North Pier Market PIERspective – Jim Scheinberg (October 19th, 2011)
“The only thing we have to fear is fear itself.”
Sentiment turned nearly to hysterics as Q3 unfolded. It was a quarter that saw volatile selloffs steadily mount in the face of a barrage of pessimistic conjecture, innuendo and uncertainty. Congress rattled nerves by playing a fiscal game of ‘chicken‘ with the U.S. debt ceiling. Then the Eurozone debt-boogieman raised his scary head almost daily in September. Wedge a downgrade of U.S. credit worthiness by S&P in between and you’ve got a saga that could have been written by the Brothers Grimm. In fact, I propose that it was.
I was astounded by the lopsidedness of the reporting being done by the talking heads of the financial press (where so many people flock to in order to get “informed”). Viewers were fed a constant flow of interviews with pessimists and doomsayers as the markets declined, exacerbating the weakness. Most sound bites were prefaced with “ifs” and “believes” and “expects” and very few “is”, “data” and “reported.” And no wonder. The actual data never depicted the “falling into the abyss” scenario painted by the emotionally driven sentiment gauges. At best, real measures of the economy showed that the pace of growth slowed from robust to moderate. Now don’t get me wrong, we are certainly not out of the woods. As a friend of mine put it a few weeks ago, “I don’t see us heading into a double dip, but we could talk ourselves into it.” If fear based sentiment sticks around long enough, it may solidify into action. But then again, now I’m speaking in “ifs.”
How the Markets Fared
Equity Markets across the globe sold off aggressively in the last week of July and the first week of August. The quarter began with both parties in Congress clashing over a routine periodic raising of the U.S. debt ceiling. Predictions of a massive global selloff in the U.S. Treasury that could ensue if an agreement was not reached had equity investors sitting on the edge of their seats. As the August 2nd deadline approached, nervous investors started selling equities to insure against a stalemate. Even though an eleventh hour deal was eventually reached, no relief was provided to equity investors. Two days later, S&P downgraded the credit rating of the United States anyway, sending markets reeling. All in all, global equity markets sold off nearly 20% in the two-week period. The remainder of the quarter was spent skipping off the new cycle lows as European debt fears and domestic economic uncertainties were debated.
For the quarter, most global equity markets suffered their worst quarterly loss since the dark days of the financial crisis. Domestic stocks were down from thelow teens to low twenty percents. Growth led more economically sensitive value stocks and large caps proved to be more defensive than their less liquid small cap brethren. International stocks moved in tandem with those in the United States during the decline but were then dealt an additional blow as European debt concerns pushed indexes even lower in September. At the same time, declines in the Euro and the Pound made matters worse for European equities when measured in Dollar-terms.
Investors fleeing stocks turned to the perceived safety of Treasuries in August, pushing yields down a dramatic 120 basis points on the 10-Year to finish the quarter at a near record low, 1.95%. (Yields had amazingly pulled back below 1.75% on the bellwether just a week prior, a rate not seen even during the mania of the financial crisis.) This run on Treasuries helped propel returns of the BarCap Aggregate Bond Index up nearly 4% for the quarter. Investors in long-term U.S. Government bonds saw returns exceeding 20%. At the same time, investors piled back into TIPS for protection against future inflation. Concerns over the health of the domestic economy, however, sent yield spreads widening on less credit worthy paper. High yield bonds saw declines of six percent net of interest during the quarter.
Shaken but Not Deterred
One need look no further than to the consumer to see the duality going on between behavior and sentiment which took place during the Third Quarter. The August Consumer Confidence Index plunged from 59.2 in July to 44.5 in August (before leveling out in September). This slide was dominated by the Future Expectations component plummeting to 51.9 for August, from 74.9 in July. These were the lowest readings in over two years. The ‘current conditions’ reading for that same period was only down a notch from 35.7 to 33.3 the month prior. Shockingly, during the same month, retail sales unexpectedly advanced by three percent month-over-month and a whopping nine percent year-over-year. Clearly the pessimism that was being reported did not change actual spending patterns.
