“This economic healing will take a while, and there may be setbacks along the way.” – Ben Bernanke’s address at Jackson Hole, August 26 2011
It’s only fitting that the final week of August was punctuated with a hurricane ranging along the Eastern seaboard, bringing high winds and torrents of rain that matched the drenching investors have taken over the last month. It’s perhaps more fitting as a metaphor when one considers the degree of alarm to the reality of the actual event: while cities such as New York City and Boston virtually shut down in preparation, the former marked by widespread evacuations, Hurricane Irene lost most of its punch on its way to the Northeast. Tropical Storm Irene will be quickly forgotten.
Such is the usual fate of hurricanes that manage to make their way up to the area north of the Hudson River: our various weather services and channels work themselves into a state of frenzied anticipation at the prospect of covering the story of a lifetime. Comparisons to the really big ones of yore are inevitably brought up, along with mandatory interviews of grizzled veterans of earlier storms. Newspeople scour the coasts, hoping to find people who – with any luck – will meet a tragic, dramatic end, pumping up ratings and making shooting stars out of reporters lucky enough to bag the heartbreaking story.
Except that as the hurricanes mosey their way across the cooler waters, they typically lose the energy that their tropical homes bestowed upon them. Morphing instead into tropical storms or fizzling out even more, they become no more destructive than a garden-variety summer thunderstorm. There’s lots of wind and rain, to be sure, and the usual damage coming from falling trees that knock down power lines and crush the odd car, leaving behind a few unlucky victims and a not-inconsiderable number of homes without power. But they don’t do damage on the grand scale – to the disappointment of many a Phil Connors (Bill Murray’s shallow weatherman in Groundhog Day) and their bosses.
The stock market and its pilot fish, the commodity markets, have been tracing a similar path. The storm clouds began with an overly optimistic momentum trade in stock prices – i.e., a mass of hot air – colliding with the frigid air, namely the zealous band of yahoos in Congress bent on using the debt ceiling process as an occasion to teach us all a stern lesson, a really, really stern lesson. The first big flash of lightning to terrify the anxious herd came when the second-quarter GDP estimate was released on July 29th, followed in rapid order by a weakening ISM survey and a Treasury ratings downgrade (have you ever seen a ratings agency work so hard to dig its own grave?).
The media has followed in step, printing up giant-type headlines harkening comparisons to 2008 and eagerly talking about another crash. You can’t blame it all on the fifth estate, but helping to stampede investors into fleeing mutual funds and selling out at market lows hasn’t helped the situation. It’s also given some clever-boots more fuel in a shot at trying to emulate John Paulson, the hedge-fund manager who rocketed to fame on short bets against the US subprime mortgage market, netting him and his investors billions in profits.
The success of such a trade always spawns a lot of copycat trades on the Street. In the first quarter of 2009, some hedge funds leaned relentlessly on financials in the credit default swap (CDS) market, where Paulson made his bets against mortgages. They would bid up CDS prices, which insure against bond defaults, and eventually one of the sellers in the CDS chain would lay off risk by shorting the stock of the institution, or buying put options and getting the dealer to do the job for them. Then the hedgies would give interviews or call journalists with lurid tales of how the banks were about to go under. From a trading point of view, it worked quite well until that fateful March day when the banks revealed that they would make a profit for the quarter. Stock prices shot up, setting off a short squeeze and forcing the CDS holders to cash out.
Now we are faced with a similar situation in Europe. CDS prices are being bid up on European banks as certain traders hope to score a massive kill, cash in a megabillion dollar profit and then write a book about it. The European authorities have shown their ignorance of the problem with such inept responses as banning the short sale of financial stocks in France and Germany (which only drives the trades elsewhere), rather than getting the international community to prohibit the purchase of “naked” CDS in most situations (CDS were developed as a way to hedge the risk of owning a bond; a “naked” CDS is where the buyer doesn’t own the underlying bond and is only speculating).
