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Weekly Review - July 13, 2015

Weekly Review - July 13, 2015

Guest Post - Monday, July 13, 2015

Summary

  • In a fairly light week for the economic calendar, data was highlighted by a decent ISM services survey, good JOLTs employment data, but higher claims. The Greece situation remained as the primary global headline, while Chinese stock meltdown and pourover concerns took second place.
  • Despite higher interday volatility, U.S. equity and fixed income markets ended the week generally flat after all was said and done, as were foreign developed market equities. Emerging markets and commodities generally sold off with carryover concerns surrounding China.

Economic Notes

(0) The ISM non-manufacturing survey came in +0.3 pts. higher than May, at 56.0, which was -0.4 short of expectations. Business activity and new orders were higher on the month, while employment and new export orders fell. Anecdotal comments from the report regarding current conditions were broadly positive, with the only exception being some Avian flu concerns (affecting poultry, which carries over to any activities involving eggs—restaurants, etc.).

(-) The May trade balance widened by -$1.2 bil. from the prior month to -$41.9 bil. Exports fell -0.8% (capital goods exports showed distinct weakness), while imports barely fell at -0.1%, accounting for the differential. These figures take the deficit level back to where it was early in 2015—in Q1, it appeared that West Coast port strikes played a big role in temporarily distorting this series.

(+) Wholesale inventories for May rose +0.8%, which was a half-percent higher than the expected +0.3%. The increase was due to both durable and non-durable goods—in the latter, notably petroleum, where higher prices inflated general levels.

A stat we don’t report on much, the Federal Reserve Consumer Credit report, showed an increase in May of $16.1 bil., a bit lower than expected, but was a seasonally-adjusted +5.8% increase over last year. Non-revolving credit (primarily auto and student loans) have increased at a much faster clip than revolving (mostly credit cards), which only gained about +2% year-over-year. What’s notable about the graph below is that year-over-year growth figures have a habit of peaking just prior to recessions in keeping with what we intuitively expect about credit cycles. Of course, there are plenty of false starts along the way as well to keep forecasters honest, as with other cyclical measures like inverted yield curves, etc. Credit hasn’t grown with the same amount of force as in prior recovery cycles, but the depth of the last recessionary low was so severe, that isn’t entirely surprising, as consumers have been working to dig out of that credit hole more than they’ve been eager to expand their balances.

(+) The JOLTs job openings report for May came in at 5,363k, outperforming expectations calling for a small decline to 5,300k—and representing a new high for this series. Gains were seen in trade/professional/business services as well as education and healthcare, although lower-paying segments (such as leisure) continue to lead. The hiring rate fell a tenth of a percent to 3.5%, while the quite rate came in at an unchanged 1.9%. The year-over-year results for this series are quite strong, but pessimists note that levels remain below highs set in the pre-recession era. To put this into perspective, openings represent 3.8% of total U.S. payroll, which is the second highest percentage on record, even though this is a fairly short series (only going back to 2000 or so).

(-) Initial jobless claims for the Jul. 4 ending week rose by +15k to 297k, which exceeded the forecasted 275k. Continuing claims for the Jun. 27 week also rose to 2,334k—which was higher than the expected 2,250k. While the Labor Department didn't note any unusual conditions to explain the rise, it's been speculated that seasonal adjustment factors around summer auto plant shutdowns may be at least partially to blame. Regardless, the claims figures remain decent—and low.

(0) The minutes from the June FOMC meeting didn't provide anything enormously different, per usual, but commentary made additional note of international conditions than was first let on post-meeting—particularly in Greece and China—and potential for contagion. The opinions of FOMC members were mixed, roughly 50/50 as to whether or not domestic data was strong enough yet to normalize policy and begin raising rates. While wage inflation has risen a bit, lower oil prices and a tempered dollar have worked in the opposite direction. At this point, consensus points to around December for the first rate hike in a decade (although the date has been consistently pushed back). Recent comments from Janet Yellen during her speech circuit has alluded to the likelihood of at least one rate increase before year-end.


Read the "Question for the Week" for July 6, 2015:

How are portfolios looking as of mid-year?


Market Notes

All I hear about are Greece, China and Puerto Rico. What do I need to know at this point?

