The perfect storm sinks stocks and bonds

Economic news this week was plentiful but uninspiring, as shopping, housing, and earnings were nothing to get excited about.

Robert Johnson, CFA 20 August, 2013 | 2:46AM
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It's hard to imagine a set of news that could collectively do more damage to so many markets than this week's reports. The Fed appears to be losing its taste for quantitative easing, the economy is looking less robust than hoped, and now even the corporate news has turned negative. The 10-year Treasury surged to 2.86% and stocks fell sharply for most of the week; on Thursday the Dow fell more than 200 points.

The Fed's San Francisco District issued a paper this week that suggested QE2 added just over 0.1% to GDP growth, hardly the kind of return one would expect from a relatively risky policy. Some of the Fed governors must have been reading the paper as even the more dovish governors seem to be entertaining the possibility of reducing bond purchases as early as September. The recent soft economic data doesn't seem to have scared any of the governors who have been speaking recently. To be fair, the Fed claims to be primarily interested in just employment data and inflation. With initial unemployment claims hitting a recovery low and year-over-year inflation picking up again (both announced this week), one couldn't be blamed for thinking the end of bond purchases remains clearly in sight. About all that stands in the way of a September tapering program is the August employment report. My guess (I am stressing the word "guess" at this point) is that it might be bad enough to give the Fed pause. However, that just delays the Fed's inevitable withdrawal from the bond market and higher interest rates.

Most of the economic news wasn't great: retail sales missed the mark, year over year inflation showed some growth again and industrial production went flat. Housing starts bounced some, but not as much as expected. Again, none of the data was a disaster; it just means more slow and unsatisfying growth. There were some positives: initial unemployment claims struck a new recovery low, Europe managed to pick itself back off the mat and homebuilder sentiment struck a new recovery high.

Perhaps most troubling to the market were some issues at some big bellwether companies. Cisco CSCO announced the layoff of 4,000 workers (5% of its work force) and Wal-Mart WMT missed it sales projections, as Macy's M did the week before. This was not a great way to end an uninspiring earnings season that will probably end up showing about 2% earnings per share growth over the same period a year ago. According to Fact Set, 75 companies issued negative earnings guidance and only 17 companies issued positive guidance, not terribly reassuring for the third quarter.

Europe's economy performing better than expected

The European economy appeared to move out of recessionary territory in the second quarter as the 17-country eurozone moved into growth territory after an 18-month-long double-dip recession. Much like the U.S., Europe was in recessionary territory in 2008 and 2009, and both economies rebounded late in 2009, 2010, and part of 2011. U.S. growth accelerated in late 2011, while Europe fell back into a second recession in the fourth quarter of 2011. For Europe, the 2013 second-quarter annualized 1.1% GDP growth rate was the first positive quarter since fall 2011.

Overall, Europe represents about a quarter of world GDP; U.S., BRICs, and the remaining economies each represent approximately a quarter. However, Europe represents a minimal 3% of U.S. GDP, because of the small export dependency the U.S. economy effectively decoupled from Europe's slump. That provides an important lesson that should also apply to China's recent slowdown. China is an even smaller part of U.S. GDP than Europe at about 1%.

As I said last week, Europe may not be totally out of the woods just yet. Seven of the 17 eurozone countries were still in recession during the second quarter, including Italy, Spain, and Greece. Germany, France, and the U.K. were the backbone of the recovery with annualized growth of 2.8%, 2.0%, and 2.4%, respectively. Weather effects, especially in Germany, hurt the first quarter and helped the second quarter, and this will not recur in the second half. Employment data didn't show nearly as much improvement as GDP did, especially in France, which is also troublesome. That said, I am pleased to see the improved data, which should make Europe less of a headwind to world growth. Recent outstanding retail sales news out of the U.K., less bad news out of China, and an improving U.S. are all positives for Europe, offsetting at least some of my concerns.

