Weekly Economic and Market Review
Clueless. That’s the word that kept creeping into my mind all last week. Private jets ferried the rich and well connected to Davos, Switzerland so they could meet the rest of the rich and well connected. Clueless. Hosni Mubarek fired his cabinet and replaced them with a different set of cronies that failed to satisfy the mob. Clueless. Senator Marco Rubio (R, FL) and Senator Bill Nelson (D, FL) sat together at the State of the Union speech and leaned in opposite directions, away from each other, as if afraid of catching something. I don’t think either said a word to the other all night. Clueless. President Obama told us that no one could predict what the next big industries would be or where the new jobs would come from and then proceeded to tell us which industries he intended to bet our money on. Clueless. He also told us the budget situation was not sustainable and then offered a spending freeze on a tiny part of the budget with projected savings that amounted to a rounding error over the next decade. Clueless. In the Republican response, Paul Ryan managed to get through an entire speech about reducing the size of government without mentioning anything specific on the chopping block. Clueless. And finally we got the Financial Crisis Inquiry Commission report, the thrust of which was that everybody was to blame and the crisis could have been avoided if regulators had regulated and bankers didn’t do what bankers do. That cost us roughly $10 million. As I said, clueless.
One thing everyone seems to agree on though is that we can’t continue on as we have been. President Obama said it, Ryan said it and most everyone at Davos said it although at Davos it was usually only in the context of how to structure a profitable trading strategy for the inevitable collapse of civilization. And it is true; we can’t continue to run deficits of this magnitude. At some point the rest of the world will stop lending to us on such generous terms. Or, based on the recent trajectory of emerging market stocks and bonds and the recent downgrade of Japanese debt to AA, maybe the rest of the world will be busy worrying about their own problems and won’t have any spare change to lend us. However it occurs, we are fast approaching the point where the clueless will have to get a clue. I had hoped that it would happen voluntarily but that may have just been wishful thinking.
I believe it is time to start thinking about what happens if there is no deal on tax reform and deficit reduction. Europe still has major problems – in some ways worse than ours – and I would be surprised – shocked – if there aren’t more countries lining up for EU bailouts this year. China and many of the emerging market countries are busy trying to nip an inflation problem in the bud that is mostly a product of Federal Reserve policy. Yes, the Chinese central bank – and most of their other emerging market counterparts – shares the blame for trying to hold down the value of their currency, but the source of the inflation is US Fed policy. Since these countries can’t change Fed policy they are forced to adopt remedies that markets appear to be telling us will cut their growth rates. Japan just had its debt downgraded and will at some point have to address their own problems. Why is all this relevant? As much as I have my doubts about the GDP report last week (see below) there is no doubt that exports have played a major role in the recovery. If Europe has problems and China slows, dragging down the resource countries and most of the emerging world with it, we’re going to have a tough time finding somebody to buy our exports. And the only way to get the Fed to change policy is for the politicians to adopt better policies.
The good news is that if President Obama and the other politicians will just make the tough decisions and act responsibly a lot of these problems will go away. But hard decisions need to be made and all sides will have to compromise. If all we get is more pontificating and politicking with no real progress, all these problems just keep getting worse. Inflation gets worse, growth falls off and the people get more restless. It’s not a bullish combination.
While most everyone pointed to the troubles in Egypt as the culprit in Friday’s stock market selloff, I suspect the disappointing economic data played a role as well. There were some positives but overall the data released last week tended to weakness, particularly in the housing sector and retail sales. The Goldman and Redbook retail reports both showed sizable drops in activity over the last week. Some of that is no doubt a result of the extreme winter weather that blanketed the East coast with snow but I can’t help but wonder if the arrival of the Visa and Mastercard bills for the Christmas season had an impact as well. January is often a weak month though and we probably shouldn’t extrapolate too much from one down week.
There were several housing related reports and while there were some positive hints at stability, the overall tone was still negative. Case Shiller reported another drop in house prices for October but the rate slowed to an annualized 0.4%. I suppose the positive spin is that another drop gets us closer to a bottom but getting there is turning out to be a slow trip. One does wonder if we wouldn’t have been better off if government policy had encouraged the drop rather than prolonging the agony. We’ll never know but I am still hopeful that the bottom is now in sight. Indeed the new home sales report, also from last week, showed a pretty healthy rise in median prices (+12%)and a drop in inventory to 6.9 months of supply. Unfortunately that inventory number is based on the rate of sales at the end of last year and other factors point to a slowdown in the first quarter. Sales were concentrated in the West, probably due to the impending expiration of a home buying tax credit in California. Mortgage applications also fell off a cliff last week for purchases as well as refinancing. The rise in mortgage rates is apparently starting to bite. Pending home sales were higher in December in what appears to be a rush to beat those higher rates. It is hard to envision the momentum carrying over into the new year.
