No Man’s Land


“We’re on the road to nowhere.” – Talking Heads

by M. Kevin Flynn, CFA

Alas for the stock market, the jobs report was neither hot nor cold. A big beat would have brought renewed confidence in the U.S. recovery, while a big miss could have inspired a “Fed is sure to help us now” rally. You may indeed already have read this elsewhere, as the weekend press is filled with similar lamentations and speculation.

Also problematic for the stock market was the European Central Bank announcement on Thursday being similarly tepid. The markets had hoped for a rate cut as large as half a point and some extra accommodation to go with it – secondary bond buying, perhaps, or even another Long-Term Refinance Operation (LTRO) along the lines of last year. What it got was a cut of a quarter-point and a trim of the bank deposit rate to zero. The latter is designed to help push the banks into lending, but in the circumstances it may do little more than further pressure bank margins.

In economic terms, we are steadily sinking into the mud between the trenches. The jobs report fell into no man’s land. The ECB action fell into no man’s land. The global economy needs policymakers to reach out with a stick and pull us out, but the response has instead been a series of sticks that are either too short, or exist in name only. We are beset with help proposals that range from sober to daffy, and generally have the common thread that they all lie somewhere over the rainbow and someone else should pay for them.

That’s not to say that there aren’t serious, substantive proposals out there that involve the need to clean up Europe’s financial debt mess and recapitalize the system – and do it with all due speed. They’re just not getting much of a hearing in the EU’s largest economy, Germany, or its relatively well-positioned allies – the Netherlands, Finland, Austria et al. It appears that until the recession starts to arrive on their own doorsteps, they are going to carry on as if recession is a disease peculiar to the south of Europe, to which they themselves are magically immune.

We have now entered a period of heightened fears and hope. Hope disappointed led to the market selling off the last two days of the week, but hopeful rumors of more quantitative easing led the Friday sell-off to recover some of its losses late in the day. With the holiday-week volume being as light as it was (the second lightest day of the year), it’s hard to draw much inference from it. The EU financial minister meeting on Monday may give renewed hopes for more action.

One school of fear is that the multiple central bank actions Thursday morning – the ECB rate cuts, an announced expansion of bond buying by the Bank of England (BOE), a program by the Bank of China that included interest rate cuts and relaxed loan ratios for banks – showed fears by the central banks that things are worse than they are letting on. That is particularly true of actions in China, where rates have fallen by two percentage points in recent weeks.

A tangential current of fear is that the reason that the Fed and ECB did not act with more force at their recent meetings is their concern that things could get much worse, and thus wish to preserve ammunition against that time.

Our thinking is that things in China certainly are worse than the government has let on. Trying to fight the collapse of a bubble by reflating it has not ever really worked, but it can postpone the day of reckoning. As for England and the ECB, it looks to us as if the BOE is trying to contain the damage from the European recession, while the latter is trying to get governments to admit to it. It must be said that aggressive central bank action has to date been largely abused by
elected officials as a pretext for doing little more than quarreling and the deferral of potentially unpopular decisions.

As for the Fed, the combination of the market rallying into the last meeting and economic data that were mildly positive, if not exactly robust, simply didn’t invite further accommodation beyond the continuation of Operation Twist. The ECB is caught between German pressure to stand fast and its own desire for policymakers to take the lead. Probably both banks are worried about keeping some ammo against a potential storm.

The hope trade is certainly out there. Hopes for more easing, hopes for some technical breakouts, hopes for good old days are what’s keeping the markets alive at this point. With the Fed’s next announcement less than a month away, the talk about more easing is likely to be a staple until then. Against the backdrop of earnings season, rumors could make the ongoing game of headline roulette even wilder than usual.

Something unexpected is going to need to come along to keep July out of the red. The last-minute rescue of June’s performance was partly the result of quarter-end window-dressing, but even more the surprise factor of the EU summit meeting issuing a positive-sounding communiqué after markets had given up on it. At the moment, we can’t see anything better for July than hopes of another Fed rescue on August 1st giving a push to the usual attempts to mark up the last few days of the month. ‘Til then, we’re in no-man’s land.

The Economic Beat

Oh, that jobs report. The Bureau of Labor Statistic’s (BLS) initial estimate of 80,000 was almost completely defective as a data point – it came up short of the original consensus of 90,000, short of the last-minute tweak of 100,0000, and short of the encouraging ADP report of 176,000 that had nearly doubled its own consensus and inspired upwardly revised estimates for the Labor Department’s total.

