“Oh treacherous villains! What are you there?” – Iago, in William Shakespeare’s Othello
Was the first quarter all a dream? It may have been for the stock market, which followed a steep twenty-percent swoon last summer with an improbable six-month momentum rally of twenty-six percent, topped off by the strongest first quarter in fourteen years. Yet for all that, after last week we are only a percent away on the S&P 500 from being right back to where we were when it all started a year ago next week.
It’s no wonder that retail investors are flocking to bonds. We noticed not a few equity fund managers last quarter confidently proclaiming their eagerness to buy any five-percent dip, and they’ll probably have their chance next week. If they can, that is, as the Investment Company Institute reported yet another outflow from stock funds in the first quarter, this time to the tune of $8.6 billion.
The week had a promising beginning, helped along by calendar-based trading and a surprise improvement in the ISM report Tuesday. Yet there was an unexpected development to go with that rally, in that prices sold off considerably in the last hours. The pattern for months has been for a persistent bid to show up on weakness, including the day before when prices managed a closing-minutes push back. The somewhat uncharacteristic fade on Tuesday was repeated on Friday, when the disappointing jobs report led to losses becoming steeper as the day drew to an end.
Much of that could be tied to Europe. Anxiety about the elections on Sunday – a Socialist on tap to win in France, and a totally fragmented outcome appearing likely in Greece – could easily have motivated a Friday desire to close out long positions going into the weekend. But Europe anxiety may have been linked to the Tuesday fade as well, as a steady stream of weak economic data continues to emanate from the continent. With the weekend elections in plain view, it may have prompted extra vigilance on taking quick profits.
Many of you may recall that as credit markets disintegrated in 2008 and holes began to appear in bank balance sheets, at one point a proposal was floated for a “super-SIV.” SIVs, or Structured Investment Vehicles, were off-balance sheet entities stuffed with mortgage-related paper that were calling into question the health of some banks, most prominently Citibank (C). A kind of good-bank bad-bank theory was to create a super-SIV that would be stocked with SIVs and sold off to investors. It never got off the ground.
Spain might do well to review the episode. Last week the country was talking up a similar solution for the disturbingly weak mortgage book its banks have, with the notion that, perhaps like the Fed’s “Maiden Lane” vehicles, all that bad stuff could be put into one place and later sold. The goal would be the same: build a firewall around the bad banks.
But the reason the super-SIV failed and the Maiden Lane entities worked is that the super-SIV, like the Spanish solution, envisioned pooling a collection of SIVs from various banks and then selling it to private investors. The banks ran into intractable problems, though, the first being the realization that putting in existing SIVs at anything approaching fair market value would backfire when the market was faced with proof of how cheap the paper really was – and by extension, how stressed the balance sheets were. Then there was the problem of valuing my paper versus your paper, how to sort out gains and losses, and the fact that the Fed wasn’t interested in guaranteeing losses in order to sell it while the profits would revert to the banks.
The Fed’s Maiden Lane vehicles, by contrast, involved single companies – first Bear Stearns, then AIG – and the central bank keeping the details close to its vest, indispensable for avoiding further panic. But the Spanish government buying the bad loans or otherwise guaranteeing them, voluntarily or not, is precisely what the market fears. Putting an arms-length market price on the paper in order to entice private buyers would raise the same problem that the Citi consortium faced. We’re sure plenty of traders remember.
The problem with Friday’s jobs report was not only was it a lot weaker than expected, but ironically, not weak enough either. As we pointed out on Seeking Alpha last week, a really big miss, something in the low five figures, would probably have induced a rally on the grounds that QE-3 was in the bag. Those kinds of rallies are beloved by traders, not only because they crush the spirit of short-sellers and catch many others wrong-footed, but after a decent interval one turns around and sells it all back to the suckers.
The Fed can cushion, it can lubricate, it can slow, but it cannot create prosperity. It can try to create the conditions for it, but it can’t hire a nation and put it back to work. Like our elected leaders, it does have the capability to bring on disaster, but that’s the nature of the beast – creating a panic in a room is much easier than ensuring that everyone is happy, So it goes with the financial system.
Look for the selling to continue into the beginning of the week. In the first place, there is little coming on the calendar before Cisco’s (CSCO) earnings report Wednesday evening. That tends to favor the current trend, namely down. The European election results look set to add to the tension on Monday, though one cannot exclude a perverse “growth is returning” rally if anti-austerity, French socialist candidate Francois Hollande is elected. Imagine that irony – a Socialist victory rallying the markets! Larry Kudlow might not ever recover.
The job market is following a pattern remarkably similar to last year – exactly what many are worried about. The change in unadjusted non-farm payrolls from December 2010 through April 2011 was plus 2,000. The change in 2012, pre-revision, is also plus 2,000. Even with a positive revision, it’s likely that the percentage change would remain identical (in case you’re wondering – in real terms, about 2% of the workforce leaves their position in January and the vacancies are refilled over the ensuing months. Seasonal adjustments smooth out the volatility). Weekly claims improved, but the drop in actual claims from the first week (reflecting end-of-quarter layoffs) to the final week of the month was almost identical to April 2011. That’s a lot of similarity.
