Starting Over

“Between the acting of a dreadful thing and the first motion, all the interim is like a phantasma, or a hideous dream.” – William Shakespeare, Julius Caesar

by M. Kevin Flynn, CFA

Down to the 200-day moving average on the S&P, are we? That has largely been in the cards for a couple of weeks now, and few floor traders were surprised. The Dow Jones Industrial Average is now down on the year, as is the Russell 2000 small-cap index. The yield on the Treasury 10-year bond is at a record low yield of 1.467%, while the German bund is at even lower 1.123%. Maybe the most significant news of all is something nearly entirely overlooked: New insurance cover is being refused for exports to Greece.

If vendors to Greece cannot obtain insurance for credit sales to Greece, then credit sales won’t happen. You may wonder who would extend Greece to credit these days, but most trade is conducted with invoices that are paid within 30 to 60 days. Those are credit sales, and if they can’t happen, the breaking point for the Greek economy gets much closer. The chokehold is not going to be overlooked by EU financial ministers (“fin-mins” in the current jargon) and certainly isn’t going to go unnoticed in Greece, either.

In the light of this development, the mid-June Greek elections and end-of-month EU summit take on more significance, the wait for them more charged. It’s questionable whether the situation can endure until the end of the month. Germany, the EU, and the European Central Bank (ECB) are all going to feel additional pressure to make decisions involving more than scheduling extra meetings.

The silver lining in the pressure is that it moves some of the more stubborn politicians (Angela Merkel comes to mind) off their “markets won’t tell us what to do, we should be telling them what to do” mentality. The risk, as always, is that decisions made under stress and fatigue are not always optimal (cf. Lehman Brothers & Hank Paulson). We have noticed increasing talk, both here and abroad, about a Greek exit being priced in and the markets already prepared. That is wrong on both counts, but it doesn’t seem as if any of the principal European actors are buying into it, and both Treasury Secretary Tim Geithner and Fed Chairman Ben Bernanke are firmly on the other side.

Here’s another silver lining: although the headlines and media reports this weekend after a less-than-stellar jobs report sound as if the Grim Reaper is at the back door, the situation could work very much to advantage. In the first place, the employment situation and jobs report aren’t as weak as they appeared (see the Beat, below), and in the second place, the headlines will nevertheless deepen concerns for both the Europeans and the Chinese. The gloom should push them into considering additional action (we don’t expect our own politicians to move from their impasse until after the election, at the earliest).

The official Chinese PMI (Purchasing Manager Index) fell to 50.4, while the privately calculated (and more widely believed) HSBC-Markit result dropped to 48.4. Brazil has posted two months in a row of negative PMI, while the latest eurozone, UK and German readings all have 45-handles, the euro area posting a decline for the 10th month in a row. Spanish 10-year yields are climbing steadily towards 7% and Italian ones back towards 6%. It’s no wonder investors are crowding into safer assets.

Equities could go lower. The market is oversold, but not as much as it was last August. One reason we may not reach such levels this time is that the politicians were on vacation in August. In normal times, this is considered a good thing, but not so much during a crisis, when leadership is needed. We would be quite careful about selling anything now, because any hint of good news in Europe is going to provoke a violent reaction to the upside.

As for the U.S., it’s a given that nothing is going to come out of our electoral body until the end of the year; at least there are no expectations to manage or disappoint. The Federal Reserve meets in about two weeks, though, and the talk about further Fed action is picking up. Many already consider some additional impetus to be a done deal.

Yet our own manufacturing seems to be holding up, and equities are close to flat on the year. That doesn’t seem like much of a basis for action. The additional data points that the Fed will have to consider before the meeting are, besides a couple more weekly claims reports, the ISM non-manufacturing survey this Tuesday, and May retail sales, inflation, and housing starts. Of course there is also Europe, including the ECB announcement on Wednesday and the Greek elections the weekend before the Fed meeting. We would expect that all of it would have to be weak before the Fed moves again.

The Economic Beat

The May report was not a great one, but perhaps its biggest sin was that it was a wide miss of expectations. Employment data tends to lag changes in the economy, so one consolation is that the slowdown in hiring may be in part attributable to the winter warm-weather effect of fewer jobs being shed in January, February and March – and also to May 2010 (read on).

Pundits are busy people, hurtling from phone call to interview to phone call, and as a result the initial take on fresh data tends to be a shoot-from-the-hip style that doesn’t leave time for analyzing real data. As we are not overly pursued by television journalists – a mystery we cannot fully explain – we had the time for such analysis, and some observations to make that may cheer you that the world may not be, in fact, going to that four-letter place beginning with “H.”

First the not-so-great stuff: the non-farm payroll increase of 69,000 was less than half the expected number of about 150,000; downward revisions of (-55,000) to the previous two months, themselves shy of expectations at the time of release; weekly hours were unchanged, weekly earnings fell and the weekly aggregate payroll index shed a tenth; the increase of the last three months can entirely be accounted for by part-time workers. Long-term unemployment (greater than 26 weeks) increased.

It’s safe to say that the job market is not accelerating. However, we wouldn’t say it’s doing all that badly either, more that it’s chugging along at steady-but-slow rates. Some of the headline data were hurt by seasonal factors and perhaps a lingering after-effect of the warm winter weather. Construction, for example, is showing three consecutive months of losses that net to (-47,000), despite increases in spending of +0.3% for the last two months. That could well be a seasonal distortion: with fewer workers sidelined by winter weather in what are usually the cold and dark months, fewer are added back in the spring and the adjustment factor converts the total to a decline.

