Economic Notes – June 10, 2013


Written by: Jon McGraw

There was quite a bit of economic data out last week.  Summary:

(-) The ISM Manufacturing report came in a bit weaker than expected, falling from April’s 50.7 to 49.0 for May, compared to the 51.0 level anticipated and pushing the measure to its lowest level in three years. Weaker underlying components included forward-looking new orders and production, while inventories rose by a few percentages points. The underlying employment segment, however, was largely unchanged.

(+) The May ISM Non-Manufacturing index, on the other hand, came in higher than the previous month and a bit better than expectations, at 53.7 versus 53.5. Details were mixed, with new orders and business activity improving, while employment continued to fall (a significant drop since January). This index, like its manufacturing counterpart, continues to plod along near its lowest level in three years, but with the diffusion index being over 50, suggests slow/moderate growth looking forward.

(-) Factory orders gained +1.0% for April, which disappointed somewhat relative to the anticipated +1.5%; however, March orders were revised down by an additional 0.7%, which tempers the overall April change. Core capital goods shipments were revised up a bit for both months, and non-durable inventories fell a bit. This looks to be more of a flat period for factory orders, while the lack of inventory is a bit of a negative influence.

(-) Construction spending for April rose +0.4%, which lagged the consensus guess of +0.9% growth; however, March’s decline revised by half. The non-residential segment rose +0.7%, running counter to March’s decline, while residential spending declined by -0.2%. Unsurprisingly, spending for Federal and state/local governments fell again, by -1.2%, resulting in a year-over-year decline of over -5%. Private construction made up the difference, up +1.0% on the month and +9% for the 12-month period.

(+) Total vehicle sales for May exceeded expectations after falling off a bit in April, as seasonally-adjusted annual units totaled 15.2 million versus the 15.1 million expected. Domestic vehicle sales as a portion of this were on target at 11.95 million. This is reassuring in that demand has not fallen off too much during a period of mixed spring economic data. In the recent recessionary years, partially as a consequence of consumer uncertainty about the economy and high and unemployment levels—and partially due to improved product quality—the average age of autos on the road lengthened to about the longest it’s ever been (over 10 years if memory serves). But, there is a finite life for these and other durable goods and purchases can be only be postponed so long. It appears the trend has improved dramatically from lows of under 10 million/cars a year during the crisis to a number more in line with the long-term 20-year average.

(+) The U.S. trade balance (aka deficit) widened a bit less than expected in April to -$40.3 billion versus a forecasted -$41.1 billion. Exports grew a percentage point, with help from a double-digit gain in consumer goods, even though imports grew by nearly 2.5%. A key component in the monthly change, other than usual volatility in petroleum, was a reversal in the trade deficit with China.

(0) The most recent Fed beige book, which covers anecdotal business activity through the dozen different Fed districts, reported that economic growth is occurring at a ‘modest to moderate pace,’ which is a slightly less buoyant description than the ‘moderate’ noted in the last report. From district to district, conditions were relatively consistent with the national trend other than the Dallas Fed, which was described as ‘strong.’ Overall, the manufacturing slowdown noted in other data was less pronounced in this report, which continued to note an expansion. This was at least partially due to construction and other real estate-related activity, which continued to be a bright spot in many regions (more on the residential side than commercial). Slowness due to sequester effects in the defense industry, though, was notable, particularly in the Richmond district where this plays a significant role in the local economy around D.C., as well as in the Atlanta region. This affected employment in those areas, but anecdotes do not appear any worse than noted in previous reports.

(0) With no special adjustments or considerations, initial jobless claims for the June 1 week dropped as expected, to 346k, relative to the forecasted figure of 345k—and bringing the 4-week moving average of claims to 353k. Continuing claims for the May 25 week came in at 2,952k, which was lower than the 2,973k forecasted figure and continued to trend lower.

(-) The ADP employment report, which comes out mid-week in advance of the closely-watched government report, came in a bit weaker than expected, showing a gain of +135k jobs versus a forecasted +165k number. Looking at these figures from an industry/size standpoint is informative. Manufacturing jobs fell by -6k, which is largely in line with weaker manufacturing survey output; construction jobs gained by +5k; and services jobs rose by +138k. From a size standpoint, large firms added 58k jobs, while mid-sized and smaller firms added 39k jobs each. All-in-all, the relationship between ADP and the monthly government report is not always consistent (as both have a high degree of statistical error embedded), but this release offers a unique and potentially useful supplemental snapshot.

