s growth level was revised downward from +0.5% to -1.7%, along with other recent GDP revisions. The net effect over the past year is zero productivity growth. Productivity is an interesting concept, with several difficult-to-measure components—we may discuss at more length another day.

(+) In housing, the NAHB homebuilder sentiment index rose for the fourth consecutive month to 59 for August, beating expectations by two points. Within the index, builder assessments of present sales improved by several points, as did future sales expectations, while prospective buyer traffic was unchanged.

(-) Housing starts rose +5.9% in July (to an annualized 896k units), but came in short of expectations calling for a +7.7% gain. The month’s increase brought the year-over-year growth figure to +21%. For the month, the single-family element fell -2% (+15% year-over-year), while the notoriously volatile multi-family category rose +26%. Building permits rose +2.7%, just short of the expected +2.9% figure. As with starts, a small decline in single family here was also outweighed by a double-digit gain in multi-family. Overall permits are up +12% for the trailing year. These stats show continued strength in the recovering housing sector from very low levels.

(+) The NFIB small business optimism index was a bit more optimistic in July, with an increase from June’s 93.5 up to 94.1 (forecast was 94.5). Underlying components were generally higher was well, including plans to hire, expectations for sales and expansion sentiment; on the other hand, feelings about the economy ironically worsened. While this index has improved to new post-recession highs, it’s below earlier cycle levels pre-recession. The contradictory tone is somewhat par for the course with small business-oriented measurements in this recovery. While owners have steadily felt better about their own business prospects and acknowledge an improved outlook, feelings about the broader U.S./global economy appear less buoyant, and are tied in with frustrations about tax and regulatory policy. Whether it’s the current administration or an ongoing condition, this is a byproduct we’re getting used to seeing.

(-) The preliminary August Univ. of Michigan consumer sentiment measure fell from July’s 85.1 to 80.0 in August, also underperforming the 85.2 reading expected, and down to the lowest level in four months. Consumer assessment of current conditions fell several points, as did expectations about the future (although by not quite as much). Inflation expectations for the 1- and 5-10 year periods looking forward were within a few tenths of a percent around the 3.0% long-term average level.

(+) Initial jobless claims for the August 10 week fell again, down to 320k—exceeding expectations of a 335k reading—representing the lowest level of initial claims in six years. The earlier ‘special factors’ of auto plant shutdowns and the like tapered off and now appear to be a non-issue. Continuing claims for the Aug. 3 week came in at 2,969k, which was lower than the 3,000k expected, and sustained the positive trend here as we

Are the stock and bond markets too high?

Stock valuation is an imprecise science, but there accepted tools we can use to gauge a general ‘range’ for where we are in a valuation cycle. Internally, we look at several different metrics, including a dividend discount model as well as relative PEG (‘price-to-earnings growth’) ratio analysis to help derive relative statistics between different equity market caps and regions (i.e. domestic vs. developed foreign vs. emerging markets, for example).

When markets are at ‘fair value,’ which several roughly are now, based on a variety of measures—it doesn’t necessarily raise a red flag meaning ‘expensive’ or ‘sell now.’ It generally indicates that pricing conditions are close to average, relative to history—that current prices are reasonable given current earnings and dividends. So, large-cap equities should be expected to perform at their ‘normal’ expected return levels looking forward.

Based on these same metrics, emerging market stocks are quite cheap—arguably the cheapest equity asset class—which falls right in line with the cash outflows from EM funds, negative sentiment and outright unpopularity/disgust. Valuations tend to have an inverse relationship to an asset class’ general popularity with investors.

In fixed income, we look at things a little differently. Over the long-term, bond attractiveness is based on the amount of ‘real’ yield being earned, which is the amount over and above that consumed by inflation. In addition to this, we look at relative interest rate spreads in different assets, such as that of investment-grade corporate debt versus treasuries, high yield bonds versus treasuries, etc. This helps us from both a long-term relative view of what ‘normal’ is, as well as a tactical standpoint, for nearer-term opportunities on the upside and risks on the downside. In bonds, when spreads are ‘wide’ (or large) relative to history or relative to other assets, there exists a potential valuation opportunity. Conversely, when spreads are ‘tight’ (or small), conditions are more expensive as you may not be compensated adequately for the amount of risk you’re taking.

As we have discussed with many of you during our regular meetings, we’ve moved from a time where spreads were extraordinarily wide in many non-treasury bonds in 2008-09 to a point nearer to long-term normal, and even tighter in some cases. This points to potentially slimmer return opportunities going forward on a relative basis. But, an overriding theme in fixed income is the movement of general interest rate levels. When rates move higher, it’s usually bad news in the shorter-term for bonds and bond funds. While an oversimplification, the math implies you’re stuck with a fixed rate instrument while market rates are moving higher…so your lower fixed rate is no longer so attractive…and the price drops. That’s the basic math of bonds.

From their last high point of the early 1980’s, interest rates are near 30-year lows, which implies they have nowhere to move but upward (whenever that may be). This doesn’t bode well for bonds, so avoiding bonds with the highest exposure to this trend (intermediate- and longer-term debt) would be a first step. Holding interest rate exposure (duration) low is critical, which we have done in portfolios—a successful strategy thus far. Moving ahead necessitates a careful balance between reducing the risk of these rising rates, while also taking advantage of opportunities where we can find them to earn a bit of return along the way. Nevertheless, it may be a time for a stronger ‘defense’ than an overreaching ‘offense,’ if you don’t mind another sporting analogy.

The Markets

Stocks had a poor week, predominantly due to weakness on Thursday caused by disappointing Philadelphia and Empire state regional reports and poor earnings results from mega-caps Wal-Mart and Cisco. Technology and industrial sectors led on the week, while utilities and consumer discretionary names lagged.

Foreign stocks held up significantly better than domestic names last week, with emerging markets posting positive absolute returns in U.S. dollar terms. In developed markets, disappointing Japanese GDP data (up +2.6% versus an expected +3.6%, following a revised gain of +3.8% for the first quarter and weaker than anticipated business and consumer spending) hurt stocks in that part of the world early in the week. There was also talk of plans to lower the corporate tax and coincide with continued increases in the personal sales tax over the coming year.

Technically Germany and France exited recession (experiencing +0.7% and +0.5% Q2 GDP growth, respectively this week—leading Eurozone growth to +0.3%). In keeping with this trend, German sentiment improved for August, for both current conditions and future expectations, which added to market bullishness—however, more so for Italy and smaller European nations than for the nations reporting. China gained over 3% on the week with stronger optimism (despite a trading glitch that caused markets to spike by 5% at one point), while other emerging market giants India, Brazil and Mexico all lost an equivalent amount.

Bond yields rose sharply as continued concerns over Fed exit strategies persist, and talk of a September taper continues to weigh on minds. All bond asset groups other than short treasuries and floating rate lost ground, with long treasuries, TIPs and investment-grade corporates coming in last place. Foreign bonds were mixed, with developed markets losing a bit less than emerging markets.

In commodity markets, precious metals were the strongest gainers on the week, with silver up +15% and gold gaining +5% (it was not enough, however, to erase the current -20% net losses on the year). Soybeans and cotton also experienced a strong week. Not to be outdone, crude oil generally gained 2-3% (depending the contract). One of the few losers on the week was wheat (again), as weather conditions for the crop remained benign.

Have a great week!