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Weekly Review - October 13, 2014

Weekly Review - October 13, 2014

Guest Post - Tuesday, October 14, 2014

Summary

  • It was a light week for domestic economic reports, generally focused on employment subtleties; however, global economic growth expectations were downgraded by the IMF, causing additional market tumult.
  • Typical October volatility returned to markets as domestic stocks experienced some of the widest day-to-day swings of the year and ended sharply negative. Conversely, bonds gained as yields fell to their lowest levels in over a year.

Economic Notes

(0) Wholesale inventories for August rose more than expected, up +0.7% versus consensus calls for +0.3%, and the July growth number was revised upward by a few tenths. From an industry standpoint, computers, drug and machinery offered the largest contributions. We care about inventories since a buildup of sorts might offer insights into underlying orders and demand that could surface in coming months, boosting consumer results.

(0) The import price index for September declined -0.5%, just a bit less than the expected -0.7%. Petroleum prices falling -2% was the primary driver, but dollar strength also appeared to be a factor, particularly as European import prices also fell by -1%. Year-over-year, the headline index (with oil) fell -0.9%, while ex-oil core import prices rose +0.7%.

(+) Initial jobless claims for the Oct. 4 ending week were generally unchanged at 287k, which was still better than the 295k expected. Continuing claims for the Sept. 27 week came in slightly lower than expected, at 2,381k, compared to an estimated 2,410k—this was the lowest/best reported number in the current recovery so far, and the best since 2000. No special factors were reported from the DOL that could call question to the data.

(0) The August JOLTs report offered some mixed results. Job openings registering 4,835k were larger than the expected 4,700k and 4,605k seen in July, with gains in education, healthcare and leisure. On the other hand, the hiring rate fell -0.3% to 3.3% (construction faring the worst, but weakening was broad here), and the quit rate was an unchanged 1.8%. Policymakers would prefer to see more direct improvement in the latter two measures, although this measure has accelerated sharply this year, to levels not seen since 2001 (just after the series was created), and is up +23% over openings a year ago.

(0/TBD) The Fed has come out with a new metric, the Labor Market Conditions Index, a dynamic model of 19 labor indicators, similar to Janet Yellen’s ‘dashboard’ approach in evaluating employment conditions. Better transparency tends to be a good thing when it comes to data, but this may add one more fickle piece of information for markets to react to on a short-term basis, so we don’t know if this will end up being a good or bad development. Also, aggregates can sometimes be tricky since underlying components, if divergent from each other, can neutralize the overall figure and offer less useful information than the individual pieces by themselves. All-in-all, apart from the month-to-month noise over time, current conditions appear to be moderately positive, moving to an index increase of 2.5 for September compared to a 2.0 rate last month—figures are quoted in terms of monthly change. (For historical perspective’s sake, since 1980, the indicator has fallen about 20 points/month during recessions and risen 4 points/month during expansions). We may or may not mention this new index on a regular basis, based on how insightful it proves to be and if markets end up caring about it.

Labor Market Conditions Index Graph

(+) The FOMC minutes from the September meeting were released, and the ‘dovish’ tone was taken quite positively from markets on Wednesday. Especially noted during the meeting was significant slack in labor markets, while growth/inflation estimates were also lowered a bit, partially in line with weakness overseas. In line with recent meetings, it appears discussion about communication expectations and possible challenges took significant meeting time. Unsurprisingly, the recent strength of the dollar was also mentioned.

We’ve discussed this previously, but FOMC members are frequently busy giving speeches at different venues within their Fed districts on a regular basis. Markets tend to have an eye on these presentations for any key words that may emanate and add helpful color for policy interpretation. These speeches are usually well-scripted, and not many surprises emerge, but occasionally the Q&A sessions can offer additional nuance—and the content can sometimes be used to clarify or add additional color to underlying policy views the Fed wasn’t clear enough on originally or were perhaps misinterpreted. Last week, for one example, comments alluded to the U.S. economy growing at a ‘more muted pace than some expect,’ and another referred to the appropriate time to begin raising interest rates as ‘sometime in the middle of 2015, but the decision remains data-dependent and will remain accommodative for some time.’ This isn’t anything new, but the more downcast tone of the individual speeches relative to official statements may be a bit noteworthy. Other members have opinions about the potential effectiveness and precedent being set for certain communication policies. Naturally, members on the cusp of retirement may have ‘less to lose’ by being a bit more candid than average.

