The Economy: A Look Back and What’s Ahead (12.30.13)

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Last Week

It was a slow week economically given the Christmas holiday, but the data that was released was positive, and supportive of the growing view that we are seeing economic growth starting to accelerate.

Last week’s highlight was the Durable Goods report, which not only was a headline beat, but New Orders for Non-Defense Capital Goods Ex-Aircraft saw a strong uptick, rising by 4.5% in November.  That’s important because it implies that business spending and investment may be starting to expand again after basically treading water since May, and if that is the case, then it’s an unexpected positive for the economy.

Housing data was also surprisingly strong, as New Home Sales showed a huge positive revision in October (the November data was down slightly month over month, but that’s only because of the huge October revision).  While it certainly doesn’t settle the debate about just how much of a headwind higher interest rates will be on housing (remember October was when we saw the dip in interest rates, so perhaps that pulled more buying forward).  Point being, the New Home Sales data was a nice surprise last week, but it’s December now, and the housing market will remain a sector to watch in the face of increasing rates.

On the consumer front, November consumer spending, which was contained in the Personal Income and Outlays Report released last Monday, beat expectations, confirming recent strength in the monthly retail sales reports.  Also in the Personal Income and Outlays Report was the “Core PCE Price Index” for November, which was unchanged from October.  That’s the Fed’s preferred measure of inflation, and what it means is that inflation remains very, very low and that gives the Fed plenty to scope to keep rates “low for long.”  (Meaning the low inflation readings help to further validate the Fed’s Forward Guidance, and markets traded slightly “dovishly” off the reading).

Finally, jobless claims saw a big drop, although this release is so volatile right now because of seasonal distortions, weekly claims are largely being ignored.   The key is that the 4 week moving average for weekly jobless claims is basically at the same level as August—so the jobs market is continuing to improve, but at about the same pace as in the last few months (meaning we aren’t seeing incremental improvement and likely should expect another 200kish monthly jobs report for December).

Bottom line last week was that while most of the data was “second tier” and none of the releases, by themselves, will change current Fed policy, the strong Durable Goods Report and Consumer Spending data in the Personal Income and Outlays Report will put upside risk to most analysts current Q4 GDP estimates (meaning the economy might be stronger than we currently think).

And, most importantly, the continued strong economic data is helping to make 3% on the 10 year yield “ok” for stocks.  As long as there is constant re-enforcement by the data that economic growth in accelerating, higher interest rates won’t be a major negative for risk assets, at least not at these levels.

This Week

This will be another slow week economically, given the New Year Holiday, although the release of the global manufacturing PMIs on Thursday morning makes this week a bit more important, economically speaking, than last week.

The flash PMIs for December were released two weeks ago, so markets will be watching to see if the final readings match the trends we saw in the Flashes—that of a slight dip in manufacturing activity in China, and stronger than expected activity in Europe.  Also, the Chinese government will release their monthly PMIs (not-surprisingly they are almost always stronger than the privately gathered Markit PMIs). But watch to see if there’s also a dip in the government data that confirms the dip in activity in the Markit PMIs.

The Pending Home Sales (this morning) is the only other notable report.  It’s November data, so it’ll be interesting to see what effect the creep higher in interest rates that occurred throughout November had on sales.

Bottom line is this week won’t have much of an effect on things here in the US (the ISM Manufacturing PMI release Thursday should only move markets if it’s a big miss), but it is an important week to gauge the progress of the global economic recovery, and the reports from China and Europe will be watched closely.

The Economy: A Look Back and What’s Ahead (12.23.13)

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Last Week The FOMC decision to taper QE was the big news from an economic perspective, but beyond that, there were a few other notable takeaways that are important in light of the new trajectory of Fed policy. Specifically, we learned last week that the economy in Q3 was stronger than we thought, that the manufacturing sector in December is a little slower than we thought and that the housing recovery is still ongoing, but concerns about a loss of momentum in the face of rising rates remain. Starting first with the Fed, though, you all know by now the Fed announced it would “taper” its QE program by $10 billion a month (from $85 billion to $75 billion) starting in January.  In a feat of monetary policy wizardry, though, the FOMC managed to taper QE yet come off somewhat “dovish.” They strengthened their “forward guidance” for keeping interest rates at 0%, saying the would keep rates at 0% well past 6.5% in the unemployment rate (thereby effectively raising the bar for when rates would start to rise).  Overall the market welcomed the news, and stocks saw a big post-FOMC rally Wednesday afternoon. And bonds, while they did decline, largely “behaved.”  It was the best-possible outcome for the Fed and for stocks. Read More

