The economic data last week continued the slowly improving trend that has been evident for months now – or at least evident outside of housing. Stocks continued their recent slow motion rally, the dollar strengthened (or more accurately the euro weakened) and commodities were generally well behaved. Unfortunately the bond market wasn’t very cooperative with all three auctions of new government bonds producing disappointing demand and higher yields. If stocks are to correct in any meaningful fashion – and at some point they will – interest rates seem likely to be the catalyst so last week may very well have been a shot across the bow of the equity market. That depends on why bonds yields are spiking higher. If it is a recognition of future growth that is one thing, but if it is instead the return of the notorious bond vigilantes, well that is a whole different problem that won’t be solved quickly and could have significant implications for future stock prices.
The economic data, as has been the case recently, showed improving trends everywhere except the housing market. Retail sales reports from Goldman and Redbook both showed healthy year over year gains in sales of over 3.5%. Of course sales were quite depressed this time last year so the gain isn’t that impressive but at least it is in the right direction. Existing home sales remained very weak at a 5.02 million annual rate. That was down 0.6% from January but up 7% over last year. I suppose it could still be the weather but that is getting old as an excuse and quite frankly, I’m not buying it. We may still see a surge of sales before the tax credit expires but even if we do it won’t last unless we start seeing some job creation soon. The problems with the housing market are many but the biggest problem is that the various and sundry government programs meant to mitigate foreclosures just delay the inevitable. Most of the “owners” who get mortgage modifications go on to redefault anyway; we’d be closer to the end of this if we had just let prices fall to the clearing level and moved on. We’ll end up there anyway; rip off the band aid and get it over with.
Durable goods orders were up 0.5% in February and 0.9% ex-transportation. After a revision higher for January that was a solid performance. Most importantly, non defense capital goods orders ex-aircraft rose 1.1% after plunging 3.9% in January. These orders are a good leading indicator of capital spending and if this recovery is to be anything more than inventory rebuilding, we need to see companies confident enough to invest. That is a very big wild card at this point; companies have the cash but seem – so far – reluctant to spend it on anything except stock buybacks and acquisitions. Those aren’t terrible for the stock market and eventually lead to better investment but I’d rather see it directly and sooner rather than later.
New home sales confirmed the miserable existing home sales numbers with February sales coming in at an all time low 308K annual rate. Prices rose some but inventory did too so that seems unlikely to last. The relapse in new home sales is very disappointing as every previous recovery has been accompanied by rising sales. While I don’t consider new home sales a leading indicator, it is hard not to notice in the chart below that sales were rising before the end of every recession since they started collecting data. To me new home sales are consumption and as such are a result of recovery not the cause but however you look at it, sales need to be rising before we are out of the woods. One conflicting signal has been the performance of the home builder stocks. If stock prices are a leading indicator we should see rising new home sales soon.
Jobless claims continued to creep lower with the weekly total dropping to 442,000. Claims are still moving in the right direction and they might even be low enough to produce some job growth, but claims will have to fall below 400k to get enough growth to reduce the unemployment rate. Remember, we need about 100k new jobs per month just to keep up with the growth of the workforce so until we get over that level, we are really just spinning our wheels. And actually to reduce the unemployment rate will require a much higher level of job creation than usual since the workforce has shrunk in this recession. As things improve, people will return to the workforce causing a higher than normal growth rate. Unemployment will be very sticky in this recovery. We get a jobs report on Good Friday – let’s hope it lives up to the day.
The only other data for the week was the revision of 4th quarter GDP which was about as expected, corporate profits and consumer confidence (to which I pay little attention). The corporate profits report was also from the 4th quarter and so didn’t really add any new information but it did confirm what stock prices have been telling us for a while. US workers are very productive and therefore US corporations are very, very profitable. If you are still wondering why stocks are rising just take a look at this:
The economic recovery may be in it’s infancy but corporate profits have almost fully recovered already.
Stock prices aren’t determined soley by the level of profits though. What multiple is placed on those earnings is a function of interest rates and last week the bond market was under pressure. The three Treasury auctions of the week all went poorly with yields higher than the when issued prices and bid to cover ratios that showed weak demand. Are investors reluctant to buy Treasuries because of the massive coming supply that will be needed to fund healthcare reform (among many other things)? Or is it just a matter of demanding higher yields because higher growth also likely means higher inflation (or at least it does when economic activity is a function of Fed money printing efforts)? I suppose that is a question that we’ll only know the answer to in retrospect but for whatever reason, rates seem headed higher.
That doesn’t mean that stock prices are necessarily too high. Stocks were higher in 2007 when the Ten Year Note was yielding closer to 5% rather than the current 4% so if profits continue to rise it seems that stocks can too. But I think it matters why rates are rising. If it is concern over deficits that is causing the rise I suspect that rates will rise much more rapidly than if it is due to higher growth and even inflation. That is because there is no easy fix to the deficit situation especially now that healthcare reform has passed. Higher inflation could be headed off – theoretically anyway - by Fed policy while deficits will have to be resolved by a dysfunctional political system that seems reluctant to solve anything. The timing of the bond market sell off makes me fear that it is deficits that has roused the bond vigilantes; if that is so, stocks may be in for some rocky days ahead.