Oil Slick

“How did it get so late so soon?” – Dr. Seuss (Theodor Geisel)

Another week of volatility, and you can expect more. This week, however, should see a return to the positive column. Friday was an ugly day, but after China’s latest reports on industrial production and retail sales beat consensus over the weekend, an oversold market should find some breathing room. So long as the Fed doesn’t shock markets on Wednesday (and one should never count too much on the Fed to do anything), stock prices should rebound through the end of options expiration on Friday.

Sell-offs in the first half of December happen more often than not, so last week’s action was no surprise. The major averages are again negative on the year, but not to worry – unless the Fed messes up, the usual upward bias to the second half of the month should begin to reassert itself. We can expect the term “Santa Claus rally” to get tossed around some more, though strictly speaking, the pattern refers to the trading period that begins on the first trading day after Christmas and runs to the day after New Year’s Day.

A couple of events at the end of the week rattled the markets, one being the International Energy Agency’s (IEA) sour outlook for crude. The other, more important news concerned Third Avenue’s Focused Credit Fund, which announced it is closing up and freezing redemptions. Another high-yield fund, this one a Stone Lion hedge fund, also suspended redemptions.

The trouble in high yield bonds has had falling energy prices at its epicenter, with rapidly falling cash flow hurting the outlook for a lot of bonds floated during the boom days of only two or three years ago. The combination of the suspended redemptions and the IEA’s forecast for a continued oil glut into at least late 2016 unsettled markets for good reason – when you see credit market trouble in a mature business cycle, it is never a harbinger of better times.

In the short term, look for stock prices to tack higher on the winds of central bank policy and the upcoming quadruple expiration date on Friday, followed by the typical upward bias to late December. So far as I am concerned, Fed action remains a wild card and I would not be in the least surprised to see the policy committee blink yet again, even if I am in the majority camp of those expecting a token rate increase.

That said, a lot of serious money has already been moving to the sidelines and a lot more of it is going to take serious note of the trouble in the high yield credit markets. We should get the year-end rally in stocks, but I don’t think there will be any conviction behind it. Credit market trouble has a way of spreading over time, and when it does the end of the market cycle starts to gain downward momentum. But the calendar is still friendly and it usually takes no little amount of time for the markets at large to move from buying dips, to trading dips, to selling rallies, to selling everything. We’re still in the calm before the storm, and it could last some time.

The Economic Beat

The report of the week was retail sales, though not for market impact. That may have belonged to the gloomy oil outlook from the IEA, or the weekend reports out of China – had the latter fallen short of consensus (they didn’t), Friday’s selling would likely have rolled over into the following Monday.

November retail sales were up 0.2%, seasonally adjusted (SA), after a tepid October gain of only 0.1% that was revised slightly downward. The usual apologists dialed in first on ex-auto sales, up 0.4%, and ex-auto, ex-gas sales (+0.5%). What matters for the direction of the economy is total spending, not month-to-month mix changes. Year-to-date sales are up only 2%, and the November year-on-year increase of only 1.4% (not adjusted) is the month’s weakest comparable performance in six years. The eventual disappearance of growth is simply a natural part of the cycle.

Falling gas prices have not helped spending, as many mistakenly assumed – they don’t change total spending, only the mix. In order to spend more dollars you need to have more dollars, either from income or borrowing. Personal income growth has been languishing just above 2% and as for borrowing, apart from cars, we haven’t tried to reach for more goods by raising our borrowing rates.

Weekly retail sales showed a return to the anemic pre-Thanksgiving sales pattern. If history is a guide, however, December sales could rise to the occasion. Though the growth momentum in the economy has nearly vanished, we are nonetheless operating at full employment and Americans tend to dig into the wallet at such times. We didn’t in November – the year-on-year gain for the month was surprisingly weak – but one would assume (or hope) that they will do so in December.

Gloomier news came from wholesale sales and inventories, which had a negative year-on-year sales comparison (-5.8%) for the tenth consecutive month. Trailing-twelve-month sales are off by 2.75%, the worst rate in over five years. Business inventories were revised downward for September, which will add downward pressure to the next revision of third-quarter GDP and inventory build was flat for October. Inventories are still too high and can be expected to be a drag on GDP this quarter and next.

The news in employment showed a little softening. The Labor Market conditions index used by the Fed fell to 0.5 in November, with October revised upward from 1.6 to 2.2 (reflecting the upward revision to October payrolls), so it may be premature to judge the current number, though it should still show some decline. The labor turnover report (JOLTS) for October continued the same story it’s been telling for months now – while job openings are up substantially, job hires are unchanged. Finally, weekly claims spiked to a rate of 282,000 (SA). One week does not a trend make, but I suspect that the good news in claims is nearly over and we are on our way to seeing year-on-year gains disappear.

Inflation did not exactly rear its ugly head, but deflationary trends did moderate in the latest reports. One can only imagine what will happen when the business cycle ends, as end it must. Year-on-year changes in import prices improved from (-10.5%) to (-9.4%) in November, with export prices going from (-6.7%) to (-6.3%). With oil prices falling again this month, the improvement is going to be short-lived. Over in the land of producer prices, the index (PPI) jumped 0.3% in November on the back of increases in prices for services, improving the year-on-year overall rate from (-1.6%) to (-1.1%). Excluding food and energy, prices are estimated to have been up 0.5% for the last twelve months, an uptick from the 0.1% increase recorded in October.

Next week will be all about the sacred Fed meeting, which comes complete with a quarterly news conference and updated FOMC (policy committee) forecasts. The central bank seems to have backed itself into a corner with expectations for a rate increase and yet another postponement might well rattle the markets as a sign of weakness. Such a reaction would probably not last long and be followed by frenzied buying, but who am I to say what the market will do in the wake of FOMC announcements. My guess is that if the Fed does as expected, markets should rally, helped along by the options expiration on Friday.

Going into the meeting, the Fed will have had a decent November employment report, a so-so retail sales report, an Atlanta Fed current GDP tracker hovering around 1.9% and fresh reports on housing starts, industrial production, producer, consumer and trade prices and the latest two business and manufacturing surveys from the New York and Philadelphia Fed regions – New York, which has been quite weak, releases its results on Tuesday and Philadelphia on Thursday, though the policy committee will surely have all the results in hand when it begins deliberations on Tuesday. I don’t exclude the Fed blinking yet again if the news appears weaker than expected, but it might take disappointments across the board.

Housing sentiment is Tuesday after the New York Fed survey, housing starts Wednesday morning followed by industrial production (all to be obliterated by the Fed decision), Philadelphia Fed is Thursday and Friday sees the quarterly quadruple expiration.

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