Fed Pivot to Forward Guidance Furthers Bear Case for Bonds

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I remain skeptical of the “power” of forward guidance and think the switch away from QE to forward guidance as a primary policy tool only furthers the bearish case for bonds.  And, my skepticism is rooted in experience and observation. Although the rise in the Dollar Index yesterday got a lot of press, the one currency that was stronger vs. the dollar yesterday was the British Pound, which saw a 0.8% rally vs. the greenback—and that’s something that shouldn’t be dismissed, because I believe that what’s happening with the Pound, the FTSE and UK Bonds, may provide us a “road map” of sorts for what will happen to the Dollar, Bonds and stocks, now that the Fed is switching to “forward guidance” as its primary policy tool. Read More

What Could Go Wrong in ‘14—A Thought Experiment

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As I start to think about the outlook for 2014, my mind almost always wanders first to “what could go wrong in the financial markets this year?” Having been raised in this business as a trader, I learned early that avoiding disaster is the first step to making money.  So, I’ve spent some time thinking about what could go “wrong” in 2014.

Maybe I’m just a product of my environment, but I entered this business in the dot-com bubble burst of the summer of 2000, started on the floor one year after 9/11, and after a few good years then ran smack into the financial crisis.  So, despite my relative youth, I’ve seen a lot of mess over a relatively short time.

Now, in fairness, the macro-horizon is as “clear” as it has been for some time.  Europe is no longer teetering on the brink of a breakup or massive sovereign default.  The financial system and banks are well-capitalized and as healthy as at any time since the crisis.  Even the U.S. government appears to be trying to behave, as we’ve got a budget for the next two years (and the debt ceiling won’t be a drama in an election year—I don’t care what the Republicans say now).  So, all things considered, the horizon looks pretty clear.

But, as I look for places where something could go “wrong,” I keep coming back to the bond market.  I don’t think there are many people who would argue that the bond market, in general, reached “bubble” territory (or at least a blow-off top of a 30+ year bull market) over the past few years.

There are multiple measures to imply this is the case, whether it’s the amount of assets that have poured into the bond market, the amount of corporate issuance, or risk spreads compressing to historic lows, etc.

But, importantly, a declining bond market, by itself, doesn’t mean a crisis.  Bonds can go down like any other asset and not cause a crisis that infects other asset classes.  But, what makes me nervous about a crisis emanating from the bond market is the fact that we have a market in a blow-off top that was largely manufactured by government policy (the Fed), combined with government-mandated structural changes to the industry that has drained liquidity and will likely have multiple unintended consequences. (I’m referring to Dodd-Frank.)

And, this sort of dangerous cocktail should sound familiar to people.  The potential negative consequence of this, of course, is a stampede to the exit by investors, but no one to buy the dip—causing a liquidity crisis in the bond market, and specifically the corporate bond market (with ground zero potentially being the high-yield market).  And, the potential set-up is for a liquidity crisis in the corporate bond market that infects all other asset classes (like subprime did to everything else).

Throw in the explosion of bond-related ETFs and the retail money that’s flooded into them, and I can imagine a scenario where there is lots of selling of these ETFs and mutual funds. This in turn results in the bonds themselves having to be sold, but there simply being “no bid” for the specific corporate bonds, which then breeds a liquidity crisis that begins to feed on itself.

This report isn’t the venue for an in-depth analysis of the risks, but a client sent me an excellent report by McKinsey on this subject (I’m lucky to have a lot of smart people as subscribers), and the link is here.  We got a warning shot on this in May/June of last year, and this is a concern that is starting to make the rounds among smart people.

I’m not a Pollyanna, but as I think of risks coming out of left field that could result in an end to this rally, this is the one that keeps popping up in my head.  Again, this is a very, very low probability scenario, and one that likely won’t ever come to fruition. But if we’re looking for something that could go wrong next year, the pieces are in place.

FOMC Meeting Preview

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The Expected Scenario:

- No tapering of QE in December, but a strong signal by the Committee that tapering of QE will happen in January or March.

- Tapering Logistics:  If asked about how tapering will work, the market expects to see an initial tapering of $10 billion-$15 billion, and the process to be linear (tapering the same amount each month or quarter, whichever they decide).  And, markets expect the first taper to be weighted toward Treasuries, while mortgage-backed securities are left alone (to help soften the blow on the mortgage market, although I’m not sure it’ll make much of a difference).

