Iraq Update

Iraq has deteriorated a bit this week and the inability of the Iraqi Parliament to choose a new PM weighed a bit on stocks late yesterday.  Before reading the particulars, keep in mind there are two negative scenarios in Iraq for the markets.  The first is that ISIS gets south of Baghdad and gains control of major oil export terminals in Basra in southern Iraq.  That would send oil materially higher.  The second is this Iraq conflict sparks a Sunni/Shiite civil was that spreads across the Middle East and pulls in Iran, Saudi Arabia, etc.  Obviously, that would send oil  higher.  Given the events of the last few days, the worry is for the later and the moment more so than the former, as ISIS remains well north of Baghdad.

Now, the reason things have deteriorated a bit this week are two fold.  First, ISIS (which is comprised of Sunni Muslims) attached a Shite shrine in Samarra earlier this week.  The last time that happened was ’06, and it sparked a nasty mini-civil war in Iraq.

Second (and more importantly) it was expected that the Iraqi parliament would pick a new Shiite Prime Minister to replace current PM Nouri al-Maliki, who is accused of largely ignoring Sunnis.  It was hoped that a new PM would be viewed as more inclusive, and ISIS would lose support among regular Iraqi Sunnis.

But, as Baghdad dithers, Iraq burns.  And, while militarily it seems a bit of a stalemate at the moment, any real solution will only come from a more inclusive government that saps ISIS’s ability to rally regular Sunnis.  Then the government can beat them back militarily.  But, the longer that doesn’t happen, the more support ISIS can gather among regular Sunnis, increasing the probability of a broader civil war.

Oil is down this morning so clearly the market isn’t worried about this yet.  But, the situation has gotten a bit and I wanted to make you aware.  A major positive in this scenario remains the appointment of a new Iraqi PM, while oil (specifically Brent Crude) remains the indicator to watch as to whether things are materially getting worse.

 

Economic data last week were universally better than expected and further implied that the pace of economic growth domestically is accelerating to the best levels since the crisis (referred to as “escape velocity,” or greater than 3% GDP growth).  Additionally, we got more signs that inflation is indeed bottoming, via the CPI.

Despite that, the Fed was “dovish” at the FOMC meeting, which helped push stocks to new all-time highs.  Interestingly, though, we saw some early signs that the market is starting to view the Fed as potentially very slightly “behind the curve” from an inflation standpoint. Meaning, the Fed is remaining incredibly “easy” despite clear signs growth is accelerating and inflation is bottoming. (That’s why bonds couldn’t rally despite the dovish Fed.)

So, the most important thing that happened economically last week was a very slight change in the market’s perception of the Fed.

Starting first with the Fed decision, it was in-line with most analysts’ expectations. However, there definitely was an expectation from some of the market that the Fed would at least hint that it’s starting to consider the normalization of policy. This hint would come via increases in Fed presidents’ projections for the expected Fed Funds rate over the coming years, and decreased unemployment rate forecasts.

That did not happen, however, as the average Fed Funds rate projection by Fed presidents for ’15 and ’16 was increased only slightly, to 1.2% for ’15 and 2.5% for ’16 – so, not enough of an increase over the March estimates to be considered “hawkish.”

Likewise, the expected unemployment rate was reduced only slightly to 6.0%-6.1% for ’14, and 5.4%-5.7% for ’15, but not enough to be considered “hawkish.”

So, the FOMC wasn’t “dovish” because of what the Fed did, but instead because of what it didn’t do.  Still skeptical of the economic recovery, the Fed seems content to ignore the uptick in growth and bottoming of inflation … and the market noticed.

Turning to the actual hard data, all three manufacturing reports further confirmed that the manufacturing sector is recovering:  May industrial production rose 0.6%, meeting estimates.  April’s declines were revised higher.  The first data points from June (Empire State manufacturing survey and Philly Fed manufacturing survey) rose to a 4-year high and 8-month high, respectively.  The New Orders components of each survey, which are leading indicators, surged higher as well.

So, the data continue to imply we’re seeing a strong rebound in the manufacturing sector after the winter dip and inventory depletion.

Finally, the most important piece of data last week was  the May CPI report, which increased +0.4% on the headline and +0.3% for “core” CPI, which is the largest monthly increase since ‘09.  To underscore the point that statistical measures of inflation are starting to move higher, looking at the last three months’ increases in CPI and annualizing them gets us to 2.8% yoy. So, while it can’t be taken as a true indication of inflation trends, it does show how we’ve seen an uptick in the rate of inflation recently.

