“All for one! One for all! Every man for himself!” – Larry, Moe and Curly (the Three Stooges) in Restless Knights
Some achieve greatness, wrote William Shakespeare, while others are born to it. Still others have it thrust upon them. Then there is the other end of the spectrum, where lemmings rush over cliff edges into the sea, and where a group of small-town Babbitts, stooges and other refugees from a Sinclair Lewis novel hold the full faith and credit of the United States in their dim-witted little hands.
In a year in which many prepared for “The Rapture” only to be disappointed (in case you didn’t know, a version of the end of the world in which the Select would be taken and their undeserving worthless neighbors left behind, preferably pleading for mercy), we now have a congressional contingent that, eyes wide open and arms beatifically spread, seems to believe it can deliver the end of all things after all. How did we ever get here?
Politics being a sensitive issue, we’ll leave that one up to you to decide. We can say this – nobody knows what will happen next week. Sadly enough, we might default. It’s unthinkable, unjustifiable and totally unnecessary. The lesson of the Lehman debacle seems completely lost as our little moths jostle to see who can fly into the flame first. Trouble is, their senseless acts of self-immolation could start a conflagration.
Should we pass the deadline with no deal, our guess is that fixed-income trading will try to proceed as best as it can, begin to slow, and then bit by bit shut down. We’ve no idea how long it would take from slowdown to shutdown and nobody else does either. It’s like trying to predict any panic – one minute everyone standing in place, the next minute total chaos. It could take an hour, a day or a week before things start to break down. There is no good reason to find out, which is not to say that we won’t.
The rest of the world looks on in horror as our runts of the intellect smile their way to disaster. It’s right out of any pulp science-fiction novel; the only thing missing being the zombies. While it may be tempting to speculate that our stooges are in fact zombies, we can dismiss that right out of hand – zombies like to feed on brains, and be assured that a no-brains diet is definitely part of the make-up of our brave warriors.
Apart from that, the economy is slowing. It was slowing anyway, and while it wouldn’t be honest to put the blame on the debt ceiling fiasco, the latter isn’t helping. We could be dealt another body-blow if default should take place, one that takes us right into recession. No doubt our little Babbitts will lay all the blame elsewhere, and go to their graves complaining that the real problem was that we didn’t cut government spending and taxes enough. What a gang of idiots.
As for company earnings, while the press labors away at trying to reassure us that earnings are beating estimates, this is nothing new. Estimates are carefully worked by both the Street and management such that around two-thirds of all companies will beat estimates in almost any given quarter. It doesn’t mean much anymore. What has mattered this season is the number of high-profile slowdowns and the amount of lowered guidance.
That’s not to say that the economy is going to the dogs. So far it isn’t and with a little racing luck next week should still avoid that fate. But it’s not growing as fast as expected either, and that is going to take a toll on estimates. There is also the possibility that the price of raising the debt ceiling is big upfront cuts to government spending, which would beckon recession. The market has begun to react to these possibilities – for the first time since March, traders were no longer able to put on the month-end mark-up rally.
August is always tricky to handicap, this year more than ever. For every version like last year, when fears of the slowdown gashed equity prices, there are one or two that melt up in a senseless sort of low-volume, weather-fueled optimism. The markets are quite likely to rally if a debt ceiling deal gets done, and the first order of the day will be to go short-hunting. That could give us a quick spike that develops its own momentum (and narrative). Backing that possibility is the widespread fear on the Street: sentiment extremes are usually followed by big reversals.
It didn’t work that way last year, though. Prices eroded steadily until Fed Chairman Bernanke emerged from Jackson Hole, Wyoming near the end of the month with the Fed’s second program of monetary stimulus, known far and wide as QE-2. Will the Fed ride to the rescue again? Can it? Would they dare to do so with commodity prices still elevated? Many are already clamoring for something from this year’s conference, set to begin in a few weeks.
It used to be a quiet month for the Street, August. It’s still the traditional vacation month for finance, as well as for Europe, but the cell phones will be turned on this year.
The Economic Beat
It wasn’t a difficult guess last week that the first estimate for second-quarter GDP would be the release of the week so far as the economic calendar went. The downbeat result of +1.3% was well short of the consensus of +1.9%, though the latter was a bit stale and the market was realistically expecting something closer to 1.5%. In either case, it came up short. The big downward revision to the first quarter – from +1.9% all the way down to +0.4% – was a bigger surprise.
The latter result should have had markets down a lot more, but in the sometimes-odd world of the markets and data, the fact that the first quarter revision was part of a large-scale overhaul of GDP data going back to 2003 provided a buffer between the markets and the facts. You see, it was all part of this big revision and who can really tell? For a short time, anyway, traders can share gestures of disbelief and disdain for the government gnomes and engage in what social psychologists like to call “cognitive dissonance:” you don’t see what you don’t want to see (and on Friday, they did want to see the beach).
The government informed us what measures of consumer confidence and sentiment have been telling us – the recession was deeper and the recovery shallower than previously indicated. Consumption is restrained, and final sales subdued. We’ve seen some attempts to pretend that the data was better than it appeared, but there were no real inconsistencies from the total. No need to torture you with a drawn-out analysis: the economy is running at slow speed.
