Economic Notes – March 11, 2013


Written by: Jon McGraw

(+) The ISM Non-Manufacturing Index for February came in better than the expected 55.0 level with a small increase to 56.0. New orders and business activity were higher, while employment deteriorated a bit (although still in expansionary territory). Inventory expansion was also slightly higher. Interestingly, anecdotal comments in the survey responses were optimistic with a general theme that business was ‘picking up’ in several industries in a more diversified way.

(+) Factory orders for January fell -2.0%, which was a touch better than the forecasted decline of -2.2%. A large decline in aircraft orders (defense and non-defense—both of which are a ‘choppy’ series) accounted for a good portion of the result. While ‘core’ (non-defense, non-aircraft) capital goods shipments fell -1.1% during the month, on the positive side, forward-looking core orders came in at a strong +7.2%.

(+) Manufacturing inventories rose +0.5% for January, which was a contrast to a flat reading during the entire fourth quarter of 2012. Nondurable inventories gained +1.0%, which provided the primary magnitude for the change, while durable inventories rose a bit as well. Overall, this was in line with expectations and was considered to be a positive input to the first quarter’s upcoming GDP.

(+) The Fed Beige Book for January, which notates conditions and commentary for the regional Fed districts around the country, described activity as continuing to expand at a ‘modest to moderate pace.’ This has been the theme of these books for several editions now—slow, but still positive growth, along the lines of industrial surveys and economic data results. In particular, the consumer sector held up better than some analysts expected, considering the slower economic conditions overall; activity in housing and manufacturing has also strengthened noticeably over time. Anecdotally, the report cited some general business concerns about the possible effects of the Affordable Care Act in upcoming quarters/years.

(+) Wholesale inventories for January increased more than expected, at a rate of +1.2% versus a consensus +0.3%, and were consistent across the board for both durable and non-durable goods. This is a sign of improved end demand, so is treated by economists as a positive, since they’re incorporated as an important input to GDP. (A positive that is, as long as inventories don’t build up excessively without ending up in the hands of consumers).

(-) The U.S. trade deficit widened to -$44.4 billion in January, which underperformed the expected -$42.6 bil. figure. The normally volatile petroleum trade balance was responsible for most of this change (imports rose by +8%, while exports fell by -17%), and other items didn’t really contribute.

(+) Initial jobless claims for the Mar. 2 week fell to 340k, more than expected relative to the consensus estimate of 355k. This recent week brought the more reliable four-week moving average to 349k—a trend in the positive direction. Continuing claims for the Feb. 23 week came in at 3,094k, which was a bit lower than the 3,120k expected.

(+) The ADP employment report for February, released a few days before and considered a decent predictor by some of the monthly government report at the end of the same week, came in better than expected, showing a gain of +198k jobs. This was a significant improvement on the consensus expectation of +170k, in addition to upward revisions for January (+192k to +215k). New jobs were consistently spread across all company sizes, which is a positive, since smaller firms were lagging fairly significantly for quite some time during this recovery. By industry, gains were in line with recent trends, with the biggest additions taking place in trade/transportation, professional/business services and construction (combined, 100k of the total number).

(+) The February employment situation report was much better than expected, with strong gains in payrolls of +236k, versus a forecast of +165K. The areas seeing strongest improvement were construction (with nearly 50k jobs added), as well as professional services (73k new jobs, and included temp work). The unemployment rate for February fell to 7.7%, which was an improvement on the expected 7.9%. Part of that decline, however, was due to a small decrease in the labor participation rate as well as, interestingly, from a rise in multiple job holders. (That said, both of these numbers surprised quite a few economists.) The broader U-6 measure fell from 14.4% to 14.3%.

(+) The average workweek lengthened an hour from 34.4 to 34.5 (while forecasters expected no change), and average hourly earnings rose +0.2%, which was generally in line with forecast and resulted in a +2.1% gain over the past year. These are positive data points from an employment perspective (you’d prefer to see more work, and longer workweeks than less, since it means there is more work to be done), but we watch the latter due to the implicit inflation pressures that can make their way into wage increases over time.

(0) Nonfarm productivity fell -1.9% for the fourth quarter of 2012, which was a bit worse than the expected -1.6%. Nonfarm unit labor costs for the same period rose +4.6% versus a forecast +4.3%

How do we interpret all this? This month’s strong gains are certainly headline worthy and probably make the public take notice more than any other economic statistic. The lack of job growth during the recovery has been a significant political and economic issue (especially, considering the Fed’s dual mandate and current focus on unemployment). We have to look at the current unemployment situation in context of where we ‘should’ be. This requires us to review the levels of the ‘natural’ unemployment rate, which is the longer-term trend rate that minimizes labor market imbalances/pressures on inflation—either upward or downward—and is also referred to as the ‘structural’ employment rate.

