Economic Notes – February 3, 2014


Written by: Jon McGraw

The week was highlighted by a fair number of important industrial reports, as well as the closely-watched Fed meeting. Unfortunately, there wasn’t enough decent news to offset emerging market-led concerns.

(+/0) As we recapped separately mid-week, the FOMC continued the taper, with an additional $10 bil. reduction in quantitative easing bond purchases. Language about conditions and business/consumer spending was generally more optimistic, which goes along with recent actions. Now, we’re down to $65 bil./mo. with more on the way, dependent on data. If this same rate is sustained, the committee is on track to finish all purchases by October. However, the ‘forward guidance’ for low rates and a generally accommodate policy remains intact, assuming inflationary levels remain low, since employment and economic targets have yet to be reached.

(0/+) The advance estimate of U.S. real GDP for the fourth quarter was released, showing a +3.2% gain (on target with consensus expectations). At the same time, some underlying figures were a bit weaker than that implied by the headline. Business fixed investment rose almost +4%, led by a strong +7% gain in equipment but tempered by a -1% decline in structures investment. Business inventories rose +0.4%, while net exports added over +1.3% to the overall GDP figure, which is significant. On a household level, personal consumption expenditures rose +3.3%, the best in over three years, but still lagged expectations by about a half-percent. Residential investment (housing) fell -10%, which we largely expected with lackluster housing figures over the last few months. Federal spending fell -13%, which trimmed a percentage point from the final GDP number. Speaking of which, in the release, the Commerce Dept. added that the government shutdown during the quarter trimmed about -0.3% off of potential growth, but this was only an estimate.

Of course, before we make too much of this, the second and third estimates may and often do contain significant revisions, but this was a decent start. Based on early estimates, the first quarter of this year looks to be quite similar in terms of magnitude, but often inventory contributions tend to be the swing factor (a few tenths of a percent are either allocated to the previous quarter or pushed out to the next one, based on manufacturing conditions and the calendar), so early estimates point to first quarter 2014 GDP potentially coming in a few tenths lower than that of the fourth quarter.

(0) Personal income for December was flat, as wages/salaries underwhelmed the expected +0.2% increase. Consumer spending, on the other hand, gained +0.4%, double what was expected; however, some revisions for previous months during the quarter took off a few tenths. The savings rate fell almost a half-percent to 3.9%, which is low relative to recent years and far lower than the 5+% readings from prior decades—some of this is cyclical, while a good majority reflects demographic trends (an aging society drawing down assets as opposed to accumulating tends to depress this rate).

(0) Both the headline and core versions of the PCE price index for December rose in line with expectations at +0.2% and +0.1%, respectively—the difference between the two being a +2% rise in energy prices. Over the past year, the headline/core are up +1.1% and +1.2%, which again reaffirm a very mild inflationary environment.

(0) On to another inflationary gauge, the employment cost index for the 4th quarter rose +0.5%, which was both a tick higher than forecast and compared to the previous quarter. Wages/salaries and benefit costs both rose at the same rate. For 2013 as a whole, compensation costs rose +2.0%, which was just a tick higher than 2012. So, again, wage pressures are contained but something we monitor more closely than some other inflation measures as they tend to be early indicators.

(-) Durable goods orders for December fell -4.3% on a headline level, which strongly disappointed relative to the anticipated gain of +1.8%. Removing the more volatile components resulted in better readings—of -1.6% for orders ex-transport and -1.3% on the ‘core’ goods orders—but these also underwhelmed relative to the small increase (+0.1%) forecasted. However, November core orders were also revised down a percent-and-a-half to 2.6%, which added additional negativity to the report. Defense orders and non-military aircraft orders were big detractors from the headline number (both fell in the -20% range), while computer/electronics products orders fell -8%.

(+) The January Chicago PMI report came in at 59.6, down from 60.8 in December, but a bit better than the expected 59.0 reading. Long-story short, growth continues to look strong by this metric. New orders and production were up on the month, while employment declined sharply for the second straight month.