Many hopes still remain for a second-half recovery in the 3-4% percent range, but we don’t see that as being at all likely. While Japanese auto production here can be expected to pick up, it just isn’t going to have that big an impact. Earnings reports from chip and electronics companies have made it pretty clear that business is slowing and nobody (apart from Apple (AAPL), perhaps) has a shortage of inventory. Eventually we will work through it and see some recovery by the fourth quarter, but the rebalancing won’t be enough to save the year (though it could save the markets).
Earnings have held up reasonably well, but we think the second quarter was the peak in this cycle. One of the things helping out the bottom line has been business capital investment: In an environment where sales growth is challenging and cash not a problem, large companies are more incentivized to invest in software and equipment that lowers labor inputs.
Corporations get a tax credit for investment and can spread the cost out over many years, lessening the immediate impact on accounting profits, while labor costs are expensed right away. The employment cost index took a jump up in the second quarter, due more to increased benefit costs rather than wages and salaries. Our take is that the increased benefit costs are partly from some companies resuming retirement plan matching contributions (401-k, for example) and partly from the ever-increasing costs of health insurance.
We aren’t tilting against business capital investment or productivity enhancement; they are necessary for dynamic economic growth. We are only pointing out that a slow-speed economy tends to tilt the balance more to capital inputs than labor inputs, and that reported earnings growth tends to peak alongside the peak in the capital-labor adjustment. This can lead to misconceptions about the underlying economic momentum, in particular the outlooks for growth in employment and demand.
The Chicago Purchasing Manager’s Index (PMI) was widely help up as a sign of vigor in the wake of the GDP report, but it was less than it seemed. Pundits and journalists – perhaps seeking to offset the GDP result – glossed the two headline numbers of 58.8 for the overall reading and 59.4 for new orders (fifty is neutral) and said well, things sure are good in Chicago.
They may be, but the numbers masked what appear to be serious signs of deceleration. The surveys essentially pose a handful of higher-lower-same questions that give little clue to degree of movement. The responses to questions about new orders and backlogs both showed substantial drops in answers of “higher;” with the reason for little change to the scores being that many “lower” answers changed to “same.” No disaster, but definitely pointing to slower underlying momentum and a lower result next month.
In other regions, the Dallas Fed showed improvement (reflecting high oil prices), while the Kansas City version showed a much-lower, if still positive growth result. Richmond reported a minor drop. There seems to be little momentum outside of energy and autos, and the former tends to put the brakes on everything else. The Chicago Fed National Activity Index fell again and is at its lowest level since October 2009.
The consumer sentiment measures reflect the confused and unhappy public. The Conference Board measure of consumer confidence was little changed, from 58.5 to 59.5. The extra point is statistically insignificant and the number itself is a recession-level result. There was no improvement in job sentiment. Also in recession territory was the University of Michigan sentiment reading of 63.7 (the long-run average is above 80).
For about the fifth month in a row, pending home sales rose, this time by 2.4%. This was followed by the usual hopeful comments from people who do not work in the homebuilding industry. Both Pulte (PHM) and DH Horton (DRI) reported last week, and they are only seeing signs of bumping along the bottom. The increases in pending sales have failed this year to convert into real sales increases: new home sales fell again in June. Although the average price increased, this is more likely a reflection of tighter credit and fewer borrowers at lower price points. The Case-Shiller home price measure showed the trailing twelve-month decline deepening, and mortgage purchase applications are at their lowest levels since February. Some pickup.
Durable goods were down in June a bit more than expected, weighed down by aircraft sales. Excluding transportation, they ticked up a tenth, but excluding defense fell 1.8%. The business investment category fell 0.4%, but the number does bounce around in an on-off pattern. The yearly change numbers for manufacturing still look decent; the main problem is that there isn’t enough of it.
Weekly claims fell below the psychologically important 400,000 level, but the catch is that they will almost certainly be revised back up above 400k by next week. Once again the previous week received a substantial revision upwards, and once again the four-week average fell from the same level it fell from a month ago. Revisions mean a drop every week with no real progress.
Next week ought to be interesting, to say the least. Not only do we find out if the stooges wrecked the party for everyone, but the July jobs report is due on Friday – assuming the Bureau of Labor reports to work that day (don’t laugh, because it’s not a given at this point). Before the Tuesday deadline, we’ll get another market favorite, the ISM manufacturing survey on Monday (along with construction spending). It’s a big week.
Tuesday will see monthly income and spending, along with car sales and possibly some improv-theatre from Washington. We could get factory orders on Wednesday (government again), should get the ISM non-manufacturing index on Wednesday (not from the government), upwardly biased same-store sales on Thursday (struggling companies drop out), and the usual teaser job reports from ADP (a big miss last month) and Challenger on Wednesday. The last two may well be taking a distant back seat to bigger headlines.
The earnings calendar is still heavy next week, but most of the top-profile market-movers have come and gone. However, there will be General Motors (GM) reporting on Thursday and Procter and Gamble (PG) on Friday.