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Weekly Review - September 7, 2015

Weekly Review - September 7, 2015

Guest Post - Tuesday, September 08, 2015

Summary

  • Economic data was mixed with weakness seen in manufacturing, while services remained strong, albeit weaker than last month. The monthly employment report disappointed relative to expectations, although it contained some positive revisions.
  • Equity markets continued to experience heightened volatility, losing ground on net for the week. Bonds benefitted from the risk-off environment, gaining as interest rates fell back. Oil prices ticked upward on the week, despite volatility there as well.

Economic Notes

(0) The ISM manufacturing report for August fell a point and a half to 51.1, deeper than the expected slight decline of a few tenths. Export orders fell below 50, to a multi-year low point, but somewhat expected given the persistently strong dollar environment and this trend alone may explain some of the sporadic results in this series. New orders in total fell by -5 points but stayed positive, as did the production index and manufacturing employment. While somewhat disappointing, this index has been choppy and indicative of the slow growth environment seen in other reports. While this is the weakest reading since Spring 2013, anything over 50 is still positive territory.

(+) The ISM non-manufacturing survey fell -1.3 pts. from last month to 59, and off of highs, but a point higher than the expected 58.1. Business activity, new orders and employment all fell, but as the headline figure implied, anything near 60 is considered quite strong. While less closely-watched than the manufacturing survey, services have appeared to be the stronger of the two surveys, and of more direct importance, this is a much larger part of the economy from an jobs perspective.

(0/+) The Chicago PMI for August came in at 54.4, just a tenth below expected, and three-tenths below July’s reading. Nevertheless, a reading solidly above 50 represents continued manufacturing growth in the quarter. New orders and production both fell slightly from last month, while employment improved, despite remaining under 50. Anecdotal information from survey contributors was mixed, but pointed to some inventory build as expectations for the 4th quarter have grown more positive. This plays out in the data as inventory indexes are quite high (over 60), which does show optimism, but could be a take-away from future months’ production. These variables are always a give-and-take to some degree.

(-/0) Factory orders for July rose +0.4%, which was about half of the forecast +0.9%, while core durable goods (which are non-defense excluding aircraft) rose +2.1%. Shipments increased at a higher +0.6% rate, while inventories declined a tick.

(+) Construction spending in July rose +0.7%, which just surpassed forecast by a tenth but previous months were revised higher, which was more of a positive.

(+) Total vehicle sales for August rose to 17.8 mil. annualized units, up +0.5 mil. from this time last year and representing the fastest pace of sales in a decade. Car and truck sales have shown consistent strength, which demonstrates a willingness of consumers to invest in big-ticket items (a positive and wasn’t the case for a few years following the financial crisis). Per the Fed, auto loan balances also rose by +8% in the 2nd quarter from a year prior, which could reflect both an increased willingness to take on debt but also banks’ willingness to extend credit.

(-) The ADP employment report for August came in at +190k, which was just under the +200k expected. Service jobs accounted for an overwhelming +173k of the total, while goods production the other +17k. As construction gained by +17k, the key decline of -7k was in the ‘mining’ area, which also includes oil extraction activities that have been on a steady downward trend.

(+) Initial jobless claims for the Aug. 29 ending week rose to 282k, higher than expectations calling for 275k. Continuing claims for the Aug. 22 week were just +4k over consensus at 2,257k. No special factors were reported. These have slowly moved higher over the past two months, but remain within low historical ranges.

(0) The big government jobs report on Friday for August was a bit mixed. Nonfarm payrolls came in at +173k, which disappointed relative to the +217k expected. A variety of areas showed weakness, including manufacturing jobs, which declined by -17k and the opposite of the prior month, and retail, which gained by +11k—about a third of last month’s increase. Unsurprisingly, the mining segment (which includes energy) lost jobs again. On the positive side, government job gains were a bit better than last month, July payrolls were revised upward by +30k to 245k and June were bumped upward as well.

The unemployment rate fell two-tenths to 5.1%, a tenth better than expected. The U-6 underemployment rate also declined a tenth to 10.3%. The labor force participation rate was flat at just under 63%, which added credibility to the report not being the result of a mathematical quirk. Average hourly earnings rose +0.3% for the month, a tenth better than forecast, and bring the year-over-year gain to 2.2%. Weekly hours worked moved upward to 34.6.