If this is what we get Thursday, don’t expect any significant, volatile reactions from the various asset classes, as again this is what’s priced in.  As far as how markets will trade beyond the immediate reaction, that’s a tough one to call.  We could either see a “sell the taper rumor/buy the taper news” reaction. Or we could see markets drop on the news, due as much to the calendar and the skittishness of money managers I’ve been talking about, given the gains so far this year. Read More

The Economy: A Look Back and What’s Ahead (12.16.13)

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Last Week

There was very little economic data released last week, and economically the focus was on trying to “game” the chances of the Federal Open Market Committee announcing a plan to taper QE after their meeting this week.

The two major pieces of data (retail sales and jobless claims) we received last week generated mixed signals.  Positively, retail sales beat expectations, and the important “control” group—which excludes automobile, gasoline and building-material purchases—continued to advance, rising 0.53% in November.

This uptick in retail sales came at a good time, as concerns about the consumer linger, especially given many retailers’ unenthusiastic commentary on the holiday shopping season.  In fact, the resilient consumer (and stronger retail sales) resulted in many analysts and strategists upping their Q4 GDP estimates, as Personal Consumption Expenditures (i.e., consumer spending) are now expected to be stronger than originally thought.

The retail sales beat was the economic “highlight” of the week, and from a WWFD (What Will the Fed Do) standpoint, it very slightly upped the chances of a taper this week. However, it certainly won’t be the deciding factor.

On the flipside, jobless claims saw a jump of 68K, to 368K, as statistical errors thanks to Thanksgiving and other factors were worked out.  That number was obviously a disappointment vs. expectations, but weekly claims have been so volatile lately that many people are discounting the adjustment.  And, most (including me) expect claims to move south toward the lower-300K range, where it’s been since August.

However, the most-important economic news of last week (both for the economy and with regard to WWFD) came from Washington, where a two-year budget deal was struck and passed by the House.

From a market standpoint, the budget agreement provides some much-needed clarity for the market, and helps remove another potential macroeconomic risk from the horizon (there won’t be another budget battle or threat of shutdown).

Finally, the agreement is being viewed (correctly) as incrementally increasing the chances of a December taper—although like retail sales, it won’t be the deciding factor.

Bottom line, last week’s retail sales data was positive and confirms the overall feeling that the economy is improving.  From a WWFD standpoint, the odds of a “Santa taper” this week did increase, although it remains somewhat of a long shot.

This Week

The FOMC announcement Wednesday is the most-important event this week and, for the next few days, Wall Street will be focused squarely on its outcome.  I’ll preview what to expect in Wednesday’s Report, but as of right now the “consensus” expectation is for no tapering at this meeting, although it is certainly possible.  Keep in mind this meeting also brings the FOMC’s forecasts for growth, inflation and interest rate policy expectations (so it’ll be an opportunity for the FOMC to further emphasize its zero-interest-rate policy). We also have the Chairman’s press conference, which will be the last with Ben Bernanke at the podium.

Away from the FOMC, there is also a lot of data coming out this week about the real economy.  While the FOMC will dominate the conversation all week, keep this in mind:  The only reason the market isn’t throwing a “taper tantrum” is because the economy looks to be improving.  If that changes and the data turns south, the market won’t be as receptive to tapering as it currently is.  Point being—the Fed is watching the data and everyone else, in turn, is watching the Fed for clues about where the numbers are heading next.

Later this morning we’ll get the “flash” manufacturing PMI for December, which will be closely watched.  We also get Empire State Manufacturing (today) and the Philly Fed Manufacturing Index Thursday (they are usually the first economic data from the current month), although those two indices will have their thunder stolen this week given the “flash” PMI comes out before them.

This week also brings a bevy of housing data (Housing Market Index tomorrow, Housing Starts Wednesday and Existing Home Sales Thursday).  The housing recovery remains the key lynchpin in the broader economic recovery.  We saw over the summer that the housing market is sensitive to rising interest rates, so how the housing market is reacting to this recent uptick in rates will be important to see, both from a “real” economy and FOMC perspective.  As I’ve been saying, the housing recovery can lose some momentum, but it needs to keep going so the economy can continue to accelerate.

Finally, jobless claims will reveal whether that big jump from last week starts to get reversed, and on Friday we get our last look at Q3 GDP. (Don’t expect any big revisions; they usually happen between the first and second revisions.)

