The economic data released last week was pretty darn lousy but managed to be overshadowed by the Fed decision to re-engage the great electronic printing press and use the cash flow from their portfolio to buy Treasuries. With interest rates at generational lows I am a bit confused about what exactly that is supposed to accomplish but then Fed policy rarely makes sense to me or other logical beings. The problem in our economy is not that interest rates are too high but that animal spirits are too low. The problem isn’t that rates are discouraging borrowers so much as their lack of a job is just plain discouraging. I suppose if the Fed buys up enough Treasuries all those bulging bond funds everyone is buying will be forced to buy some other kind of credit but that is already happening with new junk bonds practically flying out the investment banks’ windows. So what will this accomplish? The consensus of the market, after a good night’s sleep, was nothing good.
We got a pretty good look at retail sales last week and it wasn’t a pretty picture. According to Goldman, August got off to a lousy start with week to week sales slipping 0.2% and the year over year pace moderating to 3.7%. Redbook was a bit more upbeat on the weekly numbers saying that back to school sales were keeping some retailers open late but year over year numbers were lower than Goldman’s at 3.0%. The official report on Friday had a good headline due to higher auto and gasoline sales but ex those items, sales fell 0.1%. Obviously higher auto sales are good news but the rise in gas sales was due to higher prices. Sales are up 5.5% year over year though so things are improving if slowly. Inventories were also reported Friday and showed what I would guess is an unplanned build with the inventory to sales ratio rising to 1.26 the second straight month where sales fell and inventories rose. That isn’t good news for future production. The wholesale side of business isn’t any better with sales dropping for the second straight month, down 0.7%. Inventories rose as did the inventory to sales ratio.
One of the more disturbing reports of the week was 2nd quarter productivity which fell at a steep 0.9%. In what can’t be good news for the unemployed, unit labor costs rose 0.2%. That was entirely due to the drop in productivity as hourly compensation fell 0.7%. Jobless claims last week just further confirmed the weak labor picture with new claims rising to 484k. If productivity has peaked and unit labor costs are rising, corporate profits, one of the few bright spots in this recovery, are at risk and therefore so are stock prices. Unless of course, another round of layoffs is imminent. Ugh.
The trade deficit widened dramatically in June with imports rising 3% and exports falling 1.3%. It wasn’t due to oil either as the non petroleum deficit accounted for all of the rise. One month doesn’t make a trend and the biggest component drop in exports was the very volatile capital goods, but at this point I think we have to assume the worst until proven different. It also isn’t comforting that import prices are still rising (up 0.2% month to month) while export prices are falling (down 0.2% month to month). Part of the reason for the drop in exports is that pricing for capital goods is weak which of course means demand is not exactly robust.
The good news was limited but low rates do seem to be having a bit of an effect on mortgage applications. Purchase applications rose 0.3% and refinance apps rose 0.6%. Of course those are applications and anyone can apply. Whether they get approved is an entirely different story but at least some of the recent upside in the Treasury market is coming from mortgage portfolios trying to hedge prepayments so some people are able to refinance. That doesn’t mean more spending as it has in the past though; the number of refinancings that involve a pay down in principal is rising. The only other sort of lukewarm good news last week was the slight uptick in consumer confidence and the nearly complete lack of CPI inflation. After three months of declining month to month CPI readings, July saw prices rise 0.3%. Ex food and energy showed a smaller rise of 0.1%.
Markets last week didn’t respond much to the economic data but rather to the more forward looking actions of the Federal Reserve. I don’t know what traders were expecting from the FOMC meeting but whatever it was, the announced QE Lite was decidedly less filling. From the dollar to commodities to stocks to bonds, the verdict seemed to be that the Fed is behind the curve and needs to do more. Of course, all those markets could be wrong and the Fed right, but the odds on that are comparable to the Dolphins winning the Super Bowl this year. Despite the public confidence of the owners and coaches, Vegas puts the chances at roughly nil.
The technical damage to the US stock market was considerable and I remain pretty neutral expecting little progress until there is a change or an anticipation of a change in policy. That could be a change in fiscal or monetary policy but based on the tepid response to the Fed’s actions last week, it will have to be a significant change to move the market. Foreign markets and economies continue to offer more interesting and profitable opportunities. Emerging markets are not exactly undiscovered but the economies of Latin America and Asia – for now – are performing better than Europe and the US and their markets remain relatively more attractive. I am skeptical of the idea that these economies can “decouple” from the developed world completely but if the US and Europe can muddle through with slow growth, emerging economies should benefit from capital inflows as asset managers seek better returns.
On the bond side, which has provided the bulk of our returns this year, I am increasingly cautious. I do not see deflation as a high probability event as long as the Fed continues to exist. The US is not Japan and despite the superficial similarities, we will not follow their path. The massive inflows to bond mutual funds over the last couple of years seems like deja vu all over again as individual investors chase the latest hot sector. This will end badly as it always does but the timing, as it was with tech stocks and houses, is impossible to get right except through luck. If you’ve enjoyed this run to generational low interest rates, it might be prudent to think about booking some profits.