Economic Notes: July 14, 2014


Written by: Jon McGraw

  • It was a light week for economic data domestically, and little new geopolitical news.
  • Equity markets sold off on the week, helped in no way by the troubles of the second largest bank in Portugal, which was having trouble rolling over its debt.  In the risk-off environment, bonds gained.

(-) Wholesale inventories for May rose +0.5%, which was a tenth less than the expected increase and contained a small revision down for the previous month.

(-) The NFIB small business optimism index fell from 96.6 in May to 95.0 for June (consensus called for a gain to 97.0).  Expectations for the economy dropped -10 points, which represented the most significant negative component in the survey; expectations for sales and expansion plans also declined to lesser degrees.  At the same time, plans to add jobs rose a bit with an increasing number of respondents noting that jobs are getting difficult to fill (again implying a bit of mismatch present in the current job market).  Expectations of having to raise wages also rose (about a fifth of those responding), which was interesting.

(+) The JOLTS job openings report for May showed another gain to 4,635k, which outperformed the forecasted figure of 4,350k and is actually one of the highest readings in the 13-year history of the series.  The peripheral hiring and quit rates were unchanged, at 3.4% and 1.8%, respectively, and the layoff rate dropped by a tenth to 1.1%.  The job opening gains were widespread in all major sectors, which was a positive, but current figures remain low compared to previous cycles.  One example of this is the ratio of unemployed to openings, which is at 2.1 relative 1.5 or so more typical of fuller employment conditions.

(+) Initial jobless claims for the July 5 week fell to 304k, which was below expectations calling for 315k.  Although there were no special factors, the short holiday week might have added some noise and a few auto plan shutdowns for summer may affect these numbers a bit.  Continuing claims for the June 28 week rose a bit to 2,584k, which was slightly higher than the 2,565k expected.

(0) The June FOMC meeting minutes were released, and were generally neutral in impact.  Obviously, the meeting’s already long over, but these sometimes provide some color into underlying thinking, opinions and potential concerns raised by committee members that aren’t captured in the formal statement.  In this case, the bump in inflation was acknowledged, although the committee has been backtracking on how far unemployment needs to fall to justify a tightening of monetary conditions.  Also, interestingly, comments were made regarding the current low levels of volatility in a variety of financial markets.  Other discussions confirmed a Fall 2014 end to QE via tapering down to zero, and future use of reinvestments, the Fed Funds rate and forward guidance to express policy.

On a more unique note, legislation was introduced in the House of Representatives last week that would, if enacted, shake up the FOMC’s monetary policy process and reporting requirements—essentially to impose a mathematical ‘Taylor Rule’-type (quantitative interest rate model) framework for Fed decision-making, with the important part being a requirement that deviations from this model be formally documented and/or coincide with Fed chair testimony before Congress, as well as opens the FOMC to audits by the General Accounting Office.  This sounds dramatic, and doesn’t appear likely to go anywhere at this stage, but it does demonstrate growing discontent among some groups, particularly with currently low interest rate policies in an increasingly normal non-emergency environment and high levels of government debt.  Some of this started with Rep. Ron Paul’s attempts a while back to remove the prohibition on GAO audits of the FOMC, but this recent bill goes a bit beyond that.  The Fed hasn’t commented, but no doubt would oppose any regulation that takes away the institution’s flexibility in fulfilling its mandates.

One last thing.  We report on a lot of economic data week after week, some of which is worthwhile in hindsight, while other stats are revised/corrected in one way or another.  While accuracy of the final figures is important, this is an imprecise blend of art and science at times—and a lot of work goes into the tabulation of these numbers by a variety of agencies and firms.  We report on these data points because they affect investment markets, and often the first release is what drives near-term behavior on a week-to-week basis.  But the process is never perfect.  Northern Trust wrote an interesting editorial on the reality and pitfalls concerning data gathering, and corrected some fallacies.  For anyone wanting more, here’s the link to the article.

Question of the Week

With the Dow at 17,000, when is the correction in equities coming?  Aren’t we about due?

Maybe.  But maybe not.  But if that type of logic ruled such things, we’d have already experienced one by now.  This is the usual set of conditions we face in stock markets—climbing a wall of worry and dreading the worst while enjoying incremental gains in the meantime.  We’ll never know if a pause happens next week or after another 50% gain—which is why these things aren’t possible to plan for.  History can sometimes be a guide, but every cycle has its own quirks.

Based on analysis of stock market behavior over the last century, we should expect a -5% dip in prices about 3-4 times a year (we’ve had two -5% dips this year, in January and April, on track with this quarterly pace) and a more substantial drop of at least -10% about once a year.  More extreme corrections in the -20% range or so happen less often, every several years, as one would expect with cyclical variations in the financial cycle.  Last year, much of the S&P’s gain was due to P/E expansion, while this year’s return so far appears more substantiated by earnings growth—critical for the longevity of a bull market.  In brief, short-term movements are largely geopolitical-, idiosyncratic-, and sentiment-driven.

