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Weekly Review - October 12, 2015

Weekly Review - October 12, 2015

Guest Post - Monday, October 12, 2015

Summary

  • In a lighter week for economic data, the ISM non-manufacturing survey release disappointed while remaining quite positive, the trade balance deteriorated due to a stronger dollar and the FOMC minutes were a bit more benign than expected although didn’t clarify any interest rate policy uncertainty.
  • Equity markets gained in the U.S., upon stronger sentiment from higher energy prices, while bonds sold off a bit as interest rates inched higher. Commodities naturally had a strong week due to the oil impact, a rare event recently.

Economic Notes

(0) The ISM non-manufacturing survey for September fell just over -2 points from the prior month to 56.9, compared to an expected 57.5 reading. General business activity and new orders fell by several points, but remained solidly expansionary; employment increased a few points to just under 60. It’s interesting to note that readings in the upper 50’s demonstrate very strong growth in the group. While manufacturing might get more airtime, services is larger and has been significantly stronger.

(-) The trade balance, deficit really, widened fairly sharply from July’s -$41.8 bil. to -$48.3 bil. to August, but was generally in line with expectations of -$48.0 bil. The main factors were both weaker real good exports (down -1.5% for the month) and larger real good imports (up +3.1%), reversing the prior month’s movements. Naturally, a strong dollar and weaker global growth are reasonable explanations for this, although the month-to-month results can vary more significantly than one would think. Where this comes into play is potentially a takeaway from real GDP in Q3 and Q4, where exports represent a not huge but still-present input, and estimates point to a possible -0.5% or so takeaway from the overall GDP figure at this rate.

(0) Import prices fell in September by -0.1%, which was actually slightly less than the anticipated -0.5% decline. Excluding fuels, prices fell by -0.3%, which was offset a bit by prices of imported consumer goods rising +0.1%. While the strong dollar continues to have an impact, the rate of decline has decelerated somewhat in recent week but remains a source of low imported inflationary impulses.

(+) Initial jobless claims for the Oct. 3 ending week fell to 263k, which was below expectations of 274k. Continuing claims for the Sep. 26 week bumped up a bit to 2,204k, which was just +4k higher than expectations. No special factors appeared to affect numbers in this particular release and claims levels remain very low.

(0) The minutes from the September FOMC meeting were released, which, per usual, just added more details to what we knew already, but analysts seemed to be hoping for more color regarding the addition of the component referencing the challenging ‘international environment’ (inferred to be China). A wait-and-see attitude was the result, but led to some curiosity as to why an inserted non-domestic component like that would be appropriate. The answer is nuanced, but relevant, at least to many economists studying global linkages. For instance, weaker foreign currencies (and, hence, a stronger dollar) do have a tightening effect on the U.S. economy somewhat and, as much as policymakers like to respond agnostically to financial markets, wider credit spreads have a tightening effect as well—in the form of more expensive consumer and business credit. So, it’s been argued by the more dovish economists out there that these factors have done some of the FOMC’s tightening work for them, although the need for extreme zero-rate policy at the short end of the curve, of course, remains debatable. The dampening effect on inflation has also been a concern, per the difficulty in reaching the 2% Fed target.

The key theme in these minutes, also reflected in speeches from FOMC members during their regular circuits, was how close the call was between raising and not raising. At this point, probabilities of a December hike have quickly fallen to below a third, based on futures markets, due to some weakening of economic data since the last meeting. Again, October is expected to be a non-event due to the ‘informality’ of the meeting and lack of a press conference. Interestingly, Ben Bernanke (who is now a consultant to PIMCO) mentioned in a recent relatively candid presentation that it might behoove the FOMC to meet more often (as in monthly, like many other central banks do) and offer more frequent press conferences, in order to allow for more timely changes. The structure of decision-making currently is still somewhat tied to a slower-speed world than we have today.

Speaking of the Fed and interest rates, there are some calls from some unusual places, such as well-known hedge fund managers, who are making calls from the opposite extreme—for a 4th round of quantitative easing. This runs in stark contrast to the hawkish camp demanding that the low rate regime has gone on long enough and it’s time to start the ‘normalization’ process to higher rates. A lot of Fed and academic research has gone into this topic over the last few years, starting with the ‘Taylor Rule’ interest rate model, coupled with other tweaked versions. These tend to use current vs. target inflation, current vs. ‘potential’ GDP and employment as inputs. The point in all this: what is the ideal fed funds rate given today’s mixed environment? For many years, according to these models, it was a negative rate (not attractive in practicality, but did explain the rationale for a zero-rate-policy). Now, with conditions of full employment and core inflation closer to target, some research last week the Fed and others came out with pointed to roughly 1.25% as a current ‘equilibrium’ rate, although acknowledging the potential range of error around that figure. Quants know what the more inputs and moving parts there are to a model, the great magnitude for error based on the potential error for each of the variables, so take this as an interesting starting point for conversation’s sake.