Industrial production throws a bucket of cold water on manufacturing optimists

With stunningly good purchasing managers' data and improved durable goods orders, hopes were high for industrial production. Expectations were for 0.2% growth, but the index turned out to have shown no growth at all. Manufacturing, which excludes the volatile mining and utilities segment, shrank 0.1% in July. A very broad range of categories were down, with auto production leading the charge with a 2.4% decline. Out of 20 categories, only five showed growth, with all the others flat or in decline. The growth in those five groups was nothing to write home about either with just two growing faster than 2% (primary metals and petroleum). Unfortunately, the year-over-year data looks just as ugly. Growth continues to slow down. At 1.5%, the rate is the lowest of the recovery (since 2010) and well off the 50-year average of 2.6%.

I'm hoping it's just a matter of summer shutdowns depressing the current manufacturing numbers. The Purchasing Manager Report still seems to be suggesting better days ahead. However, the report seems to have lost some of its forecasting ability recently. Hopefully, the PMI data is not going the way of consumer sentiment surveys, with managers relying more on what they read in the paper and less on what their actual order books say.

Retail sales: no boom and no bust

While the market was excited by the 0.5% increase in retail sales excluding autos, I see the data as flat and relatively trendless despite the monthly ups and downs. The year-over-year three-month average shows a retail market pretty much stuck in its same 4% or so growth rate that it has been in last year. In fact, both the inflation and non-inflation adjusted numbers are a shade under the average of the last 12 months. Those seeing an accelerating economy in this particular data set have an active imagination. Not that the data is bad--it's the same as it has been, with slow, steady progress. One only needs to look at the relatively soft results from Wal-Mart and Macy's to see that retail sales aren't powering to new high growth rates just yet.

The sector data was not terribly helpful this month as it appears that weak categories in June bounced back and strong June categories softened considerably.

Lots of anomalies in this month's report suggest more adjustments ahead

There were a few category moves that were of interest. First, it seemed odd that a lot of housing-related categories were soft (furniture, building materials, and electronics) given a relatively strong housing market. The three-month data for these categories still looks strong, but the big single-month drop could be the first indicator that higher interest rates are pinching housing-related categories. Or, it might just be a case of volatile, error-prone data. Second, restaurant sales were strong at 0.6% growth following June's big slump. However, restaurant sales are little changed over the last three months despite strong hiring by restaurants, which can't continue indefinitely without an outsized gain in sales. The final anomaly was very soft non-store retailers such as Amazon. AMZN Online sales grew just 0.1% in July and that's the weakest performance in several years. Maybe the weather was too nice to stay inside and shop.

Looking ahead, retail sales could improve, but just by a little

Weekly shopping centre reports suggest that through the first two weeks of August there was a modest but steady improvement in shopping centre sales, which should bode well for the whole month. Lower gasoline prices and controlled inflation levels should also help. Furthermore, some of the anomalies reported in July could bounce back in August. On the negative side, wage growth, adjusted for inflation, was probably negative again after several months of improvement. Also, employment growth in July was the slowest it has been several months. Higher interest rates won't help, either. I still think things will be a smidge better in August.

Effects of lower gasoline prices and off-patent drugs diminishing in consumer inflation

Inflation from June to July moderated from 0.5% to 0.2% as gasoline and other energy prices slowed.

However, the news on a year-over-year basis was a little worse as year-over-year three-month average prices increased to 1.7% from May's low of 1.3%.

Ten-year bond yields soar, adjustment will continue over the next year

The higher inflation rate suggests higher interest rates in the months ahead (although rates took a nasty jump this week, already). Given that the spread between the interest rates on 10-year U.S. Treasury bonds and inflation is generally between 2.0% and 2.5%, this suggests that the 10-year bond could trade in the 3.7%-4.2% range compared with the current rate of 2.8%. The additional move will not come all at once, but will tend that direction over the next year or two, in my opinion.

Short-run year-over-year inflation could stall out, tempering some of the interest rates moves

In the short run the inflation rate is likely to fall back again, given lower gasoline prices so far in August, falling commodity prices, and a flat Producer Price Index. I would be hesitant to count on a full-year inflation rate all that much below 2%, with 2013 ending in December. Although not entirely unexpected the recent rise in the inflation rate might tame some Fed governors who thought the rate was too low and were not in favor of ending bond purchases until inflation was closer to the 2% target. That's another reason the market action was so poor on Thursday.