FOMC members aren’t the types to change their views quickly or haphazardly, or without good reason. Wherever their background (many have been trained as economists, and/or have worked in an academic research capacity), each tends to come into the job with their own view of how the world works, and two members can see the same few pieces of data very differently. Without delving too deeply into the various ‘schools’ of economic thought (Austrian vs. Keynesian, etc.), differences often surface in matters of how much government intervention should be present in the economy during normal times vs. crises, which translates into how ‘dovish’/accommodating or ‘hawkish’/inflation-averse they become when reaching inflection points. The dovish sort are very afraid of repeating the deflationary 1930’s experience, where the Fed (only 20 years old at that time) arguably removed accommodation too quickly and a drawn-out weak economy persisted for much of the decade. The hawks, on the other hand, look to the 1960’s looser policies as a backdrop to later inflationary pressures in the 1970’s that should be avoided well in advance if possible. Which is correct? We won’t know until the benefit of hindsight.

Now that we’re in the era of ‘big data,’ another index for us to pay occasional attention to is one just introduced by the Philadelphia Fed—the Partisan Conflict Index. This is a new monthly item that, as the bank puts it, measures the levels of federal political disagreement by tracking ‘the frequency of newspaper articles reporting discord in Washington.’ The premise is that such partisan conflict raises uncertainty levels for companies and households, which could play a role in reduced tendencies to invest and spend. (We did see this conservative tendency during the mid-2011 budget battles and downgrade of U.S. debt, as one example). They’ve gone to the trouble of tracking this data back over a century, and one can definitely see the higher trend towards discord beginning just after the financial crisis in recent years, but this has been on a steady upward path for some time (although history has shown other spikes in partisan conflict, per the second chart below). The causation of recent spikes is likely multi-faceted, but could be related to demographic changes, which have added to the more extreme ideologies of the two main political parties, and the exponential growth of bombarding media coverage that expands the search universe size for ‘measurable’ discontent.

Partisan Conflict Index
Partisan Conflict Graph Source: Federal Reserve Bank of Philadelphia

In the alternative investment world, perhaps the biggest news of the past week was the decision by CalPers, one of the largest pension organizations at $300 billion, to remove hedge funds/absolute return strategies from its portfolio. Granted, it wasn’t a huge allocation, at just over a percent of overall holdings, but it appeared the time and effort taken to perform due diligence, the difficulty in explaining a unique cost structure (the classic ‘2 and 20’ relative to cheap institutional pricing for other traditional asset classes), a poor stretch of performance and, lastly, the inability to scale upward to a larger allocation due to the need for even more time-consuming due diligence, was the icing on the cake.

It will be interesting to see if other such institutions follow suit. Despite their origins of being very unique, active, and in their original form, truly hedged strategies, the proliferation of structures lumped under the hedge fund umbrella has been tremendous. Unsurprisingly, while there are some unique strategies and sought-after managers doing very unique things are no doubt still out there, a greater proportion of funds appear to be driven by the same ‘beta’ exposures as traditional asset classes—being high yield credit, emerging markets, broad market equity risk, commodities, etc. And now that such individual exposures have been commoditized and can be purchased more cheaply than ever, we aren’t surprised at the higher levels of scrutiny.