Why the QE talk? It goes back to some elements we’ve discussed previously, such as slow global growth, including weakening demographics and challenged productivity growth. Some economists have alluded to a multi-year and even generational trend of slow growth that runs in contrast to the period of exceptional strength that began just after the end of World War II and rise of the baby boomers. Even +/- 1% of outright GDP growth matters when you’re talking about 2% or 3%-type annual figures. Does this potential for slower growth continue to warrant a policy of zero rates? That’s the question being posed, although it doesn’t seem likely that a small bump up in the fed funds rate would have a sharply significant impact on overall credit availability—like a much more dramatic hike and higher rates yield curve-wide would.

Market Notes

Period ending 10/9/2015

1 Week (%)

YTD (%)

DJIA

3.75

-2.32

S&P 500

3.30

-0.54

Russell 2000

4.61

-2.28

MSCI-EAFE

5.36

1.29

MSCI-EM

6.87

-10.14

BarCap U.S. Aggregate

-0.27

1.18

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

10/2/2015

0.00

0.58

1.29

1.99

2.82

10/9/2015

0.01

0.65

1.41

2.12

2.94

U.S. stocks were generally higher on the week, with positive returns across the board with positive sentiment related to oil and continued accommodative sentiment from the Fed, including the Sept. meeting minutes discussed above—this continued to lower expectations for a rate increase in 2015. The longer lower interest rates continue, the higher the implied fair values for equities.

Small- and mid-cap stocks outperformed large, due to a beta effect on the week. From a sector standpoint, energy ended up sharply higher, unsurprisingly, followed by materials; more defensive health care and utilities ended positively but at the bottom of the group. Earnings season is beginning in earnest, which should contribute to possibly higher volatility as lowered expectations compete with reality. Expect weakness in Chinese exposure and a stronger dollar to be key words expressed often. As we’ve mentioned before, steel company Alcoa is traditional bell-ringer for the earnings season, which being a materials company, unsurprisingly disappointed, but the firm’s results have tended to have little correlation to broader market earnings reports/sentiment in recent years.

Emerging market equities had an exceptional week, which due to the recent correlations to energy and commodities and index composition, wasn’t a complete surprise. Double-digit gains were the rule in commodity-heavy nations such as Indonesia, Malaysia and Russia.

U.S. bonds pulled back a bit in a fairly conventional risk-on week where asset flows moved into equities and away from fixed income. Longer-duration treasuries suffered the most damage, as usual, while many other investment-grade areas ended flattish. To the contrary, high yield corporates broke a string of recent weakness with strong gains. Managers in the high yield space (in private conversations) have recently been quite bullish on the asset class, believing energy sector-related volatility is perhaps overdone and dollar pricing appearing cheap compared to current fundamentals that look quite decent and limited default prospects; there is opportunistic bond-picking to be had in the space, it appears, with these wider spread conditions.

One interesting item last week was that the Treasury auction for new 3-month T-bills ended with a 0.00% yield for the first time (it’s happened several times in the 1-month T-bill market). Essentially, instead of paying a normal discount to get back 100 cents on the dollar in a few months, investors paid 100 cents on the dollar—so no discount, and no yield. This can be explained by technicals, where there were more interested buyers than there was supply for these safe-haven bills, which drove prices back up to par. This is the same dynamic that caused European bond yields to fall into the negative not that long ago, in an even more dramatic example.

Foreign bonds generally performed well, gaining several percent in total return, with the dollar falling back about a percent on the week, with emerging market local bonds and commodity-exporting countries leading the way, per what also occurred in equity markets. Traditional safe havens, such as the U.K. and Eurozone fell back.

Real estate, in keeping with broader equity results, experienced a strong week, led by ‘risk-on’ sectors such as lodging and office/industrial. Naturally, any prospect of lower rates for longer boosts near-term sentiment for the REIT market.

Commodity indexes rose in the low single-digits on the week, with crude oil rising almost +9%. Market participants have been attempting to get better clarity on energy inventory supply levels, which has been the unusual independent variable in the energy equation as of late (usually it’s global demand)—supply appears to finally be slowing down, including from Iran, which was an initial ‘feared’ supply source. Russia also expressed in meeting with other oil producers, which was seen as a positive earlier in the week. Industrial metals, such as copper and zinc, also gained sharply on the week as economically-sensitive assets were favored.

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 October 5th, 2015.

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