Economic Notes – February 10, 2014


Written by: Jon McGraw

The week’s economic data was generally disappointing, as reports covering the January time period were likely held back by the extreme winter weather over much of the nation. The magnitude of weather impacts can be hard to measure precisely, but as they’re also noted specifically in anecdotal comments, there was an effect to at least a certain degree.

(-) The ISM manufacturing index fell more than expected, from December’s 56.5 reading to 51.3 for January (compared to a forecasted 56.0). In fact, this was the sharpest decline since May 2011. In the details, new orders, production and employment were all down, as were inventories; and the prices paid component (likely natural gas-related) rose on the month, which was an additional headwind for manufacturers. However, it should also be noted that weather was indicated as an anecdotal reason for some of the poor numbers. So, we had growth, but it was far below the acceleration expected, and markets reacted sharply to the negative by selling first and asking questions later.

(0) The January non-manufacturing ISM report, at 54.0, was less of a disappointment than the manufacturing version, as it both improved on the December number of 53.0 and came in largely in line with expectations of 53.7. Under the hood, business activity, employment and new orders all improved, as did inventories. It appears poor weather played less of an impact on non-manufacturing activity than on manufacturing activity during the past few weeks, which, due to the nature of the various businesses being measured, makes more intuitive sense (computers don’t stop working just because of bad weather, although strength was also seen in retailing and professional services, which could have some tempered impacts from bad weather). Anecdotal references to activity also appeared more optimistic on the service side.

(0/+) The final Markit PMI survey for January came in similar to estimates, at 53.7 versus a consensus of 53.8 expected, but was just over a point weaker than December. Like the ISM, most components declined, such as output, new orders, employment and finished goods stocks all declined. Weather was mentioned as a possible catalyst.

(0/+) Construction spending for December rose +0.1%, compared to expectations for no change; however, two prior months were revised down by a few tenths of a percent each. Residential spending rose +2.6%, which was the leader of the private spending category (which itself rose +1%), while public spending fell over -2%.

(-) Unit motor vehicle sales fell a bit from 15.3 mil. units in December to 15.2 mil. for January, which underperformed the expected 15.7 mil. figure. However, on the positive side, domestic auto sales rose 0.2 mil. to an expected 11.9 mil. Here, also, automakers pointed to harsh winter weather as a backdrop for weaker sales.

(+) Factory orders for December came in a bit better than expectations, falling -1.5% compared to expectations of a -1.8% decline. The underlying detail was a bit better, as core capital goods orders and shipments were revised up by about a half-percent from initial durable goods reports.

(0) Non-farm productivity for the 4th quarter rose +3.2%, surpassing the +2.5% gain expected, up to +1.7% on a year-over-year basis. Unit labor costs fell -1.6% for the quarter (compared to an expected drop of -0.5%), and -1.3% on a year-over-year basis. Revisions took place for both measures in the same direction for the prior quarter, and total compensation per hour rose at a rate of +1.5% for the year. What figures like these continue to tell us is that we’re not seeing blatant wage increases, a frequent precursor to inflationary pressures elsewhere.

(-) The December trade deficit widened out to -$38.7 billion, compared to the forecasted -$36.0 bill. The net petroleum balance was little changed, but the ex-petroleum account widened by $3.8 bil., as exports declined (particularly in automobiles, which fell -6%).

(0) The January ADP Payroll Report came in just below expectations, with a gain of +175k compared to the consensus +185k. The largest job additions were seen in professional/business services (+49k), while manufacturing jobs fell -12k. The previous report for December was revised down a bit to +227k, but still outperformed the +87k government payroll number. It seems the ADP report may be less influenced by weather (due to a different calculation of ‘time off’ than the DOL survey), but the numbers still often diverge from the big employment report.

(+) Initial jobless claims for the Feb. 1 ending week fell to 331k, from a the prior week’s revised 351k figure and lower than the 335k forecasted figure. Continuing claims for the Jan. 25 week rose by 15k to 2,964k, but was a bit lower than the 2,998k expected. The increase in claims has been swept under the rug as normal seasonal volatility, but closer research shows that it could be due to some technical issues having to do with the expiration of the emergency unemployment compensation program (which we’re not entirely surprised by). For example, regular and extended claims in some states may have become intermingled, which most certainly would have convoluted the results. This may have happened for system reasons, such as to ease in re-starting claims for eligible folks if Congress decided to extend the emergency program. Nevertheless, it’s caused some problems in getting accurate numbers for whatever reason. We’ll give it a few more weeks to sort itself out before assuming a deeper meaning.

