Economic Notes – March 10, 2014


Written by: Jon McGraw

Markets experienced a bout of volatility early in the week as the geopolitical crisis in the Ukraine grew tense, then abated somewhat.

Manufacturing numbers continued to improve, despite a degree of continued carryover from extreme winter storms. We’re tired of discussing the obvious weather issues, but it has played a major role in causing several well-watched indicators to deteriorate over the last few months. Other economic data is mixed. The monthly employment report from Friday was decent, with smaller weather-related effects than many expected.

(+) The ISM manufacturing index rose from 51.3 in January to 53.2 in February, which beat expectations by about a point and reversed last month’s decline. However, details were mixed with new orders and inventories up several points, employment flat and production down. The trend of anecdotes describing bad weather conditions continued, particularly in orders and shipment logistics/deliveries, so it’s a good chance bad weather played a role again in the lackluster numbers, although that was improved over the previous months.

(-) The ISM non-manufacturing index, however, was weaker than anticipated, falling from 54.0 in January to 51.6 for February (expectations called for 53.5). Weather seemed the culprit again, as several respondents mentioned as much—which removes some of the economist speculation at least and grounds it somewhat to reality. Business activity and employment were both down, while new orders were up slightly on the month. Inventories were unchanged, but as these aren’t seasonally-adjusted, imposing an adjustment resulted in a large decline. Without telling the same story again and again, we wait another month with perhaps better weather conditions for more ‘normalized’ results.

(+) The final February release of the Markit PMI number showed a rise to 57.1, up +0.4 from the preliminary figure and +3.4 from January’s results. Output and new orders gained by about 5 points each, and even employment was slightly positive.

(+) Construction spending for January also surprised, gaining +0.1% relative to a forecasted drop of -0.5%. Residential spending rose +0.9%, while non-residential fell by -0.3%; private spending rose about a percent, while government spending fell nearly an equivalent amount—on par with an ongoing trend of weak government outlays. On the negative but unsurprising side, the large drop in January housing starts due to weather may bleed into February and cause a continuation of choppy results.

(+) Personal income for January gained +0.3% for the month, which was a tick above forecast; however, it appeared there were several unusual factors behind it, including some Obamacare components, welfare/social security cost-of-living adjustments and military raises. Consumer spending gained +0.4%, which more strongly outperformed expectations of +0.1%. Services experienced one of the stronger recoveries in over a decade, which we presume to be somewhat weather-oriented—especially as the strongest was in household utilities. The headline and core PCE price indexes advanced +0.1% on the month, which was as expected, and the year-over-year numbers rose +1.2% and +1.1%, both in the ‘tempered’ category.

(0) The revised nonfarm productivity number for the 4th quarter 2013 was bumped down from the initial 3.2% to 1.8% (expectations were for an adjustment down to 2.2%), resulting in a full year adjustment down from 1.7% to 1.3%. Compensation growth grew at a 0.3% over the full year, which, compared to the 4% average for several years prior to the financial crisis, is also quite tempered.

(-) Factory orders for January were slightly weaker than expected, falling -0.7% relative to an expected -0.5% decline, as well as were revised lower for December by a half-percent to an even deeper decline.

(-) The ADP employment report showed lower job growth for February than expected, with a gain of +139k relative to an expected +155k. Construction jobs rose +14k in this survey, which was first questioned as numbers often differ from the government version due to weather impacts and definitional nuances regarding how ‘time off’ is classified, but the government report came up with a similar figure. The January ADP growth number was also revised down almost -50k to +127k, in line with other measures.

(+) Initial jobless claims for the Mar. 1 ending week fell to 323k, from 349k the prior week (estimates called for 336k). Continuing claims for the Feb. 22 week also fell, to 2,907k, from 2,915k the prior week and lower than the 2,985k expected. The Department of Labor mentioned winter storms as a source of recent claim volatility.

(+) The employment situation report for February was not as tainted by the weather as many expected, which made it a bit of an anomaly for the week. Nonfarm payrolls rose by +175k, outperforming expectations calling for +149k, with gains in construction jobs in the order of +15k, as well as health/education services adding +33k and government jobs increasing +13k (all state and local, not federal). The unemployment rate rose a tick from last month (and what was expected for this month) up to 6.7%, largely due to an unchanged labor participation rate. Average hourly earnings rose +0.4%, which ended up being two times the expected change, bringing the year-over-year gain to +2.2%, and average weekly hours fell a tenth to 34.2—led by a half-hour decline in construction, which we presume is somewhat storm-related.