(0) In other employment measures, first quarter nonfarm productivity grew +0.5%, which was just a tenth of a percent below forecast and was revised down from an initial +0.7% figure quoted. Unit labor costs fell -4.3% for the first quarter, which was a bit of a surprise relative to the expected increase of a half-percent. This is a fairly extreme reading (in fact, the biggest per hour drop in per hour labor compensation since the series began in the late 1940’s)—however, it appeared to be the result of a one-time tax-related distortion….the hourly compensation for Q4-2012 was revised from +2.7% to +9.9%.

(0) The government employment situation report released on Friday showed a payroll increase of +175k jobs, which was slightly better than the +163k expected; however, there were downward revisions for some prior months. Composition of new jobs was consistent with recent history, with gains of +57k in professional/business services, +43k in hospitality/leisure and +28k in retail; manufacturing, by contrast, lost -8k and the Federal government continued to bleed jobs at a rate of nearly -10k a month (excluding the USPS, which has its own problems). The latter note was of interest for possible indications of sequester effects on the job market—these seem to be somewhat modest so far.

(0) The unemployment rate was expected to come in at last month’s figure of 7.5%, but, instead, rose a tenth of a percent to 7.6% (actually, 7.555% for those interested in more nuanced detail), much of which was due to a larger labor force participation pool. From the household survey this figure is tied-in with, employment rose +319k. Average hourly earnings were unchanged in May, despite expectations of a slight +0.2% increase (growth over the last twelve months was +2.0%, consistent with other wage growth measures), while private aggregate weekly payrolls did actually increase +0.2%. Average weekly hours worked were unchanged at 34.5.

What to make of this month’s employment numbers? Markets moved up on the news, which is a knee-jerk reaction to things not being as terrible as feared after some other disappointing data this spring. The job situation is improving, although it has taken plenty of time and hasn’t reached the thresholds everyone would like to see. The chart below depicts the change from where we were to where we are now. Based on estimates from several sources, it seems as if job gains of +200k would be required to provide the burst necessary to convince the Fed to slow the pace of bond purchases. Later this year could be the earliest; however, early 2014 or even later continues to look like the most realistic base case for such ‘taper talk’ (a term that took on a life of its own in the past few weeks). By using data and methodology provided by the Atlanta Fed, we were able to conclude that, in order to reach the Fed’s specified 6.5% target, we would need to add roughly 228k jobs over the next 12 months, or 168k over the next 24 months.

Expect markets to continue to watch these closely, for both continued signs (or lack) of economic growth as well as potential activity from the Federal Reserve.

The Markets

Equity markets experienced an up week for the first time in several, as Friday’s jobs report news boosted sentiment. Large-cap names fared better than small, and, in the S&P, consumer staples and consumer discretionary stocks were the best-performing, while materials and telecom were the worst.

In the rest of the world, stocks did not fare as well as in the U.S., but we saw strong gains in Poland, Israel and Ireland, as well as Japan and Greece in the developed world. Turkey, which has experienced a bout of geopolitical turmoil reminiscent of the Arab Spring, fell -10%, while other recently-strong markets such as the Philippines and Indonesia also pared back, as did Brazil and Mexico. S&P lowered the outlook on S&P’s BBB rating (on par with Mexico and Russia), with concerns over forward-looking growth. These concerns run throughout the emerging world, even though ratings agencies tend to be behind the curve in announcing these updates—it’s old news. This is the primary reason for poor sentiment for EM equities over the past year, although they appear to be quite undervalued at present.

Speaking of sentiment, every so often, the economics team at Goldman Sachs shares information on what news ‘moves markets’ over the previous six months or so. These make for interesting reading in terms of how sentiment evolves and from where it originates. One thing we notice right away is that interest in government/policy headlines in both the U.S. and Europe has waned, substituted by more focused concerns about the economy.

