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Weekly Review - October 6, 2014

Weekly Review - October 6, 2014

Guest Post - Monday, October 06, 2014

Summary

  • Economic reports were mixed in terms of improvement, but continue to show strength. The highest-profile report of the week, the government employment situation, came in much stronger than expected and featured an unemployment rate under 6%.
  • Equity markets experienced more volatility as investors worried about global growth and geopolitics, such as the demonstrations in Hong Kong. Bonds rose a bit on lower yields and 'risk-off' tendencies.

Economic Notes

(0/-) The ISM manufacturing survey declined more than expected for September, from 59.0 the prior month to 56.6 (consensus called for a slighter decline to 58.5), although the index indicator remained solidly positive. New orders and employment both fell by several points within the index, while production increased slightly. However, all but 3 of the 18 manufacturing industries tracked showed growth during the month, and anecdotal commentary in the report was positive in terms of underlying demand.

(0) The ISM non-manufacturing survey for Sept. came in within a tenth of a point or so of expectations, although moving down a point from last month to 58.6. Underneath the hood, business activity and new orders declined by a few points each, while the employment segment improved.

(-) The Chicago PMI fell by about 4 points to a still-strong 60.5 reading, which was in line with readings of the last year and well above the 10-year average of 56. Employment and supplier deliveries were positive contributors during the month, while production and new orders fell back. Anecdotally, the release noted the use of 'strong' and 'surging,' as well as steadily increased confidence, in reference to activity levels, which offers additional positive color.

Again, in a diffusion index, anything over 50 indicates expansion over the prior month. And the rationale for investment market reaction is that a peak in ISM and trend backwards towards contraction is the ultimate fear–and could indicate a stall in economic progress. Not seen as likely at the present time, and this is a volatile series from month to month, as are many of them.

(-) Construction spending fell -0.8% for August at a seasonally-adjusted rate, which disappointed relative to an expected +0.5% gain. Public and private spending generally fell at an equivalent rate. Nonresidential fell just over a percent, and accounted for the bulk of the decline as residential spending was barely lower. In the former, power structures and commercial spending suffered the largest declines, down several percent. Interestingly, and not surprisingly, construction of 'chemical manufacturing structures'–which are related to the shale revolution–continue to plug along at a strong pace.

(-) Factory orders for August fell -10.1%, which disappointed relative to a slightly better consensus estimate of -9.5%. In line with the weaker durable goods orders number of last week, a more typical month for Boeing brought the month-over-month change downward. Core shipments were barely changed and non-durable inventories were down a few tenths, which serves to revise potential 3rd quarter GDP down by a bit.

(0) Personal income in August grew at a pace of +0.3%, which was on target with forecast. On the other end of the consumer finance spectrum, personal spending grew at a tenth faster than expected, up +0.5% for the month. Spending appeared to be most heavily influenced by gains in motor vehicles/parts as well as higher electric bills due to warmer summer weather. The headline PCE price index fell -0.1%, while the core series rose +0.1%. The PCE core and headline price series both showed a year-over-year gain of +1.5%, which remains quite tempered and below target, in line with other standard inflation measures.

(-) The S&P/Case-Shiller home price index for July came in weaker than expected, falling -0.5% versus a consensus estimate calling for no change. Three-fourths of cities in the survey experienced price declines in the month, but several upper Midwest cities (Minneapolis, Chicago, Detroit) all lost over a percent. Year-over-year, the index has gained +7%, which is not as exciting as in recent years, but above the long-term trend (per Professor Robert Shiller's compilation of data, indicating roughly 4% nominal and just over 0% in after-inflation terms per annum since the early 1950's).

(-) Pending home sales for August came in a bit weaker than expected, down -1.0% compared to a consensus estimate of a -0.5% decline. The West was the largest positive contributor, gaining almost +3%, while all other regions declined–Northeast being the worst at a -3% decline. Sales results are +11% higher than their lows earlier this year yet -2% lower than a year ago at this time. These month-to-month releases are spotty, and, along with related housing stats, are somewhat disappointing.

(-) The Conference Board's consumer confidence survey for September dropped more than expected, from 93.4 last month to 86.0 (92.5 was the consensus expectation). Consumer assessments of the present situation and expectations for the future both worsened, as did the ratio of responses describing jobs being harder to get than they are plentiful, although the changes in responses for last month aren't that extreme.

(+) Speaking of confidence, auto sales through September have continued to look robust this year, gaining around +10% over this time last yea, and have moved upward in almost a straight line from their last low point in Sept. 2009, as seen in the chart below. Interestingly, despite perceptions, total car sales are only up a few percent from last year, while light trucks and SUV's have led the way by gaining well into the double-digits.