The problem is exacerbated in Europe by an age-old social divide that ranks ministers well above traders and the latter somewhere below cattle. The gulf is difficult for Yanks to understand, given our less stratified society, but it is very real and has people like German Chancellor Angela Merkel as the latest example in a long line of European ministers taking such affront at being called out by their social inferiors that they are unable to discern the growing chaos around them (it’s probably also safe to say the Teutonic preference for carefully ordered structure may serve them quite well in some circumstances, but less so when conditions are in flux). They will probably only act when faced with the abyss.
We were gratified to see last week’s rally, in spite of our misgivings, but we may have only passed through the eye of the storm. Wednesday saw the Bernanke-saves-us rally, Thursday the what-if-he-doesn’t selloff, and Friday was a good old options expiration day: time to bid up prices and burn all those puts bought in the last two weeks. Yes, the chairman hinted the Fed could take further action, but that’s part of the job description, like the Treasury secretary backing a strong dollar.
While the markets were guilty of excess optimism in the first half of the year, they are now swinging back to excess pessimism, which can create its own negative-feedback loop. Given the events coming up in the next couple of weeks – the U.S. jobs report, another Fed meeting (this time with higher expectations and an extra day’s duration), the next ECB meeting, the German vote on the financial stability fund (currently slated for September 23rd), an expected jobs speech by President Obama – we could see some widely divergent outcomes.
Thursday is the first day of September, and while the markets may well want to bid adieu to the traditionally difficult month of August, we are loathe to say goodbye to summer. Still, it does have the consolation of giving us Yanks a holiday: all US markets will be closed on Monday, September 5th in honor of Labor Day.
The Economic Beat
The report of the week for us was the second estimate of second-quarter GDP. It missed estimates by a tenth, something that might have frightened a high-priced market but made little impact on the current state of affairs. We had a chance to study the report in some death, and drew some interesting inferences.
The first is that while output has slowed, it hasn’t dried up as dramatically as the headlines would suggest. In fact, we would go so far as to say that given the levels of unemployment and under-utilization, the current-dollar output of GDP the last two quarters (3.1% and 3.5% annualized, respectively) has been surprisingly good, all things considered. The stronger acceleration of inventory rebuild that characterized the first three quarters of last year has subsided to lower levels. That’s consistent with our view that the inventory cycle is running in a dampened state compared to years past, with lower highs and higher lows.
The less volatile inventory cycle can be attributed to a) a much smaller manufacturing sector; b) the higher levels of slack in our productive inputs, especially labor, but also c) better inventory management. Given the last and especially the first reasons, we just aren’t going to have the kinds of recoveries characteristic of the post-WWII period.
The real GDP numbers are being held down by the increase in the GDP deflators, which are running at levels about double a year ago. This is primarily due to the rise in the price of oil, also the most important price component in the production of food. This brings up a recurring theme with us: given the post-crash nature of credit and interest rates, one of the only areas to make leveraged bets is in commodities (forget about levered ETFs).
The struggle to produce double-digit and/or market-beating returns means that neither the stock market nor the economy can get going without speculators rushing in to send commodity prices up even faster, above all oil prices. A policy issue the government can and should address is to raise margin limits to 50% on oil contracts and leave them there. Otherwise, the price of oil will act as an automatic governor on the economy’s speed, systematically rising fast enough to choke off any and every recovery. Despite the many idiotic comments by Wall Street analysts trying to talk up puny decreases in gasoline prices from recent peaks as some kind of boon to the consumer, they remain well above year-ago levels.
A growing split-speed nature in our economy is becoming evident in the regional Fed manufacturing indices. The middle regions of the country, served by the Chicago, Kansas City and Dallas Feds, are reporting fairly good manufacturing numbers, bolstered by autos and strength in food and energy prices. Kansas City reported no change in its growth index last week, in contrast to the Richmond index, which dropped sharply to a minus-10 reading. Those areas that are more dependent on exporting higher value-added goods, such as New York and Philadelphia, are suffering from the pullback in trade.