A recent speech by John Williams, President of the Federal Reserve Bank of San Francisco, pegged an estimate of this ‘natural’ unemployment rate at roughly 6% (up from a pre-recession estimate of around 5%, and above the long-term figure of 5 ½%). This tells us that in early 2008, the headline seasonally-adjusted total unemployment rate (at about 5%) was running close to the long-term trend level. In late 2009, unemployment peaked at 10%, implying the cyclical short-term unemployment during the Great Recession roughly equaled that of the long-term natural rate (quite extreme, as we all remember). Now, if the natural/structural rate is currently 6%, it leaves us the remaining 1.7% or so as the continued cyclical component yet to be unwound and corrected for. Long story short, conditions have improved, but room exists for continued repair.

Market Notes

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In stock market news this last week, the Dow surpassed its previous 2007 level to land at a new all-time high. Upon this happening, applause broke out on the NYSE trading floor. (Presumably, they were congratulating themselves, or us, but that is only speculation.) While equity mutual funds experienced net outflows of $100 billion in 2012, we’ve seen better results early this year. However, investor interest in equities continues to remain tempered and skittish as the ‘wall of worry’ is being climbed.

Market highs are a natural inflection point—exciting some investors and spooking others. It represents a behavioral response since many clients (and advisors) have questioned the sustainability of the advance up and through this point, being that the memories of 2008 are all so fresh.

The new high is only a number, albeit a newsworthy one since it puts us in unchartered territory. From the standpoint of a technical chartist, a new high can represent one of two things: a ‘resistance level’ (a negative, since this can be seen as a rigid boundary that prices are pushing up against), or a ‘breakout’ point (a positive, if prices are able to surpass the previous high for any period of time—seen as a sign of a new trend). Not surprisingly, technicians are currently split in their opinion, but seem to appear a bit more bullish than bearish. For those who are somewhat skeptical of the chart, a basic truth that the famous 1926-to-present day market graph reminds us of, is that we always have to reach a new high at some point. Equaling a previous high only means that sentiment has only reached the level of the past high, from a numerical standpoint, no better, no worse.

Of course, with a few strong months like this, we’re probably bound to have a pullback at some point (the market experiences five 5%+ pullbacks each year anyway), but of course, the timing is to be determined, and a lot of opportunity cost can be misestimated in between by making a timing attempt. Fundamentally, conditions have improved, as seen in manufacturing survey numbers, production and even employment (albeit slowly in the latter). This is not only good for the economy, which asset values reflect, but may lay the groundwork for further gains if this trend continues (absent any other global shocks or slowdowns, of course, which we are especially sensitive to being that our growth rate is so low). Valuations, which is how we look at everything, continue to look attractive—just not the ‘screaming’ buys of a few years ago when things looked much more uncertain.

Talking valuation, currently valuations favor equities, as well as corporate fixed income, as opposed to ‘safety’ in the form of cash or Treasuries. But, as valuations have moved higher, and conditions have ‘normalized,’ we find ourselves looking at incremental ‘alpha’ as much as we are basic ‘beta.’ This sounds a bit boring, but it’s actually a positive reflection of conditions getting better, less dislocated and more balanced.

Back to the week specifically, the U.S. market was led by financials and consumer discretionary, while lower beta and more defensive sectors like consumer staples and utilities lagged. Small-cap outgained large-cap.

Internationally, emerging market stocks led, including India and Brazil, while European stocks as a whole also registered gains of over three percent. While most nations ended up in the positive, Asian names generally lagged from a regional standpoint.

Bonds slipped on the week with the strength in risk assets, with the yield on the 10-year treasury jumping 20 basis points back above 2%. On the better-performing side, high yield and bank loans were able to eek out a bit of positive absolute return, while longer treasuries suffered the most due to effect of longer duration with higher rates. Foreign debt was mixed, with emerging market bonds flat and developed nations following our government markets to some extent.

In real estate, more cyclical U.S. industrial REITs gained strongly, on par with equities, followed by mortgages and retail, although European and Asian REITs also performed positively.

Commodities were up roughly one percent on the week (as measured by the DJ-UBS index) with strength from natural gas, sugar and continued increases in unleaded gasoline. Grains, especially several wheat contracts, lost several percent due to USDA estimates of higher supplies than expected (prices were already under some upward pressure from improving growing conditions and smaller export estimates).

Have a good week!