Total Vehicle Sales

(+) Initial jobless claims for the Sept. 27 ending week fell to 287k, about 10k below forecast. Continuing claims for the Sept. 20 week also fell to 2,398k, compared to an expected 2,425k. While only a single week, this was actually the lowest continuing claims report since mid-2006. No estimates or unusual factors affected claims last week, per the official release.

(+) The ADP employment report showed a gain of +213k jobs in September, surpassing the estimate of +205k. Manufacturing was by far the leading group, with an accelerated gain of +34k jobs, while professional/business services positions were +29k higher (but down from the prior month). There continues to be some doubt about the underlying usefulness of and correlation between the ADP report and official government jobs number, but it does provide another perspective on activity.

(+) The September government employment situation report turned out much better than expected. Nonfarm payrolls rose +248k (compared to an expected +215k), and the two previous months were revised higher by almost +70k–so somewhat significant. Professional/business services job gains came in at +81k, while retail jobs rose by +35k (although oddly affected by a work stoppage at the Market Basket chain of grocery stores in New England last month); state/local government positions also rose by +22k, albeit affected by some seasonality issues surrounding the start of the school year. Temporary work also rose by almost +20k, and has become a consistent segment of these reports.

The unemployment rate fell below 6% for the first time during the recovery, down to 5.9%, which was 0.2% better than expectations. The U-6 'underemployment' number also fell by two notches to 11.8%; the ratio of part-time to full-time workers has also fallen. The effect was largely driven by a drop in labor force participation by a tenth of a percent. Additionally, while household survey employment rose by +232k, adjustments that take into account definitional differences deemed the result far less impressive compared to the nonfarm payroll survey. Average hourly earnings were flat for Sept., despite forecasts for a +0.2% uptick, taking the year-over-year hourly earnings to +2.0%. The average workweek lengthened slightly to 34.6 hours.

Wouldn't it seem like unemployment is improving? Economists would say yes and no. While headline statistics have improved, as you would expect on a cyclical level, there remains a large underlying pool of workers that have fallen out of the labor force (noted by the shrinking labor force participation rate, which measures the labor pool vs. the greater seemingly employable population). Other underlying signs of job market normalization, such as wage pressures, haven't appeared.

Of course, this release and the reaction of markets gets back to what the report means in the context of both economic growth and Fed policy. Without beating this to death again, as many economic commentators have, we get back to the fickle balance between desired job growth (which implies stronger economic growth) but also the reality of Fed policy no longer being as appropriate in the current state of affairs, which would point to higher interest rates. If these rise in an unsettled, dramatic manner, the risk is negative repercussions for corporate and mortgage borrowing, not to mention a cash flow modeling effect on interest-rate sensitive assets.

Market Notes

Period ending 10/03/2014

1 Week (%)

YTD (%)

DJIA

-0.57

4.42

S&P 500

-0.72

8.12

Russell 2000

-1.28

-4.13

MSCI-EAFE

-3.43

-4.25

MSCI-EM

-2.60

-0.54

BarCap U.S. Aggregate

0.41

4.48

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

9/26/2014

0.01

0.59

1.80

2.54

3.22

10/03/2014

0.01

0.57

1.73

2.45

3.13

U.S. stocks lost some ground on the week, on net, as economic data disappointed and pro-democracy demonstrations in Hong Kong raised a bit of geopolitical tension, as a Chinese response remains uncertain, yet would send a sentiment signal as to the regime's true stance toward such activity (the world hopes for a more diplomatic response than what the regime has displayed in the past). Domestic large-cap stocks again outperformed small-caps, as the latter moved into -10% correction territory before recovering. From a sector standpoint, defensive utilities and consumer staples outperformed, while energy and materials lagged–energy stocks due to continued lower oil pricing.

Foreign equities were affected partially by a 1% increase in the trade-weighted U.S. dollar index, but even more so by weaker economic data. European stocks were hit as German manufacturing PMI for last month fell just below 50, which indicates a bit of contraction, and Eurozone inflation slipped another tick to a barely-positive 0.3%. The ECB meeting decision announcing purchases of covered bonds and later, asset-backed securities, may have struck markets as not extreme enough for the recessionary/almost deflationary situation Europe finds itself in.

Bonds experienced a positive week, with yields falling about 10 basis points in line with general risk-off sentiment. Long treasuries benefitted by over a percentage point in price gain, as did high yield in a reversal of cash outflows in prior weeks. Despite strong fundamentals and very low default conditions, it appears technicals in the high yield market, such as larger seasonal supply and increasing proportions of ETF activity, have been affecting shorter-term performance. Spreads now are a bit wider and a bit further away from all-time tight levels.

