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Weekly Review - January 11, 2016

Weekly Review - January 11, 2016

Guest Post - Monday, January 11, 2016

Summary

  • The first batch of economic data on the year was mixed, to a bit disappointing, with ISM manufacturing and non-manufacturing missing expectations, with industrial numbers generally continuing a pattern of recent weakness. The employment report for December, however was quite good and surprised on the upside.
  • Global equity markets experienced their worst start to a year in several decades, losing several percent as a result of concerns over China and energy. Speaking of energy, crude oil dropped to multi-year lows as continued uncertainty surrounded markets. Safe-haven bonds were the sole winning asset class on the week, as investors left risk assets.

Economic Notes

(-) The ISM manufacturing index for December trailed down by almost a half-point to 48.2, which was below the 49.0 reading expected. A few elements in the survey ticked upward, including production, new orders and inventories, while employment fell by several points as did imports. While a dip further into contractionary territory, this index has struggled with inconsistent result throughout 2015, with economists scratching their heads as to whether the cause is a mid-cycle soft patch (as we've seen a few times during the current recovery cycle), an isolated byproduct of dollar strength, due to extreme weakness isolated in the energy/materials area, or signs of the broader multi-year (and already-lengthy) recovery starting to lose steam.

(0) The ISM non-manufacturing survey for December ticked a bit lower by -0.6 to 55.3, falling just short of expectations calling for 56. Most underlying elements of the report were higher, though, including business activity, new orders and employment; while the less-critical segment of supplier deliveries declined, so the overall decline may not be all that meaningful. All-in-all, in looking at the two ISM reports, the most obvious takeaway is the continued weakness of the manufacturing component and strength of services.

(0) Construction spending fell -0.4% in November, contrary to an expected gain of +0.6%. The bulk of the decline appears to have been caused by lower spending by Federal and state/local governments (mostly the former), as residential investment actually gained +0.2% (with the year-over-year gain being near +11%). The Census Bureau also noted a 'processing error' of some sort over the past year that resulted in further revisions upward during the period.

(0) Factory orders fell by -0.2% for November, which was on target with expectations. Wholesale inventories also fell by -0.3%, which was few tenths worse than expected, in addition to a few negative revisions for prior months.

(+) Motor vehicle sales for December fell from a pace of 18.2 mil. seasonally adjusted annualized units to 17.2 mil. For 2015 as a whole, sales reached a new record of 17.5 mil. car/light truck units, a +6% gain over the prior year and surpassing the previous high set 15 years ago. With gasoline prices falling dramatically, heavy pickups and SUVs were a primary recipient of buyer dollars, with an average selling price of $34,428. Lower gas prices and low interest rates have certainly helped matters, but consumers appear to be in better spirits when it comes to durable goods, including cars.

(0) Initial jobless claims for the Jan. 2 ending week fell by -10k to 277k, which was just a touch above the 275k expected. Continuing claims for the Dec. 26 week moved up a bit to 2,230k, which was higher than the 2,200k expected. These measures can get a little unusual with the holiday season and shorter-term employment, but tend to normalize again early in the new year.

(+) The ADP employment report for December showed a gain of +275k jobs, which sharply outperformed expectations calling for +198k. There was a slight revision downward for November, but this was far less significant. Gains appeared to be broad-based, with positive results in both goods and services segments, including construction, manufacturing, and professional/business services. On a negative note, some economists feel the ADP report in December contains more seasonal adjustment assumptions than usual, so perhaps the results should be discounted a bit.

(+) The December employment situation report turned out better than expected, and brought some light to an otherwise dark week. However, much of the positivity was overshadowed by other global factors.

Nonfarm payrolls rose by +292k, surpassing the +200k expected. In addition, jobs for several prior months were revised upward by 50k. Gains were largely in the services areas, such as professional/business services (temp workers were 34k of the group, or about half), but also construction, which added 45k jobs. Interestingly, manufacturing jobs also rose by 8k, despite weaker ISM numbers that point to a soft patch in the manufacturing sector overall.

The unemployment rate ticked upward slightly if one is tracking it at a basis point level, but remained unchanged in conventional rounded terms at 5.0%; U-6 underemployment was also flat at 9.9%. The labor force participation level rose a tenth to 62.6%, which was somewhat positive.