Durable goods orders came in less than expected, down 2.5% in December. The year over year change is a still healthy +6.9% and ex transportation orders were up slightly (+0.5%). Transportation orders were hurt by the continued delay of Boeing’s Dreamliner which is turning out to be more like the Nightmareliner. In a positive sign for the economy though, non defense capital goods orders ex transportation were up 1.4%. Overall the report was mildly positive and shows that manufacturing is still expanding albeit at a slowing pace.
Jobless claims continue to confound rising right back to the mid 400k level. I know there are lots of seasonal factors involved and last week was a holiday shortened week and there was snow all over the East coast the last two weeks but that just sounds like bulls looking for excuses if you ask me. In a more normal recovery, claims would have already dropped well under 400k and stayed there. I don’t see how the rest of the economic data can continue to improve if we don’t start to see more job creation. There have been some tentative signs that companies are ready to start hiring but expectations and positive survey responses are not actual jobs.
The big report of the week was the GDP report and I don’t think it was coincidence that the market dropped in the wake of the report. The bulls want to blame the drop on Egypt and I suppose that was a factor but the details of this report provided plenty of reasons to book a profit. The headline number of +3.2% appears to tell a positive growth story but the details were frankly underwhelming. I don’t want to emphasize the negative too much, so first the good stuff. Net exports were a positive contributor as exports rose an annualized 8.5% while imports fell at a 13.6% pace. Personal consumption expenditures rose 4.4%, business investment in equipment and software rose 5.8% and residential investment was up 3.4%. Non residential structures also rose a bit. The negative side was led by a slowing in inventory investment and a drop in government purchases.
Now for the caveats. Exports may have risen but that big drop in imports is suspicious to say the least. With all the retail activity in the quarter and the big rise in oil prices, a drop in imports seems unlikely in the extreme. I’m not saying the numbers aren’t right just that some investigation needs to be done before just accepting them at face value. I’m on a flight home from Chicago right now and can’t check but I’m pretty sure the trade figures for December are just an estimate and the actual numbers will be available for the first revision next month. Could we see a big downward revision in the headline growth? It seems plausible. Another caveat applies to the personal consumption expenditures which while positive were funded at least partially by a drop in the savings rate. Eating the seed corn of future growth is not a long term plan. I’m also skeptical of the inflation rate used to calculate real growth. Prices were reckoned to rise by a mere 0.3% in the quarter and that seems unlikely to a man who just spent $300 at the grocery store. If prices rose at the same rate as last quarter (2.1%) real GDP growth would have been a mere 1.4%. With the headline growth rate already less than expected (consensus was for a 3.5% gain) and numerous dubious figures in the body of the report, the stock selloff Friday makes a lot more sense.
One final report last week was the Employment Cost Index which showed a rise of 0.4% in the fourth quarter and a 2% rise for the year. The employment cost index includes benefits as well as wages and salaries so it was not a good year for American workers pay raises. The folks gathered at Davos last week had a very good year; the folks back home didn’t fare nearly as well. That is a problem that needs to be addressed or we might have our own Mubarek moment soon.
US stocks were mostly down on the week with only the Russell 2000 small cap index posting a gain among the major averages. Despite Friday’s big selloff the losses were modest for the week. Not so for most of the foreign markets, particularly the emerging markets which maybe haven’t emerged as much as some would like to think. As Egypt and Tunisia have shown rather dramatically, emerging markets are prone to political risks we don’t normally face here at home. Of course, Brazil isn’t Egypt so maybe the turmoil was just an excuse to take profits. I’ve been warning about these markets for weeks now (there is additional commentary in the weekly chart review) and that was based on fundamentals, not any insight about Egyptian political turmoil.
The fact is that what has been going on in most of the emerging markets is an old fashioned inflationary boom – a product of our very own Federal Reserve with some collusion from the ECB and the emerging market central banks. Eventually the inflation will end and with it so will the boom. Could some early investors be trying to get out before the inflation ends? I don’t know about anyone else but that has surely been a motivating factor for me. With emerging market countries actively fighting inflation with higher interest rates, higher reserve requirements and capital controls and QE II ending mid year, I don’t intend to wait around to find out if these countries are successful in their fight against foreign capital inflows and rising prices. If they succeed in killing inflation, growth will be a victim too.
We were stopped out of part of our gold etf position last week. I have been a gold bull for a long time but I am beginning to think there might be a significant pullback. After 10 straight up years and with nearly everyone on the bandwagon it seems an opportune time to reassess. Other commodities continue to rally although oil would have had a down week but for the rally Friday based on the potential for Egypt’s troubles to spill over to the rest of the Middle East. I don’t expect that to continue though if gold continues to fall. If capital comes out of gold and starts to flow into real productive investments, that is a very positive sign for the US economy and should be reflected in a higher value for the dollar. And a higher dollar likely means lower commodity prices. All of that is dependent on better economic policy though and we’ll need more than what the President laid out in the SOTU speech to make it happen. If it does though the upside for growth investments is considerable and the downside in commodities is symmetrical. I am still skeptical that the politicians will actually get their act together and do what is necessary to address the deficit and future growth but hope springs eternal.
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