Bottom line is it’s a big week from a policy and real economy perspective.

Still Keep an Eye on SHY

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SHY:  The last few days have seen the short end of the curve sell of moderately as a December taper becomes a possibility.  As long as the decline doesn’t accelerate materially, though, tapering won’t kill the rally in stocks.

 

Is the S&P 500 forming a double top?

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Term Structure in Natural Gas Has Turned Bullish

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Any real commodity trader or analyst knows that watching the “term structure” of commodities can offer substantial insight into whether the trend in that commodity is turning bullish, or bearish. The term structure of natural gas has become significantly “backward-dated” in that the current month’s prices (for January delivery) are trading higher than February’s price. Prices for February delivery are trading at a higher price than March delivery, and this lasts all the way out until June 2014. Term structures can be an important indicator of physical demand for a commodity, and as the backwardation in natural gas implies, we are seeing a systemic increase in demand for natural gas—not just a temporary uptick in demand due to cold weather to start the winter. And, that is potentially bullish not just for natural gas, but for natural gas producers. Read More

The Economy: A Look Back And What’s Ahead This Week 12.9.13

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Last Week

Last week’s economic data continued the trend of surprising to the upside, highlighted by the jobs report on Friday. The takeaways from last week’s data were threefold: First, from an economic perspective, the data further implied we’re seeing a mild uptick in economic activity, although nothing huge. Second, from a WWFD (What Will the Fed Do) standpoint, the economic data now solidifies January as the consensus expectation for the first tapering of QE (December remains a remote chance). Finally, looking a bit beyond the immediate term for Fed policy, last week showed inflation remains very, very low, and that will help traders continue to believe the Fed’s ZIRP pledge, which should continue to steepen the yield curve (good for banks).

Starting with the jobs report, it was just about perfect, from a market standpoint. Job additions printed above 200K for the second-straight month, and revisions (remember, the direction of the revisions often reflects the general momentum in the labor market) were mildly positive (net revisions to September/October were positive, with 8K jobs added).

One detail that wasn’t widely reported but is important was the drop in the “U-6” unemployment rate, which is a more-accurate picture of the actual labor market than the more-publicized unemployment rate because it factors in the underemployed and detached workers. It fell to 13.2%, the lowest level since November 2008. Undoubtedly, there is some positive seasonality in the jobs data that likely will be reversed in Q1 ‘14 (most of it having to do with holiday hiring), but broadly we can say we’re seeing improvement in the labor market.

The second-most-watched number last week (and usually the second-most-important monthly economic number behind the jobs report), ISM Manufacturing PMI, also was strong. It printed its highest reading of 2013 at 57.3, and New Orders, the leading indicator in the report, rose to 63.3.

New Home Sales saw a big jump in October and a steep drop in September, and that mostly reflected the relative level of interest rates (remember they dropped sharply back in October). Bottom line with the housing market is the recovery is ongoing, inventory is low and prices are flat to higher.

But, going forward, the data since May has shown the recovery is sensitive to the rise in interest rates (as you’d expect). So, as rates continue to rise, housing numbers will need to be monitored, as an ongoing recovery in housing is essential to economic growth accelerating from current levels.

Finally, it was overlooked in all the focus of the jobs data Friday, but the “Core PCE Price Index”—which is contained in the Personal Income and Outlays Report, and is the Fed’s preferred measure of inflation—showed inflation increased just 1.1% year-over-year in November, down from 1.2% in October. That remains well below the 2% goal for the Fed. Although it won’t delay tapering, it does imply that the Fed does have substantial room to remain accommodative, even if the economy starts to accelerate (which would be good for stocks and hard assets).

This Week

It’s a very quiet week, economically speaking. The only two domestic reports to monitor are weekly jobless claims and retail sales (both Thursday). In particular, retail sales will be watched because last week’s commentary on the holiday shopping season turned pretty negative from a bunch of retailers. American Eagle Outfitters (AEO) and Big Lots (BIG) both joined a growing chorus of retailers saying the holiday season isn’t going well. So, retail sales, although its November data, will be watched closely.

It’s equally quiet in Europe this week, as EMU Industrial Production (also Thursday) is really the only material economic release. The one region where there is some action, however, is China. We already got China’s latest trade balance and CPI numbers over the weekend, and Tuesday brings the release of November Industrial Production and retail sales. China remains important because a material economic slowdown there (of which there are fears) remains one of the macroeconomic risks to the global rally in stocks. So, the outlook for China remains important.