Greece

Some key global investment banks, such as Morgan Stanley, recently upped their probability for a Grexit from a 50/50 toss-up to 75%. This wasn't surprising, given the election results in which the Greek populace overwhelmingly rejected the Eurozone's most recent proposal (although it was taken off the table prior to the vote, ironically, perhaps making the whole exercise moot). Where is Greece left now? The banks have been running out of Euros and the ECB appears understandably reluctant to provide more aid in that the Greek debt situation looks like a bottomless pit. Given a Thursday deadline to come up with a better plan, the Greeks submitted a proposal closer to what the Eurozone was looking for, consisting of additional pension cuts (including phasing out a special additional payment for poorer pensioners), increasing the corporate tax rate by a few percent, higher VAT taxes, privatization of certain industries—like electricity—and an overhaul of the collective bargaining system, among others. By earlier Sunday, these weren't deemed good enough, but as of this morning (after most of this was written), there appears to be an agreement on a third bailout package totaling 82-86 bil. euros ($91-96 bil.). This is subject to final approval, including a vote in the Greek parliament.

Aside from today's agreement, which is kicking the can down the road again, many worst-case scenarios that were originally seen as less likely (like a ‘Grexit') had now been increasingly accepted as realistic and are further priced in to markets, which is always healthier than expecting a miracle and being disappointed. In contrast to just a few years ago, now 80% of Greece's sovereign debt is effectively held by the IMF, ECB and the European bailout fund (European Financial Stability Facility) which essentially ring-fences the impact of a default.

The Greeks had been left with very few options—bad and worse. In the short term, both looked unattractive—(1) Succumb to ECB demands, resulting in more austerity (more spending cuts, tax increases and pension reforms) and likely continued recessionary conditions; or (2) leave the Eurozone, reinstate the drachma and suffer severely in the short-term as assets are revalued, likely deal with high inflation for a time, but regain more control over their destiny over the longer-term. We'll hope this doesn't fester until next time, but it could.

China

The local Chinese market has continued to correct (although seeing a bit of a respite last week, due to interventions noted below), and while the impact appears relatively contained from a global market/liquidity perspective, concern continues to surround the potential impact on broader sentiment if its severity deepens further.

As an important backdrop, even though the economy has been liberalized somewhat, the Chinese populace haven't been given a lot of options for their growing savings over the past decade. What they can choose from has been limited to bank deposits, some real estate and, very recently, equities. Real estate, conservatively backed by physical assets, had been a favorite until markets softened due to overbuilding concerns. Stock shares used to be considered highly speculative, akin to gambling in some circles, but interest has naturally improved as prices have skyrocketed. Now, the government has a vested interest in insuring this newly-accessible market stays buoyant.

Crashes anywhere don't typically help people feel good about things, especially when it's their money. It can be accompanied by a realization that underlying fundamentals could be worse than first predicted, liquidity being a lot tighter than expected, valuations a lot more overstretched, or some deep structural issue that has been hidden but could come to light. In this case, an exponential run-up in (mostly smaller-cap) Chinese equities coupled with a populace relatively unfamiliar with stock market behavior and tendency for volatility has accentuated the problem. Valuations haven't been cheap in certain segments for a while. While local A-share blue-chips have been trading right around a 16x P/E (near that of the developed world), the ‘ChiNext' market, which is much more speculative, has been trading near a 75x P/E. Good things don't usually happen when a price ratio is that high, so this pullback is part of the Chinese market's growing pains. On the positive side, the lack of an embedded equity culture (like retirement savings held in 401k equity mutual funds and the like) provides some insulating effects in China, which could be why this correction has been further under-the-radar than if it were elsewhere. Nevertheless, policymakers and institutions globally watch for other warning signs, such as further economic slowing if a negative wealth effect response takes hold (citizens feel poorer so spend less) or shakiness in financial infrastructure that could carry over to other global assets. For just one example, if Chinese growth were to continue its downward turn, demand for base commodities like copper could be threatened, which could affect export economies from Australia to Chile. We've already seen some market reaction here.