Average hourly earnings were unchanged, despite consensus expectations calling for a +0.2% increase, although the year-over-year change in earnings was +2.5%, which was just higher than the rate of broad inflation for the period. The average workweek length was also unchanged at 34.5 hours. Many are looking for signs of stronger wage inflation to demonstrate a 'next level' of economic improvement and, ultimately, higher broad goods inflation. The traditional way of looking at this is the 'Phillips Curve', which shows an inverse relationship between unemployment and wage inflation, e.g. when unemployment hits very low levels, competition for workers increases and wages start to rise. While on a broad scale this hasn't happened yet, it's shown more signs in some industries as opposed to others—services, tech and construction have shown some movement, while heavy industry, transportation and mining (which includes energy extraction) have not. Considering the nature of recent pricing in those industries, this probably isn't too surprising. But this is another display of the bifurcation seen in the economy as of late, between the better-growing services segment and very challenged energy/materials group (investment markets certainly have already figured that out).

(0) As usual, the FOMC meeting minutes didn't contain a lot of surprises. In fact, these are so routine typically that they're almost not worth spending much time reporting on. The underlying message was a relatively upbeat outlook for the U.S. economy and especially employment, although there continued to be concerns over inflation targets being reached (which they think will occur by 2018). At the same time, there was little detail about continued policy 'normalization' efforts, expected to be in the form of several rate hikes in 2016. Specifically, volatility in the high yield bond market was discussed during the meeting, but concerns were generally tempered due to the isolated sectors involved.

Market Notes

Period ending 1/8/2015

1 Week (%)

YTD (%)

DJIA

-6.13

-6.13

S&P 500

-5.91

-5.91

Russell 2000

-7.88

-7.88

MSCI-EAFE

-6.14

-6.14

MSCI-EM

-6.82

-6.82

BarCap U.S. Aggregate

0.64

0.64

U.S. Treasury Yields

3 Mo.

2 Yr.

5 Yr.

10 Yr.

30 Yr.

12/31/2015

0.16

1.06

1.76

2.27

3.01

1/8/2016

0.20

0.94

1.57

2.13

2.91

You may have noticed a profoundly negative start to the year in equity markets; in fact, it's the worst start to a year in several decades. From a sector standpoint, the winners you would typically expect, defensive utilities, telecom and consumer staples, did hold up better; materials and financials were the biggest losers, down over -7%, although no sector escaped a negative result on the week.

As if often this case, it's been a behavioral reaction to several events overseas. For one, Chinese markets lost significant ground (-7%) on Mon. and again on Wed. resulting in 'circuit breakers' tripping, stopping trading to prevent further volatility. This is the first time the circuit breakers have gone off, likely spooking some less sophisticated local Chinese investors, which could have exacerbated further selling (in the same vein as a 'bank run' analogy). The sell-off in that part of the world was due to news of continued weakness in manufacturing for the 10th straight month, taking PMI down below 50, indicating contractionary territory. This is not dramatically 'new' news, as this has been a key area of concern for global markets for much of 2015. A significant positive is that Chinese authorities possess significant resources to inject targeted stimulus into the economy, which lowers changes for a 'hard landing'. At the same time, we know that Chinese growth likely won't be at the same high rate of the prior decade, as the economy matures into a steadier pace and domestically-focused consumption. The circuit breakers themselves had been described as poorly designed, so have now been turned off. (Circuit breakers in U.S. markets were implemented in the late 1980s' in the wake of the Black Monday selloff in 1987, and have been refined on an ongoing basis since.) Other factors involved here are the pending expiration of a ban on insider selling, although there's a good chance it might be extended after the week's volatility.

Chinese injected a large amount of stimulus during the week to stem the damage. This is in addition to a report showing that, in December, Chinese spent the equivalent of over $100 bil., taking their reserves down to $3.3 tril. (albeit still a high level, just no longer rising as it was). Their other technique is further strategic weakening of the yuan, which is their primary remaining tool to make exports more competitive. They'll likely continue down this road of weakening their currency's value, which shouldn't concern markets overly if it's done in an orderly and transparent fashion, but the key worry is that growth conditions are more challenging there than first thought, and the administration is having a more difficult time combating the situation than they are letting on. Their communication efforts have also been described as poor at best, which doesn't help investor psychology.

The other news earlier in the week was from the Middle East, which is always full of odd surprises. After Saudi Arabia executed several dozen prisoners over the prior weekend, including a prominent Shiite cleric, protesters in Iran attacked the Saudi Embassy in Tehran, which prompted Saudi officials to cut off diplomatic relations. Interestingly, an event like this would have likely spurred oil prices sharply higher in the past (the actual result today was just over a percent), which would be welcomed by some folks currently suffering from low prices—including the Saudis.