Some of the brighter spots: the unemployment rate amongst the college-degreed fell to 3.9%, which is really quite low. The participation rate picked up a couple of ticks for the first time in a while, explaining the one-tenth increase in the unemployment rate. Transportation and warehousing jobs, which have some leading indicator value, were reported to have healthy increases. The household survey showed an increase of 422,000.

Looking deeper into the data produces some interesting facts. The unadjusted, or actual increase in May non-farm payrolls was 789,000 jobs. The May average going back to 1980 is 780,000. Adjusting for the size of the work force, the average increase for May as a percentage of the April workforce is 0.703% since 1980; last month was 0.601%. That is admittedly a little below average, but since the year 2000 the average is a more modest 0.586%. In 2006, the May increase was 0.603%, nearly identical to this year (and also four years out fromd recession).

It’s been a low-growth decade for jobs, so we don’t want to be exuberant over modest data, but the reality is that the 2012 May unadjusted increase is better than last year (+649k). The year-over-year percentage increase in May payrolls (unadjusted) was 1.29%, versus the 1981-2012 average of 1.24% and last year’s increase of 1.18%. However, the May 2010 increase was 1,120k, the strongest May since 1996 (absolute) or 1998 (percentage), and that outlier is undoubtedly weighing on the seasonal adjustment factor.

The job market is neither strong nor weak. The April over December change in real employment (leaving out seasonal adjustments) dropped to a minus 27,000 after the revisions, which isn’t a sign of a booming market, but not a terrible either. A modest negative is no death knell, and some good years for the market and the economy (e.g., 1995-1996) have produced weaker changes. The May numbers are better than the Bureau’s report.

For that matter, April had an increase of 857,000 in the unadjusted monthly payroll series, which helps explain the modest increases in personal income (+0.2%) and spending (+0.3%) for the month. Real disposable income was up 0.6% from a year ago, which isn’t much but is an improvement and the best since October. The year-on-year increase in real spending (PCE) was 2.1%, the best since September. However, the April 2010 increase in unadjusted, non-farm payrolls was 1,129,000, more than 25% higher than April 2012, and that goes a long way to explaining why the April adjusted increase only comes out to 77,000.

The instant explanations of real spending (5.2% annualized rate in the first quarter) outpacing real income (3.4% Q1 annualized rate) are usually that Americans are dipping into their saving, and in particular wealthy American are liquidating assets to maintain spending. May income was up 0.2%, while spending up 0.3%. But we think there’s a simpler explanation: auto sales.

The American car fleet is at near-record age levels, and credit is widely available at low rates. So we are replacing our older cars with new ones. The quarterly increase in real spending in the first quarter of 2012 was about $63 billion dollars, and about $46 billion was spent on buying new motor vehicles. Not all of the vehicle total comes from consumers, but we reckon enough of it is to fill the gap between spending and income. It isn’t that we’re dipping into our savings or spending money we don’t have, it’s that we’re buying more cars than we did a year ago and taking advantage of attractive terms. That isn’t a warning sign of a struggling consumer. New car sales in May were ahead of expectations.

The ISM manufacturing release was a mixed bag. At 53.0, it still indicates expansion and the fact that it missed the consensus of 53.5 isn’t terribly significant, except perhaps on days when the jobs report has come up short. New orders were reported as increasing somewhat to a robust 60.1, “the best since April 2011,” but take that number with a big dose of seasonal salt. The percentage of respondents reporting increases fell from 41% to 37%, decreases rose from 11% to 14%, and the net fell from +30 to +23. That big April 2011 number also turned out to be a worthless indicator of the ensuing months.

Prices are a better real-time leading indicator, and the drop there was stunning, from 61 to a contracting 47.5 (50 is neutral). In an above-average economy, there are at most one or two sectors reporting lower prices and quite often none, but last month the score was nine reporting decreases against six increases.

Yet the responder comments were broadly positive, and 13 out of 18 sectors reported expanding conditions. It’s hard to know what to make of it, but the Dallas Fed did report a decline in its survey, and the Chicago PMI was a disappointment too, coming in at 52.7 versus 56.2 in April and expectations for 56.1. New orders in Chicago were at its lowest rate of increase since September 2009. Both reports had good readings in employment, though. Caution is setting in, as evidenced by the Conference Board’s confidence report (an unexpected big decline) and other data.

Caution is setting in other areas too: the weekly chain store sales series are talking about a negative May, and so are the weekly mortgage data. We don’t have to tell you about the stock market. But auto sales are holding up fairly well, with the domestic manufacturers putting up good numbers in May: remember that 3.9% unemployment rate for the college-degreed, and consider also that the unemployment rate for the over-25 population is a more reasonable 6.9%. The headlines about the stock market and Greece are taking a psychological toll, of that you may be sure, but the damage could pass quickly – or worsen, if policymakers privilege ideology over pragmatism.

Next week will slow down on the data side, at least domestically. Factory orders for April are due on Monday, and will be struggling to overcome a weak durable goods report. The highlight of the week for us, though, will be the ISM non-manufacturing report on Tuesday, and from Europe, EU retail sales and PMI services Tuesday morning and above all the ECB policy statement on Wednesday morning. Chairman Mario Draghi will be doing his press conference and taking questions during market hours, late afternoon European time and morning for American markets, plenty of time to react for better or worse.

There are hopes for an interest rate cut, or more repurchase operations, or something, or anything from the ECB. An announcement of more easing could set off a violent relief rally; no change will continue the selling pressure on equities and periphery sovereign bonds. Volatility could get another boost from the Beige Book report on regional business conditions later that afternoon. It probably won’t have any surprises, but prices often bounce on a phrase or two anyway. It’ll be a volatile month, let’s hope it’s not hideous.

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