We find this again reinforces valuation being as the most useful gauge from long-term hindsight.  Using a variety of metrics, current valuations range from a bit cheap (earnings yield) to the more expensive side (market cap as percentage of GDP and Tobin’s Q, based on asset replacement cost), with the classic price/earnings ratio and dividend discount model fair value falling right in the middle, near long-term average or ‘fair value.’  As always, there is debate about the respective meaning of these various statistics in each cycle.

When large-cap equities are trading near ‘normal’ fair value (like now), we have tended to earn ‘normal’-type results, although the band is wide.  The extremes of cheap and expensive create more dramatic long-term outcomes (naturally, strongly positive expected returns happen when stocks are cheap and everyone is afraid to buy them; weak or even negative expected returns occur when stocks are priced more richly and investors have become overly enamored).

There are other measures as well, but correlations are imprecise.  We see the VIX pointed to quite a bit, as it’s quoted by the minute and now that it’s at lower levels in its range.  In the past year, it has fluctuated between levels of below 10 and over 20.  It’s important to remember what the VIX is and what it’s designed to measure.  Specifically, it’s the mathematical output of the Black-Sholes option pricing model for the S&P’s near-term standard deviation.  So, as much as anything, and in keeping with the timeframe for many option traders, it reflects the recent past.  The ‘father of the VIX,’ Vanderbilt professor Robert Whaley, who developed it for the CBOE in 1993, also assuaged concerns about recent low levels and put it into perspective—reaffirming the point of the number is to describe nothing more than the level of volatility expected over the next 30 days.  So, while it’s a figure we keep tabs on, we also don’t put undue pressure on its ability to measure with precision.

So far in 2014, equities are up at a pace just over their long-term average (if we use a figure of roughly 10% annualized), while bonds are also above their long-term average (which has tended to be 5-6%).  How can everything be winning?  There appears to be a fork in the road in terms of fear:  sentiment has vacillated between optimism (economy takes off from the lackluster past few years and winter doldrums) and pessimism (China slowdown, European deflation, Ukrainian war, now Iraq).  When you combine these two together, you get an ‘average’ year, which is what we seem to be having up until now at least.  No doubt, this is probably healthier than extremes in either case and perhaps most realistic since there is always something to worry about (that is so easy to forget).

Some choppiness wouldn’t be out of the question, whether it be from earnings in July (as investors see if the spring rebound translates to company top- and bottom-line growth), escalation of the Iraq situation (and accompanying higher oil prices that would be more worrisome than the conflict itself), or another wildcard of yet unknown origin.

How is sentiment?  Getting better, although retail investors continue to appear skittish.  Institutional investors have moved more bullish as underlying economic conditions now appear to be improving, and interest rates remain very low (which allows ‘carry’ or borrowing opportunities for those using leverage).  We’ve seen this in the form of equity exposure, but also through increased merger and acquisition activity, and the issuance of IPO’s.  In the 2nd quarter, the number of firms going public rose by over 40% over last year at this time.  While tech and consumer companies are always high-profile firms in the IPO arena, health technology/biotech represent a particularly large chunk in this cycle, as new and targeted technologies in the device and genetic arena have altered the paradigm for treating certain diseases and Wall Street has made note of it.

What about bonds?

Fixed income is the ongoing enigma in 2014.  Despite theories about why long bonds have been so popular this year (such as heightened interest by corporate pension plans, etc.), analysis from PIMCO pointed out that foreigners and banks are by far the biggest buyers.  There are some structural reasons that explain some of this—neither of which are directly related to U.S. economic conditions—such as Asian/European investors seeking an alternative ‘safe haven’ and regulatory considerations for safe capital that financial institutions needed to fulfill, as well as interest rate risk shifting among market players.  Important, but not glamorous.

Now that economic and employment conditions are showing improvement, and inflation has risen somewhat, there’s been increasing debate recently about where ‘real’ rates should be.  A nominal yield at least as high as inflation is a historical must-have (over the long-term anyway), while the ‘real’ rate is the amount of additional premium needed for a bond to entice buyers.  Short-term bonds don’t need as much enticement, so anything around inflation plus a little bit of extra yield has sufficed.  Longer-term bonds contain much more uncertainty about future prospects, so the real yield has needed to be higher to compensate and entice investors to take on this risk.  Historically, this real rate has varied dramatically from sharply negative to sharply positive, based on conditions, but has averaged anywhere from 1-3% or so (that range intentionally ambiguous).