Positive revisions were a plus in the April report, with 19,000 added to February and 34,000 to March (though further undermining the case for QE-3). That left some instant commentators assuming another such revision was in the bag, and that the consensus of 165,000 would eventually prove to have been right, with some of the difference being warm-weather payback and the rest added later.
Whether or not such a revision is certain, the employment market is easing. Additions to non-farm payrolls for the first four months of the year are, in thousands, 279, 259, 154 and 115. It would obviously take a very large revision to raise April past March. The household survey – the one that everyone likes to talk about when it’s higher than the payrolls number – actually showed a decline of 169k.
The average workweek has barely moved: 34.5 hours in April, the same as March, down a tenth from February and up only one tenth from April 2011. No pressure there. Average weekly earnings are down from February, and goods production eased to a gain of 14,000 in April, the lowest since November and lower than the year-ago month (39k).
However, we don’t see the report as presaging recession. Our view for some months has been that the employment market has largely been in low-growth equilibrium. The pulses around the central tendency are meaningful only insofar as they overexcite the markets (though that is hardly new), or make the Fed staff look bad with endless wrong revisions to their outlook. While GDP should plod on, eventually leading hiring to shift a gear up again, it’s likely such increases will remain transient.
The declining participation rate – the lowest since 1981, on the off chance that you haven’t read that scandalous fact already – is a problem. It is partly a reflection of demographics, and partly a reflection of how difficult it is for the longer-term unemployed and the never-yet-employed to get hired. The former group is stagnant, the latter grows naturally, and so the participation rate falls.
Personal income rose a bit more than expected in March but spending a bit less, the latter helping to keep a lid on the market on the last day of the month. That said, growth in real personal income in the first quarter was only 0.4% against 2.5% in Q1 2011, and real disposable income grew only 0.1% versus 0.3%. It’s going to be difficult for a consumption-dominated economy to accelerate with such sluggish income growth.
Productivity fell in the first quarter, leading many to hopefully speculate that employers will be forced to hire, but take that idea with a grain of salt. The fall had more to do with a slowing of output that was not immediately matched with a cut in labor, and is likely to be a transitory effect. Employers hire because sales are growing, period. It isn’t because productivity ratios are falling, or any other excuse made up to advance a theory about how the world ought to work. It’s only when employers need the extra inputs.
Same-store sales were on the disappointing side. It’s a shade ominous, as the small group remaining that still reports (only 18 companies) is upwardly biased: most chains stop reporting after comparisons become challenging. The combined March-April increase (to account for Easter) was lower than a year ago (4.5% vs. 6.4%). The weekly reports, though, were completely at odds, so perhaps it’ll be an average month.
The ISM survey reports were a big factor in the week’s volatility. The manufacturing survey on Monday was a positive surprise and was puzzling in some ways because the increase to 54.8 was at odds with a batch of recent regional reports, particularly Chicago. The components were satisfactory too, with new orders increasing to 58.2 and the number of sectors reporting growth a robust 16 out of 18. There were a couple of cautionary comments, but it was a sound report, and the occurrence on the first day of the month helped ignite a nice rally, though it lacked finishing power.
The production picture got another improvement from the March factory orders report. It showed an atypical decline, but the good part was the revision to business investment spending, from the (-0.8%) initial estimate to (-0.1%).
The non-manufacturing report, however, was a clear miss at 53.5, down from 56 in March and the lowest since October. Be careful with diffusion reports: the economy could grow nicely for a long time at 53.5, so it was no disaster. But the timing was lethal, coming the day after the ADP payrolls report and some weak European data had reawakened fears of a slowing economy (did anyone notice that the ADP report, roundly trashed on Wednesday as being unreliable, wasn’t mentioned on Friday despite having been dead-on?). The part that concerned us was less the drop in new orders, which aren’t so significant in services, but the major drop in prices, a more sensitive indicator of demand. Though the category is volatile, a ten-point fall (63.9 to 53.6) is a rare sight for any category.
The domestic calendar is light next week, a circumstance that favors short-term continuation of the current downward trend. There’s consumer credit Monday afternoon, small business optimism Tuesday, trade data Thursday and the PPI on Friday. A datum we’ll be looking at with care is wholesale inventories for March, which are released Wednesday. Not a market-mover, but a good clue to where investment is headed going into the second quarter.
The spotlight next week should thus be on the European elections and Chinese data. The latter will release its trade balance, price indices, retail sales and industrial production data over Wednesday and Thursday, and you can bet traders will be looking for further clues to where the global economy is heading. Some are already predicting weak data that would lead to another relaxation in reserve requirements for banks and thereby spur lending. It’s just possible that the numbers might be ever so slightly refined by the authorities. Stay tuned.