Such volatility isn't unusual for a young stock market, reminiscent of the pre-regulatory era in the U.S. during the high-flying 1920's and like patterns in other nations. For now, Chinese officials have put some additional restrictions in place, including halts in trading for certain securities, a moratorium on IPOs and a six-month restriction on sales for senior management and those with a 5%+ ownership stake. They're also investigating some short-sale abuses and possible market manipulation, and, perhaps most importantly, providing government injections of cash to purchase certain equities. Unfortunately, restrictions aren't always effective, as they block the flow of normal supply-and-demand processes that keep markets efficient. The Chinese government has certainly played a role in perpetuating this bubble by encouraging investor flows through easing margin requirements and rates; now, they're forced to help clean up the mess. Social stability remains one of their primary governmental objectives, and anything that threatens that fragile balance is tackled aggressively.

Puerto Rico

We would be remiss without mentioning the commonwealth, which has experienced its own set of recent problems. Although it's been placed in the same category as Greece, it isn't Greece, but the headlines are still dramatic—not the least of which because it's a U.S. territory and Puerto Rican debt is widely owned by individual investors and municipal bond funds. (As a backdrop, the unique status of debt issued by U.S. territories Puerto Rico, Guam and the U.S. Virgin Islands allows U.S. citizens to claim interest earned as 'triple' tax-free at Federal, state and local levels—just like you would interest on muni bonds from your own state. So P.R. bonds are heavily used as a tool to increase after-tax yields in state-specific funds particularly, and to add some diversification somewhat.)

Like Greece, this isn't a new development, as Puerto Rico has been experiencing well-known financial and demographic challenges for many years. Residents are poor, with a high percentage earning minimum wage and/or receiving Federal benefits; per capita income is roughly half of that in the states (although it has improved a bit). As a result of these tough conditions, there's been a steady outflow of residents to the mainland (Florida, New York City, Hartford and other locations) as job prospects are no doubt more promising elsewhere. Puerto Rico has tried to implement a few improvements over the years, such as attempting to turn itself into a vacation destination, enticing corporations to relocate there and take advantage of the advantageous tax structure (due to reduced U.S. corporate income taxes, at least until rules changed a few years ago). Unfortunately, fiscal mismanagement and over-indebtedness from pension obligations and other spending has proved a big burden, prompting the governor last week to announce that the island's debt is ‘not payable.' This is despite the fact that interest has been steadily paid, the commonwealth began fiscal year 2016 with a balanced budget—but lessened debt flexibility tends to hamper politicians' policy efforts. In fact, Puerto Rico's treasury secretary affirmed the ability to pay outstanding debts, but many believed the money was best used ‘on other things'—not possible given current covenants. The constitution requires that all G.O. debt be put first in line before other payments, similar to the majority of states. Budget and cash projections remain mixed, so there is a lot of obfuscation about what's tenable and what isn't.

With comments like this, it can be difficult to separate the financial reality from the political theatrics. Some of this was intended for internal legislative discussions, perhaps a shot across the bow to creditors, and could even have been part of an effort to enlist Federal government aid or a bailout of some kind. The support for such a bailout is not high in Washington, although the comments have now spurred renewed discussion. Puerto Ricans aren't afforded a member of Congress and don't cast electoral votes for Presidential elections, so there isn't a huge incentive to spend a lot of time or political/actual capital on this. While local U.S. municipalities and county jurisdictions are sometimes eligible for bankruptcy provisions (based on specific state law), states themselves and a commonwealth like Puerto Rico are not. Municipal funding legalities are extremely complicated—much of the fine print is focused on what entities can go bankrupt and which can't, and how the process takes place in conjunction with creditor dealings, including the treatment of any recoveries.

Fund managers have known about these problems for some time, so credit analysis became critical in order to determine what specific collateral backing applied to which bonds. Markets didn't much care in the shorter-term, as all Puerto Rican bonds were painted with the same broad brush, and often experienced heightened volatility. (For example, a Federal appeals court recently affirmed a decision to invalidate a commonwealth act passed that would allow for renegotiation of the island's electric, highway and sewer authorities—essentially ruling in favor of bondholders.) In many cases, this created opportunities, as attractive yields overcompensated in some cases for very different risk structures. For those (primarily retail) investors buying straight Puerto Rican G.O. debt, and who didn't do a lot of due diligence beforehand but were enticed by the very high absolute and especially after-tax yields, the market price volatility of these bonds was likely more than many expected.