Revised nonfarm productivity for the 2nd quarter, which was released earlier in the week, showed a gain of +3.3% in the 2nd quarter, which beat expectations of +2.8%. However, the year-over-year result was a tempered +0.7%, and continued a trend of tempered productivity readings. This included, unit labor costs fell -1.4% for the quarter

August employment reports have a tendency to be odd, and, interestingly, have missed consensus almost 80% of the time during the past three decades. It could be summer seasonal issues, including a low survey response rate, but no clear-cut culprit has been identified. The good news is that during the last few years, Aug. reports have been revised dramatically upward in subsequent months; regardless, the weakness of the report coupled with economic volatility in Asia bleeding over to U.S. markets perhaps buys the FOMC a decent enough reason to stay on hold during the Sept. meeting, which is now the consensus case.

(+) The FOMC beige book, packed full of anecdotal economic conditions around the country, showed continued expansion—along the same lines as recent releases and trends. Expectations were also positive on a nationwide basis, with a few small exceptions. Manufacturing activity was described as ‘mostly positive,’ with growth in consumer spending, notably in the tourism sector. Housing activity was strong nationwide, although construction was more of a mixed bag based on region. The oil sector continued a downward path of pessimism, as activity was described as stable to declining—representing a low spot in the book. Employment growth as characterized as slight to moderate, so not quite as strong as in recent reports, but was coupled with higher wage pressures in some areas like in more specialized/highly-skilled positions. Overall, it offered no major surprises, but was a bit better than expected compared to other manufacturing and sentiment surveys in recent weeks that have been spottier.

Market Notes

Period ending 7/10/2015

1 Week (%)

YTD (%)

DJIA

-3.21

-8.07

S&P 500

-3.36

-5.37

Russell 2000

-2.28

-4.90

MSCI-EAFE

-4.37

-3.97

MSCI-EM

-3.86

-17.54

BarCap U.S. Aggregate

0.27

0.78

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

8/28/2015

0.06

0.72

1.52

2.19

2.92

9/4/2015

0.02

0.71

1.47

2.13

2.89

U.S. stocks started the week down sharply again, as manufacturing data in China experienced its sharpest decline in three years and sentiment remained shaky around the growth situation as a whole. Some recovery towards mid-week netted out some of the earlier moves, in a similar situation to the prior week, before lagging again Friday with a lackluster jobs report that left participants wondering again about Fed timing. Some of the positivity was perpetuated by comments from ECB president Draghi indicating that the European quantitative easing program could be extended—with an increase in the cap they’re allowed to purchase of any given member nation’s sovereign credit from 25% to 33%. Also, last week, the IMF downgraded global growth forecasts a bit—offsetting some of this ‘good’ news—to 3.3% this year, down a tick from 2014’s 3.4%.

From a sector standpoint, telecom, consumer discretionary and staples outperformed with smaller losses than the broader market, while utilities and health care lagged.

Foreign equity returns were largely negative in line with the U.S., but no clear regional pattern came into play, other than commodity producing countries like Australia, Brazil, South Africa and Russia continuing to experience higher volatility with uncertainty about global growth and mixed weakness among Asian nations seen as most dependent on Chinese strength. On the other hand, Eurozone PMI improved to above 54, which likely helped sentiment there in relative terms, along with the ECB announcement about additional easing capacity.
Canada, an economy we don’t talk often about despite its proximity, fell into recession during the 2nd quarter (at -0.5%), although economists expect this to be a short-lived event. Like Australia and Russia, the Canadian economy is very dependent on commodity activity, and lower pricing plays a strongly negative role, although it’s not as sensitive as it used to be. More importantly, Canada represents just under 20% of U.S. exports, so continued weakness could play a role with domestic earnings.

U.S. bonds gained on the week with risk-off sentiment and negative equity results, and credit (including high yield) outperformed governments by a few basis points. Fears of slowed global growth translated through to lower prices for TIPs as well as a sell-off in emerging market debt, more directly related to China from a sentiment standpoint. The dollar was little changed on the week, so didn’t contribute much as a factor.

In a recent conversation with our global fixed income management team, in a market segment that has been disappointing over the last few months due to the China issue, it was clear that underlying long-term themes haven’t changed. Demographic growth and economic evolution from base manufacturing to next-state service-type activity, as well as steadily increasing wages and higher consumption, point to emerging markets continuing their trend of convergence with developed markets. It’s also important to remember the differences in critical conditions for equity and fixed income—the former requires earnings growth to justify valuations ultimately, while bondholders just need their loans paid back. Fundamentally, such nations are in much better shape than they were during prior crisis, such as the late 1990’s, when pegging currencies to the dollar was much more common. So, instead of nations taking on the currency risk themselves, this is now being passed on to bondholders (if they own local currency debt—increasingly the most common variety), which explains the bouts of volatility in this asset class as of late. However, opportunities here remain much more attractive, particularly in the nations lying on the cusp ‘in between’ EM and DM than in the low-rate regimes of the Japans and Germanys of world, with rates at or under 1%.