U.S. fixed income pared back a bit last week with the cash flows moving to equities—this has been a trend throughout the year thus far, albeit tempered. With a weaker dollar, developed foreign issues led from a performance standpoint, although yields rose a bit with the ECB keeping rates steady at 0.50%. Long treasuries, TIPs and emerging market debt lagged other fixed income assets. The Reserve Bank of Australia kept its main interest rate at 2.75%, despite pressures from low inflation and declining export activity (per the slowdown in China and EM in general, which represents a large portion of the Australian economy), causing the Australian dollar to fall a percentage point.

Asian REITs were the best performers on the week, followed by U.S. residential, while U.S. industrial/office lagged. Despite strong gains so far this year, a report Tuesday that the JCB had reached its ‘limit’ in terms of buying JREITs alarmed markets. That’s one drawback of too much transparency—these programs have to come to an end sooner or later, and the removal of the punchbowl ruins any party.

REITs have certainly experienced some volatility as of late, and it’s not especially difficult to see why. While unique, REITs aren’t a huge asset class in general, and can be affected by cash flows to a larger magnitude and more quickly than equities or fixed income. They also have the unfortunate moniker of being considered interest rate-sensitive, which is somewhat true, so can suffer volatility in periods of interest rate uncertainty (as in recent weeks). This is a characteristic of any leveraged entity, but, at the same time, underlying real estate fundamentals remain relatively sound, with a lack of commercial overbuilding (the bane of many real estate market cycles in the past) and much stronger balance sheets than we’ve seen in quite some time. They can also perform well in periods of inflation, and there’s been a bit less of that to worry about lately.

In commodity markets last week, ‘softs’ such as cocoa and cotton experienced strong gains over some supply concerns. Crude also gained 4%, leading the energy complex due to a sharper-than-expected drop in national stockpiles. Natural gas, silver and wheat were generally the worst-contracts on the week.

The U.S. Energy Information Administration reported that American output of crude oil surpassed imports (by 32,000 barrels/day) for the first time in 16 years for the week ended May 31. As we’ve discussed in the past, this isn’t a new development as the expansion in oil/gas fracking activity has resulted in the U.S. meet 88% of its own energy needs since February of this year (highest level since April 1986)—remarkable considering the skepticism about ‘energy independence’ just a few years ago.

U.S. production has climbed over 40% over the last five years and has a few OPEC members worried, particularly those in West Africa who produce light crude most similar to the North American variety. Many of these nations rely on petroleum exports as a primary revenue source, and, in some cases, governmental stability is dependent on these cash inflows—therefore, ministers are of the hope that emerging Asia and other developing regions can pick up the slack in demand.

There’s one last asset class we don’t often discuss—cash—mostly, because we don’t utilize it as a major element in our asset allocation portfolios other than for transactional liquidity (the other reason for general lack of interest is that current yields are hovering around zero). But, there are some changes that the SEC has proposed for further regulation of money market mutual funds that may affect how they’re used in the future. Note that these proposals/recommendations are preliminary, and subject to a 90-day comment period (during which many industry heavyweights will no doubt share their opinions and lobby for adjustments) and any final ruling may take months or years to realistically implement. The bulk of the proposals affect ‘institutional’ money market funds (nearly a $1 trillion market), and there are already quite a few exceptions for retail funds.

The proposed changes include two separate alternatives that could be implemented separately or in combination:

(1) Use of a ‘floating’ NAV. Instead of the amortized cost/stable $1.00 a share method we’ve become used to, funds could be required to calculate a daily market value of up to four decimal places (we might see NAV’s of $1.0045, etc.). This rule is recommended for institutional prime and municipal/tax-exempt money market funds only, but not treasury/government funds of any kind, nor any retail funds under this change.

(2) Use of ‘liquidity fees,’ which implies that if a fund’s ‘liquid’ assets fall below a certain threshold—presumably during times of stress and heavy cash outflows—a fund could impose a 2% fee on and suspend all redemptions for 30 days (aka a redemption ‘gate’). Treasury/government funds would be except presumably, but could ‘opt in’ voluntarily. Notably, decisions about the amounts and timing of both of these restrictions would be retained by each fund’s board of directors, which adds some gray area to this component.

Regardless, these are only preliminary ideas, but we wanted to comment about the direction the SEC seems to be headed in their thinking. We’ll undoubtedly hear more about this debate and possible ramifications going forward.

Have a great week!

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