As with any municipality, the story is nuanced. The fact that 60,000+ total municipal issuers in the U.S. and 1,000,000+ individual issues are outstanding adds to the complexity of that market—two almost-identical structures on the surface can have very different dedicated collateral and revenue sourcing behind the scenes, which can radically affect their chances of a default, and, if a default were to occur, their opportunities for recovery. This isn't discussed frequently, but municipal bond ‘net' defaults (outright defaults less eventual recoveries) are extremely low. Moody's data covering the past several decades puts BBB-rated muni debt on the same cumulative default level over a multi-year period as AAA-rated corporate bonds. This always surprises people. The reality is that munis, while more credit-sensitive than they used to be—especially with the decline in bond insurance wrappers since the financial crisis—fall in a category between Federal government debt and corporates. Really, this is where they've always belonged. Distressed debt hedge funds have already entered the Puerto Rican market, which could make things interesting (such firms have a habit of occasionally earning decent profits when expectations are lowest). In fact, in our new tax-efficient model, the ‘high yield muni' component owns a limited component of certain Puerto Rican bonds, primary because of the attractive yields available and risk/reward credit analysis of individual structures and collateral backing. No doubt, more to come from this island.

Market Notes

Period ending 7/10/2015

1 Week (%)

YTD (%)

DJIA

0.19

0.90

S&P 500

0.03

1.95

Russell 2000

0.31

4.61

MSCI-EAFE

0.20

6.09

MSCI-EM

-3.26

-2.45

BarCap U.S. Aggregate

-0.11

-0.42

U.S. Treasury Yields

3 Mo.

2 Yr.

5 Yr.

10 Yr.

30 Yr.

12/31/2014

0.04

0.67

1.65

2.17

2.75

7/3/2015

0.01

0.64

1.64

2.40

3.19

7/10/2015

0.01

0.65

1.68

2.42

3.20

U.S. stocks experienced an interesting week with a lot more volatility than we've been used to, coupled with a technical glitch on Wednesday that halted trading for several hours (it was deemed an internal software issue as opposed to a cyberattack). Markets recovered by Friday, with improved hopes for a Greece/Euro settlement as well as Chinese government intervention into local stock markets. After all that, net results were flat. From a sector standpoint in the U.S., defensive consumer staples (drug store, tobacco, beverage, et. al.) and utilities outperformed with solid gains of 1-2%, while materials (industrial metals-oriented due to presumed China impact) and energy brought up the rear with losses over -1%.

The dollar weakened a bit, but not enough to help foreign stocks and bonds in a significant way. European equities, including peripherals such as Spain and Portugal, gained with hopes of a Greek resolution. Emerging markets on net underperformed developed markets. Areas of weakness were in the Pacific region, including Japan, as well as Indonesia and other commodity exporting nations potentially affected by China. Chinese equities declined dramatically again early in the week (with the losses reaching 30% over the past month in local markets) but saw signs of life as government support boosted sentiment, which led to a +5% on the week on net. Chinese CPI also came in better than expected, up +1.4% year-over-year, but is still low enough to provide credence for more government accommodation.

U.S. bonds were little changed on net, with rates ending close to where they started, although they moved nearly a quarter percent in between. High yield corporates and TIPs lagged a bit more than average. Foreign bonds came in positively by a fraction of a percent on average, outperforming U.S. names and a more significant flight-to-quality impact.

Real estate gained on the week, with U.S. names generally outperforming foreign—led by strength in healthcare and residential.. Japanese and other Asian REITs weakened along with general negative sentiment in Asia.

Commodities, represented by the GSCI, fell over -4% on the week, led by declines in energy. West Texas Crude fell from the $56.50 range down to just under $53 to close the week, as U.S. rig counts and global production from OPEC continued to tick upward. Industrial metals also softened, in an area that has been very China-demand focused in recent quarters. Corn and sugar gained on the week, while precious metals ended up being the best-performing overall group, with only nominal losses and plenty of geopolitical uncertainty that usually benefits the gold and related contracts.

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 July 6, 2015.

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