Both exports and imports fell in the GDP report, something that speaks to the daft race for austerity around the world. In the 1930s countries tried to resurrect home markets by erecting various trade barriers, including tariffs, that were ruinous to global trade. It seems that the modern variant is to protect home sovereign ratings with austerity programs that drag economies down further. Give that the most significant contribution to deficits around the globe is far and away the slumping economy, the size of the disconnect is startling.
New orders for durable goods rose strongly (+4.0%) in July, but the markets were understandably underwhelmed by the fact that most of the increase came from Boeing. Excluding transportation, the increase was 0.7%, and the business investment category actually fell by (-1.5%). Our take is that while the latter number isn’t great, durable goods are quite volatile from month-to-month and the year-on-year number for both overall new orders (+9.8%) and business investment (+11.8%) are still good. Anyone who thinks that the latter category is going to keep rising every month in our post-credit-crash world isn’t keeping up with the program.
Vanishing confidence could mean a further slowdown, we are well aware, touched off by the falling stock market. The upside to the pause is that it may embolden political leaders to propose something more courageous than repeating political cant while hoping that central banks can do all the heavy lifting. Bernanke’s remarks last week certainly indicate what many economists already know – central banks can’t do it all on their own.
Fallen confidence is certainly a news item right now, with the University of Michigan repeating its dismal performance in its final August reading of 55.7 and the Conference Board due to report another stinker this Tuesday. Still, both readings are off recent lows, along with other measures as stock prices recovered a bit. Yet weekly claims edged back up a bit last week, due no doubt to the caution induced by the falling markets.
The bad news in new home sales is that they fell back below the 300k rate in July and both June and May were revised downward. The good news is that the supply of new homes available for sale sets a new post-Depression low every month, and when conditions in markets begin to ease the sector is going to see quite a rebound. Next month marks three years since the crash and five years of falling home sales; it’s been a long readjustment period from the bubble but time is healing the wound. Federal lending data reported another month of price increase in July, which is encouraging, but we think mix is largely responsible. Recent data from the Mortgage Bankers’ Association indicate another slowdown in purchase applications, as headlines threw a scare into buyers.
Next week is loaded. The redeeming aspect is that when a week is as heavy with data as next week, it tends to overwhelm the markets ability to digest the news and so they tend not to make pronounced moves in either direction. That said, if both the ISM manufacturing survey (Thursday) and the jobs report on Friday throw up big uglies, tendency may matter very little.
Here’s what we’re looking at: Monday will bring July income and spending before the open, and pending home sales and the Dallas Fed survey afterwards.
Tuesday has the aforementioned Conference Board consumer confidence index (consensus a bottom-scraping 52.5), the Case-Shiller price index for existing home sales and in the afternoon, the minutes of the last FOMC meeting. Since there were three dissents at the last meeting, it ought to make for interesting reading.
Wednesday has the Challenger and ADP jobs reports before the open, followed by the Chicago manufacturing survey (PMI) and July factory orders shortly afterward. It’s also the last day of the month, and there could be some weird price action as portfolio managers scramble to dress up the ledgers.
Thursday, the first day of the new month, will see some chain store sales reports for August along with motor vehicle sales, weekly claims of course and the big one looming over the week, the ISM manufacturing survey. Consensus is for a drop to 48.5. It’ll be accompanied by July construction spending.
Friday is the jobs report and the beginning of summer’s last long weekend, Labor Day weekend. We may go into the weekend screaming for relief, and then again we may not. While we are not about to tell you that corporate CEOs are great forecasters, we think it worth noting that many have said that they think the current hysteria is overdone, so there is reason to hope that the current consensus of 65-70.000 new jobs isn’t too high. On the other hand, many of the larger financial and tech companies announced major layoffs last month, and those may start to filter into the system.
Keep in mind again that if the jobs number does turn out to be a lemon, it may at least push our Congressional mutts into finally doing something more than posturing for the next election. Happy Labor Day.