Outside the U.S., the stronger dollar provided another headwind for foreign fixed income, however, European debt gained strongly on hopes for continued Euro stimulus and accompanying lower rates. Emerging market debt, particularly in Asia, lost ground, primarily due to the currency impact.

Broader real estate indexes were roughly flat on the week, with a bit more strength in residential/apartments and retail, and sharply negative returns in Europe and Asia–no doubt impacted by the dollar.

Commodities were hit with a continuing headwind of dollar strength, which affected the majority of contracts adversely. Coffee prices bucked the trend, rising 10%, on fears that current drought conditions in Brazil will adversely affect next year's crop. You tend to see soft commodities like this act together in some instances, as many are grown in bulk in the same tropical areas (Brazil is a big one). Cocoa bucked this trend, falling nearly -10% as top producer Ivory Coast raised the price paid to farmers. In less obscure segments, gold fell as economic concerns abated a bit in light of stronger U.S. employment figures. West Texas crude oil fell to under $91/barrel, its lowest price since April 2013 when prices fell into the 80's–technical trends are certainly working against oil prices presently for those who follow the charts. Interestingly, the Saudi's, not known for being especially willing to cut deals in oil markets have lowered prices to Asian customers (if even only by $1/barrel or so) in order to remain relevant and competitive with increased competition from neighbors like Iran/Iraq and indirectly from North American supplies. One might argue some commodities are more important to watch than others, but oil prices are usually only newsworthy while they're spiking–which can be a dramatic increase in budget overhead to corporations, governments and households; however, lower prices can free up additional resources for better uses.

If you're looking for a one-word summary for how the 3rd quarter ended up, it would be 'currencies.' The U.S. dollar index rose over 7% in the quarter versus a developed market basket of currencies, and roughly half that amount when compared to a basket of broader emerging market currencies. This is substantial, as strength in one's domestic currency translates into corresponding weakness for foreign currencies translated back into dollars–so consider it a major headwind for returns last quarter. It's worth putting out a reminder of how volatile and fickle currency trends can be (central banks themselves have historically experienced a hard time managing currency expectations, let alone bucking market trends). Just a year or two ago, we remember responding to inquiries from clients wanting to 'sell all their dollars' and move into whatever foreign exposure or hard asset (real estate, gold...or firearms and canned goods) they could get their hands on. Naturally, this was poorly timed, and the opposite condition ensued, albeit through some patches of volatility. We aren't in the habit of making currency predictions, but extreme moves in any assets should give an investor pause as to their continuity.

Trade Weighted U.S. Dollar Index: Major Currencies

The expected dollar collapse was based on the rationale of QE exploding beyond expectations, resulting in rampant inflation, which has a currency-depressing effect. Inflation by conventional measures hasn't taken off as of yet, but, even more importantly, ambitious stimulus measures in Japan and Europe have sunk the Yen and Euro, respectively (it's easy to forget that any two currency pairs are priced in relative terms only to each other). So, coupled with a U.S. economy gaining more solid footing and lessened need for our own stimulus (QE ending in October), we've perhaps been the best-looking currency option out there for now. This explains some of the recent technical strength.

Other than that overriding component, returns for domestic stocks and bonds ended up fairly tame in the 3rd quarter, in the range of 0-1% for both the S&P 500 and BarCap Aggregate. Foreign equities, with the above-noted currency effect embedded in returns and working against them, were notably lackluster, and brought returns for most portfolios into the negative. On the positive side, our portfolios generally held their ground better than did our set of blended benchmarks during the period. Ironically, foreign bonds were a very large positive contributor, but the bulk of asset classes added some degree of value over the period, while domestic corporate bonds lagged a bit due to the influence of high yield.

During our recent monthly advisor meeting, we demonstrated that over the last almost-90 years of market history, certain patterns have surfaced on a seasonal basis. In large-cap U.S. equities, the most notable is the differential between 'winter' months (Nov. through Apr.), which have gained an equivalent annualized return of 13.5%, while 'summer' months (May through Oct.) earned a less robust 6.8% (the overall market earned an annualized 10.1% over the entire period). Over the last twenty years, this pattern has become even more dramatic, with 'winter' periods improving to a 15.4% annualized rate, while 'summer' has deteriorated to 3.3%, with the overall market falling at a leaner 9.2% rate.

From a monthly standpoint, we just finished the seasonally worst month on a historical basis–September–which is the only calendar month with a losing record. While more volatile than average, October returns have been slightly positive, with November and December among the most productive months to be an equity investor. No forecasts for this year, but history has tended to look favorably on the holiday season.

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, September 29, 2014.

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