There were some positives – temp hiring picked up, though this particular time it may reflect some Europe-induced caution. The aggregate payroll index rebounded nicely after two months of declines, and the year-on-year gain went back up over 4%. Manufacturing hiring was steady. The household survey, though subject to bigger revisions. reported an increase of 156,000 jobs. The goods production category, while not robust, snapped back nicely from May’s decline (+13k vs. -21k).

The main weakness in the total came from construction, which rebounded only 2,000 from May’s estimated (-35,000); retail trade, which had a small decline; and transportation and warehousing, which declined after a big May gain. Something is amiss with these categories.

The construction spending report released on Monday showed a second consecutive month of strong gains in spending for May (+0.9%), which does not square with the loss of 35,000 jobs reported by the Labor Department. We suspect distorted seasonal factors again, as the mild winter weather meant fewer layoffs and thus fewer returning workers, translating a stable workforce number into first an overstated one and then into a declining one. There hasn’t been any data from homebuilding or commercial real estate that would corroborate the dramatic decline in construction employment – on the contrary, the numbers suggest modest growth. Somebody is miscounting.

The Monster Employment Index, by contrast, showed a strong increase in June, with the strongest jumps ironically being – retail trade and transportation and warehousing, the two weak categories in the BLS report. As we said, there are clearly some kinks in the data.

In addition, as we observed on the Seeking Alpha website, the employment picture is holding up better than the headlines have made it out to be. Not only is the percentage growth in actual jobs (not seasonally adjusted) from the end of January slightly above the average since 1980, but also at the current rate, by the end of the year we could even finally catch back up to the number of people employed in December 2008. Weekly jobless claims data may disperse a bit around the regression line, but that line is showing a steadily consistent 10% improvement over last year.

Factory orders were a bit better than expected, coming in at +0.7% for May with an upward revision to new orders for durable goods. After two months of declines, we were due for a rebound. Against that, the ISM manufacturing index backed off in June. While the reading of 49.7 is not significantly different from an unchanged reading of 50, new orders plunged from a 60.1 reading to 47.8, while prices also experienced a double-digit decline. Exports fell sharply as well, and the growth-contraction tally was an uninspiring seven to nine. Even so, responder comments were not really downbeat, with concerns mostly centered on orders from China and Europe.

The ISM non-manufacturing index slowed to 52.1, a bit lower than expected, and again the responder comments talked about caution and slowing growth rather than decline. Prices, a better indicator than new orders, were virtually unchanged. The growth-to-contraction sector score was a better 12-4.

While car sales were better in June than expected, it appears at this point that retail sales overall were soft again. Considering the headlines over Greece, Europe, China and the severe weather in much of the country, it isn’t surprising. As our own dread builds of the approaching election season and its onslaught of hysterically negative ads, we might add that there is virtually nothing that Obama, Romney or their respective parties can do about any of the foregoing.

The unfortunate truth is that most of the deceleration we’ve seen recently is due to the European slowdown and concerns about a possible global financial meltdown. The presidential campaign issues of adding or subtracting a bit of tax here and regulation there are like a debate over which wax to put on your skis. Faces may turn purple arguing the ideal wax, but most of the run is going to be determined by bigger factors.

Next week is a light schedule for economic data, with probably the most interesting domestic piece being the release of the FOMC minutes on Wednesday afternoon (“Will they ease? Huh, huh, will they?”). There is also consumer credit Monday afternoon, small business optimism on Tuesday and some inflation data (import, export, and producer prices) towards the end of the week.

Some interesting data is due from overseas, with EU June industrial production scheduled for release Thursday morning and Chinese reports on industrial production, retail sales and second-quarter GDP coming Thursday night. It will be interesting to see what the last number is, given the reports swirling in the investment community about the Chinese slowdown being understated by government statistics, and the fact that China’s official GDP data has never enjoyed a reputation for premium accuracy.

The focus should move onto the beginning of earnings season and trying to handicap the odds of more quantitative easing. Alcoa (AA) kicks things off on Monday the 9th. Texas Instruments (TXI) follows on Wednesday, and the week’s highlights come Friday morning before the open: JP Morgan (JPM) and Wells Fargo (WFC).

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