If inflation moved to the Fed’s target of 2% (call it 2.25% on the CPI to account for differences in that versus the FOMC’s preferred PCE index), that puts us at a nominal yield for Treasuries at 3-5%—again we’re being vague on purpose as to not imply too much precision into the calculation.  Rates are significantly below that right now, and real rates are also significantly below historicals (and negative in short-term bond assets).  This unusual low real rate condition may be in place for a variety of reasons, including levels of financial leverage in the system, risk tolerances, and lower inflation uncertainty in recent years.  But, despite still-slow growth and lack of upward move to this fair value more recently, this represents a steady pressure in the bond market, as there isn’t much room for error.  If things continue as they are now, the bump in rates might be delayed.  If things improve more than expected, a rate rise wouldn’t be at all surprising.  (The only eventuality not mentioned, a recession or less severe downturn, could turn rates lower yet again, but the spring gets wound pretty tightly at levels below where we are currently—not saying it’s impossible.)

Corporate bonds, of course, have an additional layer of spread to account for the probability of default.  Credit has been good to us in portfolios over the last several years, but this will, too, someday come to an end.  Both investment-grade and high yield spreads have moved tighter this year, and, eventually, the smaller reward won’t be worth the risk.  The high yield market is fairly new, so the graphs below (courtesy of the St. Louis Fed) provide some intermediate-term high yield spreads and a long-term historical context for AAA and BAA (top-grade and lowest level of investment-grade, respectively) corporate spreads versus the 10-Year Treasury.  As you can see, spreads are tighter as conditions are stronger, so another area we’re keeping close watch on.

Source:  St. Louis Fed (using monthly yields, AAA and BAA 4/1953-6/2014, BofA Merrill Lynch High Yield 7/1996-6/2014)

Market Notes

Period ending 7/11/2014

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BarCap U.S. Aggregate




U.S. Treasury Yields

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5 Yr.

10 Yr.

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Stocks were largely negative on the week, as a lack of positive data and a scare in Portugal.  From a sector standpoint utilities and consumer staples outperformed, while energy and financials lagged.  Small caps were hit especially hard in a risk-off week.

The second quarter earnings season is set to begin, and expectations remain tempered, but positive.  The number of negative EPS preannouncements has been shrinking, while the number of positive preannouncements has been rising (although the number of negative still outnumber positive).  Strength in expectations appears to be coming from info tech, health care and industrials/materials, while consumer discretionary and financial stocks appear to be weaker going into the reporting period.

At the same time, the bulk of the ten S&P sectors are expected to have better earnings results than in the 1st quarter, which were brought down by weather effects in line with the broader economy.  All-in-all, expectations for index earnings growth hover around 5% (9% year-over-year) with revenue growth of 5% year-over-year.  Profit margins remain high, so those will also be likely watched quite closely.  That doesn’t necessarily mean a terrible outcome for return on equity, though, as the slack could be picked up by leverage or sales turnover—the latter of which is at currently very low historical levels and could certainly be improved as economic growth picks up.

Foreign emerging markets were only down a fraction of a percent, led by gains in Indonesia, Turkey and Brazil (and Argentina, perhaps helped by World Cup success).  Developed markets were down a significantly larger amount thanks to peripheral Europe, specifically a -10% loss in Portugal.  Investors were spooked a bit by the rumors that Portugal’s second largest bank, Banco Espirito Santo, was on the path to filing for insolvency by not being able to roll over its debt.  Interestingly, while stocks moved backward on the news, credit markets (who would presumably be more sensitive to such news) didn’t move as much.

Bonds gained on a flight to quality, and falling yields on the order of a tenth of a percent.  The best-performing segments were long government bonds, unsurprisingly, while European core and Japanese debt was also higher on the overall flight to quality.  Floating rate, high yield and peripheral Europe sold off a bit on the week.

Real estate returns were led by a strongly positive week in U.S. retail and residential, while industrial/office also bucked the trend of other equities by rising a bit.  Europe lost a few percent on the week, ending up in last place.

Commodities were generally lower on the week by several percent.  Precious and industrial metals bucked the trend by gaining a few percent on the week—gold has performed a bit better as of late, with the geopolitical flare-ups and again lower real yields in fixed income.  Industrial metals have also moved higher, with better PMI strength around the world providing a boost for materials.  Coffee and grains were significantly lower (as in more than -5%)—both have seen a bit of a correction as a stronger coffee harvest in Brazil better grain crop estimates in the U.S. have led to better supply balances, and lower scarcity fears.  By the way, in other mundane commodities news, the well-known Dow Jones-UBS (formerly DJ-AIG) index has changed sponsorship yet again—now, it is being referred to as the Bloomberg Commodities Index.

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