Munis were boosted by an agreement between Puerto Rico’s electric utility company and big muni issuer and bondholders—the utility had likely hoped for deeper debt forgiveness while debtors had pushed for full payment. As a solution, an offshore special purpose vehicle was established to collect payments on behalf of bondholders and debt itself was restructured at a price of 85 cents on the dollar. While less than par, granted, this was expected, and pricing had been as low as the 50’s and 60’s, which implied a much more negative outcome. Consequently, this solution was a boost for muni sentiment, with the high yield muni index rising by over a percent on the week.

U.S. real estate experienced sharp losses on the week, while European and Canadian names fared significantly better. Residential and regional malls were the weakest segments, while mortgage REITs held up far better with lower rates and potential for postponed Fed easing.

Commodity indexes as a whole only suffered slight losses on the week, as all segments lost ground with the exception of energy, which rose a bit. Despite a risk-off week, gold lost ground, while industrial metals continue to suffer under China growth concerns. Crude oil bounced around mid week as rumors of OPEC concerns over low pricing spurred possible discussions with other non-cartel nations about production levels caused prices to spike by 7%, before Asian economic concerns reset prices dramatically lower the following day—after all this, per barrel prices settled higher on net at just under $46.

On an updated note about ETF liquidity, as we expected in a few cases, some of the smaller, less-popular products have begun to experience closures. The smaller providers featuring nichier ‘themed’ strategies struggled from the outset, especially as low asset bases and continued high fees caused a self-fulfilling prophecy of failure—relative to the broad market exposures available to investors for a little as 5 or 10 basis points. Now, even large providers have begun shuttering strategies that have failed to garner sufficient interest, such as in Canadian small-cap stocks, Asian tech sector companies, or various sectors of the real estate market (like distinct exposure to office or retail REITs). It’s unfortunate, since these products were useful for gauging sector characteristics and sentiment, but it seems the next wave of ETF consolidation is happening. No doubt more to come as investors focus increasingly on low costs, and, increasingly, liquidity. The difficult reminder of the past few weeks is that smaller ETFs in nichier areas aren’t a foolproof way to obtain exposure in a less liquid bucket of stocks, but the products themselves can experience twists and turns when market behavior gets more erratic.

We’re again entering a volatile time of year, as trading desks are getting back to full staff from summer vacations and volumes traditionally pick up. There have actually been some academic research papers on the topic of why trading activity and volatility pick up so dramatically around this time every year, but the ‘vacation’ hypothesis is about as good a story as any researcher has been able to come up with. You would think these types of things would allow for better answers than they do.

Since 1950, the average day in the S&P experienced an absolute (either up or down) change of +/- 0.66%. When reviewing sessions that ended +/- 2%, we end up with only the most volatile 5% or so of days over that time—so roughly about one per month. Volatile days have been shown to be ‘stacked’ together in distinct periods, as are periods of low volatility. So, long-story short, we could see more of this as we enter into the most volatile months of the year.

As we should have expected, this vol caused the VIX implied volatility index to shoot sharply higher, hitting 40 the prior week before ‘settling’ into the 30’s and upper 20’s last week. Regardless, far higher than the 10-15 range we’ve been used to for much of 2015. One interesting tidbit is that every time VIX has exceeded 40 over the last 25 years (7 times), the market ended up positively over the following 12-month period.

While the stock market correction and volatility is certainly a change of pace from the slow summer and has been/continues to be unsettling to some clients, context is critical. One is always reminded of this when looking back upon familiar charts of famous stock market drawdowns. Seeing names like ‘Pearl Harbor,’ ‘Cuban Missile Crisis,’ ‘Volker inflation fighting,’ and ‘Dot-com bubble’ point to critical geopolitical or valuation mania events with unsurprising volatile outcomes. It remains to be seen whether a title of ‘Chinese growth slows from a very robust 7% pace to a more sustainable 5-6%’ warrants the same reaction and similar level of concern in the long-term picture.

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 August 31, 2015.

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