Fed governors sounding more as if they want to tame bond purchases sooner than later

This week, more Fed governors seemed to go on record saying that they would entertain the idea of tapering bond purchases as early as September. The remarks have continued despite some economic indicators that have not been particularly strong of late, and corporate earnings news has been disappointing on balance. The reasons for this became a little clearer on Monday when the San Francisco Fed released a paper suggesting that the second round of quantitative easing didn't do much to help the economy — the U.S. is currently in round three. The paper suggested that round two (QE2) added just 0.13% to GDP growth. I suppose that means that tapering purchases wouldn't have much effect on the economy, either. Obviously, markets disagree as the increased risk of immediate tapering sent both bond and stock markets down sharply on Thursday.

Housing starts bounce back up, but no new high ground

June's housing starts shocked everyone with a large drop to 836,000 (annualized rate, seasonally adjusted) versus a year-to-date average of 929,000. Looking to July data, in an allegedly hot market, there were hopes for either a huge bounce in July or a large revision to June numbers. The starts number did bounce to 896,000 and June was revised up to 846,000. However, this still left July below the year-to-date average, lower than four of the last six months, and lower than consensus forecasts. Single-family starts were down between June and July with the growth all in the multifamily category. The overall report certainly wasn't terrific, but it will make it nearly impossible to get to my conservative forecast of 1 million housing starts for 2013. Through July, starts are now averaging 912,000. The good news that is the year-over-year growth rate in total starts has arrested its decline, but single-family starts are still down slightly.

Permits data paints mediocre picture for the months ahead

Permits between June and July actually dropped from 953,000 to 943,000, which probably means they won't have a big boom in August. Permit growth is below starts growth rates year over year, which is also a bad sign for growth the following month.

Builder sentiment surprisingly strong given the starts data

One mystery remains: the continuing boom in the Builder Sentiment Index. The index hit a new recovery high of 59 for July, following a big pop in June when starts were an admitted disaster. So there have been two great months for this index, without much real movement in housing starts, which is quite unusual.

The outlook for six months from now is the strongest of the three components that comprise the builder survey; current activity is not quite as high and traffic is still soft. Perhaps this means that the good news of this report is yet to come. The industry is still struggling from a lack of labour, land, and money that is keeping a lid on housing starts and even homes to show in the short run. It's not demand so much as supply that is limiting starts. So while the short-term starts outlook is mediocre, the long-term outlook for the industry is excellent, especially for those with access to land and capital.

More housing data, fed minutes, and world flash PMI data due next week

After a week of unending information as covered above—and I left out the Treasury budget report, small-business confidence, inventories, and productivity—next week's calendar is skinny; existing- and new home sales and the market-moving Markit World Flash PMI reports are due next week. Fed minutes, which I hope will be dull, are anticipated on Wednesday.

Existing-home sales on Wednesday are expected to be almost flat with the prior month at 5.12 million units. Low inventories have kept acceleration here to a minimum. In fact, inventory levels may prove to be the most important part of the report. At this stage of the recovery higher inventory levels are better. Unlike existing-home sales and housing starts, new home sales have been on fire. Averaged year-over-year new home sales in June were up 30%, while single-family housing starts were up just 15%. This month the market is expecting some moderation with growth from 485,000 in June to 497,000 in July.

The Markit manufacturing (PMI) data is also due next week and will be watched very closely. The U.S. data has been improving for some time, although it certainly didn't show up in the last two months of industrial production. Europe has more recently gotten better and is now in growth mode, but China has softened considerably in June. With some China export data from July looking better and Europe picking up steam, there is hope that China's Purchasing Manager Indexes will stop falling. If the index were, surprisingly, to fall again, the market would not be at all happy.

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Robert Johnson, CFA

Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis for Morningstar.

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