Market Notes

 

Period ending 10/10/2014

1 Week (%)

YTD (%)

DJIA

-2.70

1.60

S&P 500

-3.09

4.78

Russell 2000

-4.64

-8.57

MSCI-EAFE

-2.41

-6.56

MSCI-EM

-0.74

-1.28

BarCap U.S. Aggregate

0.63

5.14

 

U.S. Treasury Yields

3 Mo.

2 Yr.

5 Yr.

10 Yr.

30 Yr.

12/31/2013

0.07

0.38

1.75

3.04

3.96

10/03/2014

0.01

0.57

1.73

2.45

3.13

10/10/2014

0.01

0.45

1.55

2.31

3.03

Volatility is back from summer break. U.S. stocks started the week off on a poor note, but gained strongly Wednesday as the FOMC meeting minutes were more dovish than anticipated, holding off fears of rising rates anytime soon; yet, Thursday and Friday saw a complete reversal of those gains as less-than-reassuring comments implied from Mario Draghi (Europe’s problems being structural, not cyclical) and Carl Icahn’s assessment that a market correction was inevitable (yet, at the same time, raving over Apple) and general worries about global growth, particularly regarding some poor German industrial numbers. On the week, defensive segments utilities and consumer staples led, while energy and telecom suffered the worst declines (lower oil prices being the driver of the energy group).

Such is the story of October markets. The VIX has moved from lows of around 10 in July to the low 20’s in recent days, and technical corrections occurring in several global markets, including Germany, the broader Eurozone, as well as U.S. small cap. It doesn’t necessarily mean the world is falling apart, but a pullback always serves its purpose as a healthy ‘pause to refresh’ and prevent things from becoming too overheated on a short-term basis—just like in an economy. The IMF hasn’t done the world any favors by again tempering predictions for global growth in an environment described by Christine Lagarde as ‘brittle, uneven and beset by risks.’ For 2015, estimates were lowered from 4.0% down to 3.8% (albeit better than this year’s 3.3% rate), and warned that the Eurozone faces a 40% chance of a third recession since the global financial crisis.

While overall global growth isn’t what many would like it to be, U.S. fundamentals have continued to strengthen. Onto a somewhat more positive note, from a fundamental standpoint, what is the U.S. earnings picture looking like for this quarter? Per FactSet, who tracks these things, a fewer number of companies have issued negative pre-announcements for the third quarter in a row. The bulk of the improvement seems to have taken place in materials, industrials and technology. For the year-over-year period ending in September, earnings growth is expected be to in the range of +5% (albeit down from +8-9% estimates earlier in the summer). These estimates have been markedly downcast over the past several years, and generally, stocks have beaten them. Telecom and health care are largely expected to fare best, as firms with U.S. revenue exposure are unsurprisingly anticipated to outperform those with significant overseas operations, due to foreign weakness and dollar strength.

Traditional bonds experienced an exceptionally good week, with the risk-off tendencies of equities—rates fell 10-20 basis points across the curve, as the 10-Year Treasury reached its lowest level since June of last year. Long government bonds naturally led the way, gaining a few percent due to duration effect, while mortgages and investment-grade credit also fared positively. Despite their strong fundamentals, high yield bonds were hit by a combination of factors, including widening spreads due to risk avoidance, fickle investor cash flows affected by ETF markets and a wider supply calendar, that has lowered prices in recent weeks.

Foreign bonds were theoretically aided by a weakening reversal in the dollar, but lack of further easing discussion in Europe and some risk-off tendencies in emerging markets led to little change on net.

The real estate sector was led by strong gains in residential REITs, which gained several percent upon continued strength and low vacancy conditions in apartments (to the detriment of home sales to some extent, witnessed by a poor week in the homebuilding sector), while retail and industrial/office also gained. European REITs were the worst performing, in the negative by a few percent, as economic prospects continue to look dicey, which threatens tenant demand.

Commodities experienced a mixed week, although a weaker dollar last week helped their general prospects. Soft commodities (coffee and sugar) experienced another strong period amidst supply concerns, while gold rallied with lower bond real yields and the general risk-off environment, bringing year-to-date returns to just barely positive. Oil and natural gas lost up to -5%, with the West Texas Intermediate Crude contract falling into the range of the mid-$80’s. This drop in price, as noted earlier, has been a significant headwind for energy equities but certainly a positive input cost for most other economic segments.

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, Robert Shiller–Yale University, 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, October 6, 2014.

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