(+) The S&P Case-Shiller home price index of twenty major American cities declined -0.1% for November—the first decline in a year—while on a seasonally-adjusted basis, the loss turned into a gain of +0.9%, so it all depends on how you care to look at it. The biggest gains for the month were in Miami (which gained +1.4%), but at least half the cities experienced a decline on the month (again, non-seasonally-adjusted…if seasonal adjustments were taken into account, every city gained). Smoothing these things out, the twelve-month gain remained quite strong at +13.7% for the index and every city registered at least a 6% gain or better (the lowest being New York and Cleveland, the best being Las Vegas, LA and San Francisco with +25% gains).

(-) New home sales for December dropped -7.0%, far weaker than the anticipated -1.9% decline; in addition, sales for October and November were revised downward. The regional results were quite divergent: sales in the Midwest rose +18%, while the Northeast declined -36% and South and West segments of the nation fared in line with the averages, down -7% and -9%, respectively. This volatility is likely partially due to this period being the weakest of the year on top of extreme weather over the month. At the same time, real estate inventory has fallen to its lowest levels in June.

(-) Pending home sales also fell for December, by a rate of -8.7%, compared to a minor expected decline of -0.3%. This was one of the larger declines in about three years. Metrics were lower across the four major regions, being a little worse in the Northeast and West (down -10%) and a bit better in the Midwest (down -7%), but not much differential to speak of. Unfortunately, this likely signifies poor existing home sales results for coming months (per the National Association of Realtors, 80% of pending sales become ‘existing’ sales within two months).

(+) The Conference Board consumer confidence survey for January came in a bit better than the anticipated 78.0, moving up to 80.7, which is yet again close to a post-recession peak. Under the hood, consumer assessments of present conditions and future expectations moved up several points. As an aside, consumer confidence in the European Union has also shown improvement. Many countries remain in negative territory and are behind readings in the U.S., but have steadily improved over the past year. Measures in U.K., Ireland and Sweden are currently strongest, while Spain, Italy and France remain the worst of the larger EU nations (the French reading is somewhat surprising, but perhaps not when political sentiment is included). Confidence in Portugal in Greece remain horrible (as in -50 readings…hard to fathom here), but have improved there as well. Some of this should probably be taken into context as Europeans may have a different and more skeptical view about their economies and political conditions in general than we’re used to.

(+) The Univ. of Michigan consumer sentiment survey for January came in at 81.2, which was slightly better than expectations of 81.0 and the preliminary reading of 80.4. Like the Conference Board’s version, consumer assessments of current conditions and future expectations both improved a little bit. In terms of inflation, the 1-year expectation rose a tick to 3.1%, while the 5- and 10-year look-ahead guesses were just under at 2.9%.

(-) Initial jobless claims for the Jan. 25 ending week rose almost 20k from the prior week to 348k, underperforming the 330k estimate. No special one-offs or other factors appeared to be the cause. Continuing claims for the Jan. 18 week fell a bit to 2,991k, a bit better than the expected 3,000k.

Market Notes

U.S. equities experienced one of their choppier weeks in some time, with a combination of lukewarm economic and company earnings news, the Fed meeting and emerging market troubles. Large-cap stocks generally outperformed smaller-caps. From a sector standpoint, utilities outperformed with a gain of 3%, while consumer discretionary, consumer staples and energy lagged with losses over -1% on the week.

Foreign developed markets lost the most ground of any equity asset class, with Europe and the U.K. down -2% and Japan losing -3%. This was despite some decent news from places like the U.K., which had a decent GDP report (+2.8% year-over year, the best in six years). Emerging market equities surprisingly outperformed developed markets, led by South Korea, China, Malaysia and Turkey.

Turkey was in the news again, based on their decision to hike their overnight lending rate from 7.75% to 12.5% to stem the fall in their lira currency (India and South Africa also raised rates, albeit to a much lesser degree). You might ask, why would a country do something like this?