This Week

Given the increased focus on inflation, the Personal Income and Outlays report this Friday will be the most-important data point this week.  That’s because the Fed’s preferred measure of inflation (Core PCE Price Index) will be released within that report. If we see a decent uptick in that price index, the idea that the Fed is “behind the curve” from an inflation standpoint will gain more traction (which will be positive for gold, and negative for bonds).

Beyond that, the global flash manufacturing PMIs for June hit earlier this morning and we get the U.S. reading later today. This and the Core PCE Price Index are the two most-important numbers to watch this week.

We also get some incremental insight into the economy, as May Durable Goods comes Wednesday, as does the final look at Q1 GDP (which is going to stay shockingly negative, but the market’s moved beyond it at this point).

Finally, we also get more insight into the state of the housing recovery via existing home sales (this morning) and new home sales (tomorrow).  Housing remains the one sector of the economy that hasn’t enjoyed a “bounce” off the winter dip. However, over the last month, the housing metrics have implied that may be changing.

Last week, new home sales was a headline miss but the details were “OK” as single-family permits rose nicely. If May existing and new home sales show continued signs of improvement, worries about the pace of the housing recovery will further recede. This will be a positive for the economy generally and the market.

 

 

 

 

Last Week

Last week ended up being a potentially very important week, but not because of the actual data, which slightly disappointed in the U.S. and came in generally in-line in China (further implying the pace of growth is stabilizing).

The most important event of the week came Friday morning, when Bank of England Governor Marc Carney surprised markets by hinting the BOE could raise rates this year, which is sooner than the market expectation (Q1 2015).  That surprise comment sent the pound nearly 1% higher vs. the dollar and the FTSE down more than 1%.

Carney’s comments matter especially in the context of the Fed meeting this Wednesday.  I’m going to flush this out more in the preview of the FOMC, but if there’s one thing the market seems too “complacent” on, it’s that global central banks are going to keep policy static for quarters to come.

Point being, the stock market has not priced in the Fed suddenly upping the time frame of rate increases or an acceleration of tapering.  If the broader market is as surprised as London was by Carney, and the prospects of a rate increase become more real, that will be a negative on the market.  It’s early yet and Carney just “hinted” at rate increases, but it underscores the point that markets are very complacent about the expectation for monetary policy in the UK and U.S., and that is a source of risk we need to monitor.

Turning now to the actual data, there were only two releases worth covering in the U.S.:  weekly claims and May retail sales, and both were slight misses.

Claims ticked higher to 317K, while retail sales increased in May by 0.3% vs. (E) 0.6%, while the “control” group, which is the best gauge of consumer spending, was flat in May (which reflects an uninspired consumer).  While slightly disappointing, though, the data didn’t change the outlook for the economy going forward (GDP estimates for Q2 remain around 3%).

Finally, China was in focus last week as CPI, PPI, Money Supply, Industrial Production and Retail Sales were released.  All the reports were basically in-line with expectations, which further confirms the pace of economic growth in China is stabilizing and implies the chances of a Chinese “hard landing” continue to get smaller (so, point being, China isn’t a threat to the global rally).

This Week

It gets a bit busier this week from an economics standpoint, with the highlight clearly being the FOMC meeting Wednesday.

First, it’s a meeting with staff projections and a Yellen press conference.  That’s important, because as we saw in March, there is the chance for a “hawkish” surprise in Fed officials’ expectations for the economy, and from Ms. Yellen herself (i.e., the “6 months” comment during the March press conference).  Additionally, given the Carney comments last week, markets will be nervous about anything that might be incrementally more “hawkish” than consensus expectations.

Again, the thing the market seems most-complacent with right now is the outlook for Fed policy, so that’s an area we need to continue to follow, as surprises usually come from things with the most complacency.

Away from the Fed, we get our first look at June economic data via the Empire State Manufacturing Index (this morning), and Philly Fed Index on Thursday.  While neither moves markets the way they used to (given the “flash” PMIs, which will be released a week from today), Empire State and Philly still are important in the context of a market that needs constant re-affirmation that the economic recovery is accelerating.

Also this week we get the first piece of May housing data via Housing Starts on Wednesday.  The April data implied we may finally be seeing a “bounce” in housing like we’ve seen in other sectors of the economy after the winter weakness, so data that further confirm this will be welcomed by the market.

Bottom line is this week will be Fed-dominated, especially in light of the Carney comments.  But, the rest of the week’s data also matter, because the market does need constant proof that the economic recovery in the U.S. is continuing to slowly gain momentum. Multiple pieces of evidence to the contrary will act as a headwind.