(-) The big Friday employment report for January was a bit of a dud, with establishment survey nonfarm payrolls coming in at +113k for the month, which underwhelmed the +180k expected. It was a bit more convoluted of a report than normal, with several revisions for prior periods and benchmark survey data going back a year, and the market seemed to shrug off the report as weather-driven.

On the positive side, the revisions for November and December were higher and netted an additional +34k jobs, which helped the base. Construction jobs were up +48k and more than reversed losses of the prior month. On the negative side, retail trade jobs fell -13k, a dramatic change compared to December’s gain, and health/education services jobs lost ground again, as did government employment, which was down almost -30k.

The unemployment rate fell another tenth to 6.6%, despite calls for no change to the prior month’s result and household survey employment rose by +638k. Labor force participation rose two-tenths to 63.0%, contrary to expectations and discussion about the troubling trend downward. Additionally, the U-6 measure of broader underemployment fell four-tenths to 12.7%. Average hourly earnings rose +0.2% for the month, which was on target with forecast, and the average workweek was unchanged at 34.4 hours.

We won’t digress again into a long dissertation about the labor participation rate, but it does appear to be one of the more closely watched variables this year, particularly because it directly affects the calculation of the headline unemployment rate. We continue to find a substantial difference in opinion between economists about the causes (hint: the cyclical vs. structural thing again). While the Fed’s opinion has pointed more toward cyclical, we see other evidence of a structural shift—shown by the participation rate declining since 2010 when jobs began to be added to the rolls. So, without delving into a huge amount of detail, the bottom line appears to be down to a few possible culprits as to what’s causing the rate decline.

One is the ‘aging of America’ theme, which began prior to the Great Recession and may end up carving off 0.20% off the participation rate per year at current trend.

The extension of unemployment insurance in recent years may have allowed a convenient ‘bridge’ for workers after full employment as they ease into receiving Social Security payments, as have disability payments, although debate exists regarding how well the disability measure captures ‘employable’ individuals (although over the last decade, this number has grown from 3 to 9 million). On the cyclical side, workers going back to school to improve skills has been seen in higher college enrollment rates. Others are staying home to care for children, since the ‘break-even’ between working at a lower-paying job and paying for expensive childcare just didn’t make economic sense. We’ve been told of this may times directly from individuals making that choice.

Lastly, and something we’ve touched on before is the ‘automation of America,’ which is the substitution of routine functions with computers or machinery, in both manufacturing (such as automobile assembly) and even services (think of video rentals as a tangible example, but there are many others). This latter trend is a bit more troubling as it may eventually result in an eventual elimination of certain types of jobs, which need to be replaced somehow.

Why do we care? Poorer employment prospects or changed expectations lead to different expectations for Fed policy, and that affects interest rates, as well as inflation and markets. Fewer workers means fewer consumers, which affects GDP and company revenue, and poorer conditions mean lower rates for a longer period of time. Without casting a dire scenario, we’re again reminded of the exceptional amount of human ingenuity we have been the beneficiaries of during the last few decades, and no doubt this will continue. In like manner, the workforce must change along with it, but no doubt there will be some pain along the way as there is with any type of change during history.

Market Update

U.S. stocks weathered a poor -2% Monday due to the disappointing ISM number to a trough mid-week and back again full-circle to a positive result—more day-to-day volatility than we’ve seen in some time. Cyclical consumer discretionary and materials stocks led, while defensive utilities and telecom lagged by the largest amounts on the week. We all know these bouts happen occasionally; and, like a compressed spring, the chances of a larger drop increase the better conditions are and the longer we go without one. We’ve come a long way in equity markets over the last four years, so it’s natural to experience a few rough patches.

We would be remiss not to mention the ‘January effect,’ now that the month is far into the books and equities lost over 3%. To put this into perspective, over the last 86 years the S&P has experienced 31 negative Januarys (a ‘batting average’ of 64%, which is in keeping with general market averages for most months), and 14 of those have resulted in a full year negative result. So… a bit less than a 50/50 chance, so really no different from any normal year.