(0) The Fed’s anecdotal beige book that contains information from the various regional districts described activity as ‘modest to moderate,’ with weather being a commonly-mentioned situation nationwide (it was mentioned over 100 times in the release), mostly in the context of production/supply disruptions, utility outages as well as lower sales. Nonetheless, 8 of the 12 districts reported improved growth conditions, with Chicago and Kansas City stable, while New York and Philadelphia showed weakness.

After the events of last week, it brings up the question of why Russia cares so much about the Ukraine in the first place, aside from historical cultural connections and a shared Soviet parental relationship for much of the 20th century. It’s about geographic position, military access and energy. Without going into too much about the military and strategic positioning component, Ukraine provides a physical ‘buffer’ between Russia and the rest of Europe. This may not seem like a hugely relevant factor in recent years (until a few weeks ago), but considering the WWI and WWII dynamics Europe remains very cognizant of, this is considered strategically important, as is the Russian naval access to the warmer weather ports of the Black Sea and, hence, the Mediterranean. This is also why Turkey cares about the outcome of this. However, as importantly, it’s the oil/gas pipeline access that is critical, as Ukraine lies in much of the Russia-to-Europe route. For Europe, access to energy is an important consideration; for Russia, the revenues from this trade.

One might also ask how the Ukrainian crisis can/could trickle down to the investment world and an asset allocation portfolio. Aside from broader ‘risk-off’ sentiment (that we saw on Monday, which was somewhat reversed by Tuesday), Russia may well have more to lose than the Ukraine, as the latter is much smaller with fewer developed securities markets. The Russian ruble fell dramatically, which raised imported inflation risks and prompted the central bank to raise interest rates by 1.5%, in the same vein as Turkey in recent weeks. This affects bank and corporate balance sheets in Eastern Europe especially, but potentially much of Europe, as Russia is a primary destination for investment and an important trading partner.

Also, there’s the obvious potential commodity impact—as Russia’s key advantages lie in their vast abundance of natural resources, including oil and natural gas. A shock to the supply (as a side effect of war, or Russia attempting to exert more control over exports) could cause some price volatility. This could hurt the European recovery if it is severe enough and goes on long enough. The U.S. wouldn’t be hurt quite as dramatically, due to our increasing degree of self-reliance on the energy front, but it could trickle over to global markets nonetheless.

Market Notes

U.S. and global stocks started skittishly with the Ukraine-Russia tensions running high, but recovered on an easing of these by Tuesday and beyond.  From a sector standpoint, financials and industrials outperformed, while utilities and health care lagged.

The bull market that began with the trough on March 9, 2009, where the S&P stood at 676.  There were no shortage of naysayers at that time, with sentiment being as bad as it was, and that has continued throughout the last five years, now that levels have surpassed 1,880—new all-time highs and a 180% price gain (dividends aside).  Still, while valuations aren’t as deeply discounted as they once were, and some early year volatility, they stand near or just over fair value on a wide variety of metrics (dividend discount model, price ratios, etc.).  Smaller cap stocks are a bit more expensive than this, and foreign stock markets are a bit cheaper on net.

In foreign markets, Japan and Europe were up slightly, while the U.K. was down a percent.  The Ukraine situation spooked Europe early on, especially the eastern portion, which resulted in a bad week in those markets (losses in Poland and Russia—down -6% in the latter—despite a minor recovery from earlier in the week).  Emerging markets in general gained with several names rising a few percent on the week, including Asia, India and South Africa.  Chinese stocks were mixed upon the government releasing official growth rate estimates of 7.5% for this year—unchanged from 2013—disappointing some economists hoping for a lower target rate as a result of recent slowing activity.  Later, the finance minister noted that 7.2-7.3% growth would be ‘acceptable,’ despite the higher official target.

Bonds were beneficiaries of a quick safe haven trade earlier in the week, with the 10-Year Treasury falling to 2.6%, but rates rose toward 2.8% later in the week on better economic data and perceptions of eased global tensions, so most bonds sold off.  Foreign bonds gained slightly, while most other categories lost ground on the level of a half-percent or so.  As expected, long treasuries and corporates were the most negative, with losses of a percent or more.

Real estate securities were mixed, with Asian REITs gaining (on par with regional equities), while U.S. retail and industrial/office lost about a percent on the week.

Commodities gained another few percent on the week, continuing their run this year (the DJ-UBS index is up 8.5% year-to-date).  Again, an example of the value of contrarian thinking as many investors were set to give up on the asset class entirely at the end of last year (we received several questions about it at that time).  The week’s returns were led by coffee, up 9%, again pushed upward by South American weather conditions, and wheat and corn, which gained over 7% and were affected by events in the Ukraine (a big wheat exporter).  Crude oil was generally flat, while industrial metals (particularly copper) fell by a few percent again.

Have a great week!