Not a Home-Run but Maybe a Home-Base-Hit
Although moderating from their March highs, the latest readings for pending home sales are running nearly eight percent ahead of the same month last year. People are clearly continuing to take advantage of the most affordable housing market seen in generations. JP Morgan calculates that the average new mortgage now costs less than 11% of average personal income. This represents nearly a 50% reduction from the 2007 peaks. Low interest rates and greatly deflated values in most markets make purchases very reasonable for those who qualify. But therein lies the rub. Take it from someone who was one of those homebuyers in Q3, qualifying is an arduous task, even for those with strong credit. The good news is that cash buyers continue to step in, now accounting for 30% of purchases (up from 12% just two years ago). With rents rising nationally, it appears that values are so compelling, that cash investors see a floor near these levels. The Case Shiller 20 City Index seems to support this notion, with July representing the fourth monthly home values gain in a row. Housing Starts for September confirm this notion, rising a surprising 15% from August and 110% year-over-year.
Business to Business Still in Business
I have asserted numerous times that the economic recovery has largely been lead by business-to-business activity. Most all indications point to this crucial engine of the recovery still maintaining forward progress, albeit at a less robust pace. The Conference Board’s Leading Economic Index® (LEI) for the U.S. increased 0.3 percent in August, following a 0.6 percent increase in July. Ataman Ozyildirim, an economist at The Conference Board commented, “The August increase in the U.S. LEI was driven by components measuring financial and monetary conditions which offset substantially weaker components measuring expectations.” Again, as we see with the consumer, sentiment has weakened but activity has not. We see the same pattern in corporate capital expenditures which also moderated during the quarter but are continuing to show modest growth.
At North Pier, the most accurate gauges we have monitored since the crisis first hit have been the Institute of Supply Management’s Purchasing Manager’s Indexes. As with last summer’s temporary moderation, the PMI has retreated from robust growth readings earlier this year, to more modest economic progress this summer. However, even in the wake of all the negative events previously discussed, these indicators have not dipped into ranges forecasting contraction. Through September, both the Manufacturing and Services sectors continue to show better readings than 50, indicating continued expansion. Manufacturing has shown the biggest pullback with new orders and backlogs posing more troublesome indicators. However, the Non-manufacturing indexes actually exhibited improvements in new orders and backlogs in September. In the very least, it appears that those on the front lines of business are not battening down the hatches for an economic storm. If the pattern of last year repeats itself, expect large advances in both of these indexes for the remaining months of the year.
The Labor Department reported that the economy added 103,000 new jobs in September. Although this number is still weaker than the 150,000-200,000 a month needed to begin reducing unemployment, it does not appear to be indicating that conditions have materially worsened either. However, there seems to be a bonus beneath the headline September number that was released in the latest report. The Bureau of Labor Statistics also revised gains in nonfarm payrolls for July and August up 42,000 and 57,000 respectively. This means that as of the latest report, 202,000 new jobs were actually reported. If this trend of report and upward revision holds, the labor market may in fact also be poised for a comeback.
I often found myself asking this question during the Third Quarter, “What’s new about this that we didn’t already know a couple of months ago?” We all had anticipated a short-term pause in global growth in the aftermath of the Japanese earthquake, which happened just two short quarters ago. The well examined European debt situation revealed no new systemic vulnerabilities, just speculative concerns over the political response that would be needed to address it. And domestically, fears of soaring interest rates that might result from a failure to raise the debt ceiling and/or a U.S. credit downgrade turned out to ill-founded. In fact, the antithesis happened, as interest rates plummeted immediately following the S&P downgrade. Sorry folks, I just didn’t see what the mania was all about.
And I still don’t. Business activity is healthy. Labor, although lackluster, is not deteriorating, and in fact is showing promising signs of stability. Housing prices and activity appear to be bottoming…finally. The consumer, despite what they say they feel like, is spending again (after paying down debt and increasing savings rates). Corporations’ earnings continue to climb, now matching all time record levels. They too, have much improved their balance sheets these last few years, holding over three Trillion in cash that they are beginning to deploy. BRIC nations continue to emerge, adding tens of millions of new consumers to the global market each year. This rise continues to benefit multinational corporations both domestically and abroad alike. Add to the equation U.S. stock market valuations that are near historic lows (<11x forward S&P 500 earnings estimates), while profits are growing at a robust rate and it becomes hard for me to accept the pessimistic case being made by the naysayers whose arguments begin with “I feel.” But that’s just my PIERspective.