In foreign stocks, the U.S., the EMU was up +3%, U.K. gained +1.5% and Japan just +1%. The ECB kept rates steady, so a few peripheral European and troublesome EM nations mounted the strongest returns of the week, seen in +4% gains for Greece, Turkey, Ireland and Spain, while stronger nations Indonesia and Poland also gained. News surfaced that European authorities may extend the maturity of Greek loans by up to 20 years, as well as lower the interest rate and qualify for up to 15 billion Euros of additional funding this spring. Also, Greek banks, which contain a surprisingly large exposure to their Turkish neighbors, represent a fifth of the index and thereby have a vested interest in more stability next-door.

Despite the small recovery week, concerns in emerging markets continue—whether it be the corruption/currency crisis in Turkey, currency reserve depletion in Argentina, protests in Thailand and the Ukraine, or, most troubling, the weaker manufacturing index data in China as well as their ‘credit trust’ default scare. (Despite the improving conditions in at least an equal number of other nations not expressed as often in the headlines.)

We don’t want to jump to any macroeconomic conclusions, but conditions for ‘contagion’ do not appear as likely compared to the EM crises of the late 1990’s. At that time, many more emerging market nations pegged their currencies to the U.S. dollar. This isn’t as easy as it seems, nor as automatic, as it required large foreign exchange reserves to eliminate any imbalances between the two currencies—so continuous trading by a country’s central bank/treasury to make these tweaks. When conditions worsened for a particular foreign nation, and their currency plummeted in value dramatically and/or quickly, officials were forced to deplete foreign currency on hand, all while their own currency lost value and lost global purchasing power by the week.

In recent years, and as a result of that crisis period, currency pegs have become less common, and emerging nations are issuing more debt in local currency terms—effectively, putting the currency fluctuation risk back onto investors. Smart move on their part, and is either a good or bad move on the investors’ part (depending on how one feels about a particular currency). Currency fluctuations have always explained a good deal of the volatility in foreign bond markets, but they also provide opportunity for those seeking countries with improving fortunes (you are given the chance to earn a good coupon plus any currency appreciation that occurs, which can be additive or subtractive from total return). So, there is potential reward attached to the risk. The risks have always been there—they are just arranged differently than before.

Credit markets in China

To digress for a moment into one particular emerging nation, the Chinese Credit Trust Co. issue is an interesting one. If more similar situations surface, could well test the resolve of the Chinese regime and its goals of moving towards a more ‘market-oriented’ structure. It’s one of almost 70 ‘trust’ companies responsible for 10 trillion renminbi as of 9/30/13 ($1.6 trillion in USD, a 60% increase compared to a year prior). The $500 million trust in question (with the innocuous name translating to ‘Credit Equals Gold’) is essentially a multi-tranched high-yield (9.5% rate) structured product that was assembled and marketed by Industrial & Commercial Bank of China as a very low-risk retail investment vehicle, in a nation where there aren’t many conventional investments to choose from. The initial capital proceeds of the trust were lent to a coal mine, which has since gone bankrupt, leading to the principal repayment issue. The structured product concept isn’t new, and we see the structures in the U.S. and Europe in the form of structured notes and CD’s (some of which are FDIC-guaranteed but many aren’t). A former Bank of China official termed the structure a ‘Ponzi’ scheme, which these can be if the underlying math doesn’t pan out.

The Chinese central government agreed to step in to provide needed liquidity for repayment of principal, although apparently investors won’t get interest earned for the past year. This helped stabilize short term interest rates as well, which were fluctuating somewhat wildly in the uncertainty. In that sense, a bailout of the type we experienced several times a few years ago in the U.S. The formula isn’t new either, and is a classic one in human financial history: bank makes loans, investors like attractive yields, bank responds to investor demand by making too many loans, investors like increasingly higher yields from riskier loans, credit availability gets too loose, loans get flakier, some (or many) loans go bad, and bank becomes insolvent. This is where the government often steps in to infuse capital to prevent this from spiraling downward and carrying over to other financial institutions that could cause public panic, bank runs, etc. All bad things. In general, it appears Chinese bank loan quality overall could be poorer than advertised, as bank profitability looks to be a higher priority than capital ratios, but, then again, it seem the central government has taken a backstop role to prevent any bank from encountering too many embarrassing blowups, and they have the assets to do so.