A note about volatility: episodes of it tend to happen sequentially. Low-volatility periods have traditionally been self-perpetuating, while higher-volatility periods have done the same, showing some 'clustering' tendencies, so back-to-back 10% corrections after a significant low-volatility period wouldn't be overly surprising and within historical norms.

Other foreign regions were almost exclusively in the negative as well, with Japan and the U.K. faring a bit better than the rest, but most performances fell within a fairly tight range. The outliers on the downside were naturally China, where local markets lost nearly -12% on the week (although their 12-month return in local terms is just barely below zero), and commodity producers Australia, Brazil, South Africa and Mexico, which all continue to feel pain.

On to other markets, U.S. bonds experienced a decent week with assets moving away from risk, as would traditionally be expected. Bellwether domestic interest rates fell back to the 2.1% area for the 10-year Treasury, resulting in price gains for intermediate-term debt in the government and investment-grade corporate areas, while high yield and floating rate lost ground by a fraction of a percent. Some foreign bonds were helped by a weaker dollar; the best returns in the fixed income universe originated from Japan, U.K. and Germany—the traditional safe havens in times of turmoil around the world aside from long treasuries. Unsurprisingly, emerging market bonds in local terms suffered the most, losing a few percent on the week.

Real estate suffered along with other risk assets, although not to the same degree as broader equities. In the U.S., retail and mall assets generally suffered the smallest losses, while the higher-beta lodging/resorts group performed worst. Most U.S. groups generally outgained foreign REITs on the week.

Commodity indexes were driven lower again, as was the case throughout 2015, with the S&P GSCI index down over -5% on the week. This was largely due to its heavy weighting to energy; a drop in the price of West Texas Crude from $37 at year end to just under $33 on Friday represented another sizeable move in percentage terms. Industrial metals also lost a few percent, as these are sensitive to Chinese growth prospects and sentiment, while gold actually gained over +3%, as investors sought out safe havens and interest rates fell lower.

A key question for 2016 is: what will happen to oil? The lower the price gets, the more concerned some investors become as additional stress is placed on marginal energy producers and related firms—to earnings and the sustainability of debt interest payments. Unsurprisingly, there are differing views on what the ultimate 'clearing price' should be. Unfortunately, unlike other assets we deal with in portfolios, like stocks and bonds, there's no cash flow component that allows us to run a financial model and find a 'fair value' for a commodity. Investors in this space are left with less precise and indirect tools such as supply/demand dynamics, momentum/sentiment, and cost of production (which is also quite variable and producer-dependent with a variety of values per each commodity).

On the low end, as we usually see after a large drop, there are analysts/strategists that feel oil may continue to go lower—to $30 or even a bear case of $20. In the shorter-term, that's certainly in the realm of possibility. However, like with any other asset, the lower a price goes, the less sustainable that price becomes as selling pressure eventually fades and production costs provide a natural floor for what a barrel of oil is worth (we know it certainly isn't $0 or even anywhere close). The recent posturing between the Iranians and Saudis flipped the normal response to Middle Eastern flare-ups on its head, as in the past such uncertainty would have caused prices to spike; instead, each party threatening to ramp up production to damage the other has exacerbated fears of a supply glut and is pressuring prices lower. This can't go on indefinitely, as the budget balances of major oil producing countries are already very strained—the worse that gets, the greater the chances of internal unrest, which is the worst fear of these governments (think Arab Spring). Analysts on the opposite side of the table feel we are on borrowed time with artificially low prices, and when cooler heads prevail, a snapback to higher levels would be quite feasible.

What is a rational price for oil? Investment banking and trading groups who spend a good deal of effort on the supply/demand side, reviewing inventories, production capacity and other intermediate-term factors, continue to place a 'fair value' somewhere in the rough $50-60 range, with a higher price the further the estimate goes out over the next several years. Timing, of course, is the wildcard. While some might be tempted to speculate on what might appear to be obvious 'cheapness' in oil and the broader commodities complex, while others have given up on oil prices rising ever again in a shale-supplied 'new normal', these calls can be very difficult to get correct, in both magnitude and timing.

Have a good week.

Sources: FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger's, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder's, Standard & Poor's, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.

Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.

Additional Reading

Read the previous Weekly Review for January 4, 2016.

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