Well, currencies are a fickle area for analysis due to the variety of cross-currents affecting their values—both quantitative (open-market trading and interest rates) and qualitative (geopolitical conditions and general credibility). Any national crisis generally hurts a currency, while strength/stability usually provide a boost upward (hence the strength of the Dollar and Yen over the years, despite policy like QE that would/should add a headwind). Another factor is that currencies only change in value relative to each other, a component which is often forgotten but not as relevant here, as a trouble emerging market nation’s currency will often fall versus absolutely all other major currencies. One positive tailwind for a currency is the nation offering a high interest rate—it attracts depositors looking for ‘carry’—essentially borrowing money at cheaper rates and investing at higher rates, all else equal, so raising interest rates is one way for Turkish officials to offer a bribe essentially (no irony intended) to world markets to buy lira.

Of course, there are other problems that emerging markets often uncover in conducting ‘emergency’ operations like this. While they might stem the tide in the immediate term and stop a currency run, higher rates are naturally restrictive, so can serve to slow an economy down if used for an extended period. Then again, if they aren’t kept high for long enough, you end up back where you started with currency outflows, Lira depreciation and huge purchasing power erosion for Turkish citizens, which translates to higher imported inflation and potential social stability concerns. The government hasn’t alleviated these inflation concerns, operates with a huge current account deficit and possesses scant foreign currency reserves to defend the lira. So, that’s why the concern.

No doubt some emerging markets are in better shape than others. On one hand, Mexico and several nations in Eastern Europe (such as Poland) have established their financial footing more firmly since the Great Recession (a few didn’t even technically experience a recession during those years, amazingly enough), while the poster children of problems—including India and Argentina continue to make the headlines. Then again, Turkey and South Africa were on the ‘up and comers’ list not that long ago, so this is again a reminder of how quickly things can change. The answer isn’t short-term band-aid solutions like rate hikes or currency manipulation, but long-term structural reforms to promote fairness, rule of law, central bank credibility, lack of corruption and incentives for businesses to become more efficient and shareholder-friendly. This is happening in a variety of places, but we are happy to be approaching the emerging market complex through a ‘bottom-up’ country-by-country strategy as opposed to making political guesses from a macro level.

Based on assessments provided by strategists with whom we monitor and closely work, there doesn’t seem to be a consensus view of a widening emerging market ‘crisis.’ EM cash flows have moved in a type of ‘risk-on’/‘risk-off’ manner historically, although nations have become more differentiated in recent years. U.S. markets react to EM problems as well, but with only 5% of the S&P 500’s revenues coming from emerging markets, and low exposure when measured by overall exports and banking claims, the impact could be more muted than some might believe.

There are cash flow technicals going on here as well—when investors are seeking higher yields and returns, they look to risk, and emerging markets are there to provide it. Conversely, when rates begin to move higher domestically, suddenly other (‘safer’) alternatives back home look a little more appealing, and the money begins to drift back. After riskier nations either experience a crisis or avoid it, fringe capital again begins to seek out the higher potential returns from such risky locations, and the cycle continues anew.

Bloomberg / Business Week had a good summary for Emerging Markets as well.  Click here for a link to the article –> Emerging Market Tremors

Bonds have been the winning investment so far this year, falling several basis points in the last week and 35-40 b.p. since year-end, with a ‘risk-off’ focus away from stocks so far in 2014. Investment grade corporates and long Treasuries gained strongly last week (and have led year-to-date), while floating rate and shorter-term bonds were generally flat to slightly negative. Foreign bonds were adversely affected by a strong dollar, by a negative fraction of a percent, with developed and emerging market nation indexes impacted to a similar degree last week.

REITs actually fared quite well on the week, with gains of several percent in the U.S. industrial/office and residential areas, while Europe and Asia lost ground.

Commodities were largely down on the week by about a percent, likely due to the USD strengthening by the same magnitude in the opposite direction. Coffee and sugar prices increased sharply on the week as a heat wave in top producer Brazil threatened crops. WTI crude also gained by about 50 cents to near $97.50—crawling back from as low as $91.50 mid-month. Industrial metals lead and nickel suffered huge losses on the week, perhaps in a snapback to spikes mid-month due to tighter Indonesian export policies. Gold also lost ground, which is a bit surprising considering both the risk-off tendency on the week and the seasonal impact of the Chinese New Year.

Have a great week!