Credit growth in an economy tends to be associated with higher GDP growth, but when it begins to outpace economic growth, problems can emerge and probabilities of a crisis also increase—especially when coupled with asset price increases. And, after credit growth peaks, within a few years, GDP growth has been shown to slow in a regression to the mean of sorts. This makes intuitive sense as the ‘fire’ of economic growth isn’t fueled by the same explosive ‘tinder’ as it once was. Measured by a credit/GDP ratio standpoint, Chinese credit over the last five years has grown at about twice the clip of the next-nearest competitors, Turkey and Brazil.

China, being internally financed (much like Japan), as opposed to externally indebted (like the U.S. and Europe), the internal dynamics may play out differently than with other emerging market nations that rely on foreign (often developed market) financing that can turn on or dry up quite quickly (we see this in the smaller emerging market nations especially). However, the Chinese banking system may require further maturation, including deeper reserve requirements and higher non-performing loan assumptions, although this naturally cuts into growth and profitability in the near-term. On another hand, some real estate leverage issues encountered in the U.S. (where home loan-to-value ratios tend to be in the 80% range, or more, pre-2007) are perhaps less of an issue in China where all-cash purchases and loans of less than 50% LTV are much more common. Naturally, this puts home price pressure back on buyers as opposed to MBS investors. Personal savings rates are also much higher, which could allow a better buffer here than in other nations.

There’s no exact estimate as to how much debt China really carries, as it’s spread between the central government, local government as well as a variety of state-owned enterprises. And no one is sharing too much, but the infrastructure may not allow for easy measurement, either. (Estimates range from as low as 50% to as high as 80+% of GDP, not including the ‘shadow banking’ component often discussed, so total debt over 200% of GDP.) As it is a relatively closed economy, however, there isn’t the externally-held issue some countries are faced with. So, while newsworthy, many Asian experts aren’t of the thinking that a crisis is brewing.

Back to the market week, bonds experienced a mixed result, with lower rates at the middle of the curve and higher on the long end. Accordingly, shorter bonds gained, as did high yield and all credit. Long-term treasuries were the losers on the week, although the year-to-date returns have been in the 3-5% range for that end of the curve. (Despite their low nominal and real yields at present, this again reaffirms the place of long government bonds as the ‘anti-stock’ for those seeking one of the assets least correlated to risk historically.) Foreign bonds in both the developed and emerging market regions gained strongly on a 1% weaker dollar on the week.

On the topic of bonds, we have another new entrant into the marketplace…the treasury floater. Other countries have experimented with this type of product, but the first U.S. auction was held Jan. 29, for a $15 billion note with a 2-year maturity, weekly reset based on the 13-week T-bill, and quarterly income payment (and plans to auction similar notes once a quarter). The pricing structure is somewhat similar to the floating rate corporate bank loans we use in our asset allocation portfolios, with a starting base reference rate and the potential to ‘float’ upward if rates rise. Of course, there’s a catch: for the implied ‘call’ option to capture the rising rate, you give up the immediate gratification of a higher fixed coupon (small as that is at the moment, so not much opportunity cost given up at this point, but down the road that may matter a bit more).

There hasn’t been much fanfare about these yet, but with a tight spread over the 3-month T-bill (and below that of the 0.40% of the fixed-rate T-note of the same 2-year maturity), that’s probably not so surprising, but it took TIPs a while to be well understood and catch on, too. One more hammer for the toolkit. However, yields are so low for these types of cash alternatives they don’t offer a lot yet from an investment standpoint. For portfolios, we still prefer floating-rate MBS and/or ABS to something like this.

Real estate gained in most areas, led by Asian names, but also U.S. retail and residential up several percent. Office/industrial brought up the rear, but also gained a half-percent.

Commodities experienced a strong week, gaining a few percent from an index standpoint and no doubt aided by a weaker U.S. dollar. Wheat and coffee rose dramatically due to dry/hot weather conditions in Brazil, but crude oil also rose with continued cold conditions nationwide. Natural gas, after recent extreme volatility of up to +/- 10% on a daily basis, corrected on net by a few percent.

Have a great week!

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