North Pier Market PIERspective – Jim Scheinberg (January 19th, 2012)
Global equity markets again regained their senses in Q4 and recovered from an emotionally-charged summer selloff, just as they did to finish 2010. Over the last two quarters we commented on the similarities of these two fear-based corrections. This quarter, we draw parallels to the recoveries that followed…and note the differences. After faltering on curveballs thrown from the Gulf oil spill in 2010 and the Japanese earthquake in 2011, sustained economic growth may finally be at hand, at least here at home. The picture is becoming clearer. Though skepticism still rules the day, I think the case is strong that we are heading for an economic surge that will surprise most, and leave some behind.
How the Markets Fared
Similar to 2010’s late-year rally, during which fears of a double-dip recession subsided, the U.S. stock market rose double-digits again in Q4, erasing much of its summer losses. Small cap names led in the recovery (reversing their larger drop during the decline). Amongst larger names, we are beginning to see a shift into value-oriented stocks, which outperformed growth indexes by a few percentage points during the period. This is typical in the first several quarters of an economic recovery. If the economy is truly heating up, it is highly likely that this cyclically sensitive side of the market will dramatically outperform traditional growth names, near-term.
International equities rebounded as well in Q4, but not nearly as well as they did in Q4 of 2010. In both periods, developed international markets lagged the U.S. in performance. The predominant reason for the differential in performance abroad between this year and last was that the Euro sold off against the Dollar in Q4 by about 4%, which muted performance in Dollar terms (vs. a more modest decline of just 1% in Q4 2010). Actual stock index returns were also not as robust, as the European region’s economy was not expected to accelerate in tandem with the United States’ this year, due to their debt struggles. (More on this later.)
After such a volatile Q3 for U.S. Treasuries, the fixed income markets were surprisingly calm in the last three months of 2011. The benchmark 10-year Note was virtually unchanged, falling just 5 basis points to end the year at a near record low 1.87%. One big difference between 2011’s year-end rally and last year’s was that there was no rebound in yields. If the massive drop in yields in government bonds in Q3 2011 was a result of a “flight to quality” trade, then where was the reversal as the risk-trade came back on and equities rallied? With the exception of a small rebound spike in yield in October, interest rates in the T-note traded in a remarkably tight range of about three tenths of a percent. This may be influenced by rather aggressive comments from the Federal Reserve that they intend to keep short-term interest rates low into mid-2013, at the very least. Further, the Fed’s “Operation Twist,” in which they have begun selling short-term paper and buying longer-term Treasuries in the open market, has also put downward pressure on the longer-end of the yield curve. The Fed intends on buying $400 billion in longer-term paper between Q3 2011 and Q2 2012. The stated intent of their activist, low interest initiatives is that lower interest rates are necessary to stimulate the struggling economy. What is curious, however, is that they continue to make these statements and push this policy in the face of improving economic numbers.
In other areas of the debt markets, returns were slightly more positive. The TIPS market posted another decent quarter as demand from inflation-anxious investors pushed prices even higher. Premium pricing for TIPS is now resulting in negative real yields for all maturities shorter than 10 years. North Pier continues to be concerned about a bubble in the inflation protected market but sees no catalyst for an unwinding of this phenomenon in sight. (For more information on the displacement in the TIPS market, request our position statement paper on TIPS.) Q4’s improvement in economic conditions and sentiment helped yield spreads tighten, resulting in the high yield market completely wiping out its losses from Q3. Similarly, emerging market debt rebounded nicely as well. However, due to the previously commented decline in the Euro, developed market international bonds provided zero net returns for the quarter.
The media, pundits, policy makers and other talking heads alike, may have braced for a doubledip recession this summer, but American businesses never did. North Pier has been closely tracking the Institute of Supply Management Purchasing Managers Index and its subcomponents for some time, and never saw more than a modest slowdown in the pace of growth. As the fear shockwave from the debt ceiling issue subsided, businesses began to resume their expansion. Both the PMI manufacturing and service indexes failed to dip below the key 50 level (indicating contraction) and are now climbing back up the ladder, indicating robust growth ahead. The most recent manufacturing index has climbed back to 53.9 from a low of 50.6 in August. The non-manufacturing index (services) now stands at 52.6, having only dipped to 52.0 in November. Of still further encouragement is that new orders in manufacturing are quickly mounting, with a robust reading of 57.6 in December after briefly stalling out at 49.6 in September, when the world took a pause.
In fact, it appears that even in Q3, business-to-business activity never really slowed. Capital expenditures have been soaring, led by exploding growth in software and equipment. Some figures suggest that these areas are growing at a pace between 17% and 30%. As we have always asserted, it is this business activity that has been the driving force in the economic recovery underway since the spring of 2009. This assertion was recently supported in an observation from Citigroup Vice Chairman, Peter Orszag:
“In the third quarter of 2011, private-sector investment in equipment and software accounted for more than 60 percent of total growth in gross domestic product.”
That’s remarkable considering we live in a country where over two-thirds of GDP is attributed to the consumer. Clearly ‘business’ has been the workhorse of any expansion we have seen in the last several quarters, but that may be changing…
Strengthening business conditions finally seem to be leading to sustained job growth. In our Fall Commentary, I noted that there was some encouraging data lurking behind the September headline jobs growth numbers. Though September’s initial report originally came in at a lackluster 103,000 jobs created (a number of 200,000 or more indicates meaningful improvement), I noted that the prior two months had been revised upwards, tallying an additional 99,000 jobs. My theory of shadow job creation proved correct when the October and November announcements showed the same pattern. October’s report showed a gain of only 80,000 jobs but upward revisions of another 102,000 to the prior two months and then November showed gains of 120,00 jobs and 72,000 in upward revisions. Again, when summed, the net gain reported for all of these periods was approaching the magic 200,000 mark. Ironically, the final tally for the original September period (for which I initially noted the trend) was indeed, 210,000! Finally, December’s recent headline report showed a gain of 200,000 jobs for the month with no meaningful net revisions. This trend over the last four reporting periods has helped whittle the unemployment rate down from August’s 9.1% to 8.5% in December. Labor conditions are finally strengthening.
Housing: Declines are on the Decline… It’s About Time!
No, we still are not on the rise quite yet, but the rate of descent of home prices in the United States seems to be leveling out. Although down about 3% nationally year-over-year, the Case Schiller 10 and 20 City Indexes are essentially unchanged over the last 18 months. We seem to be skipping across the bottom, which was a similar pattern seen after the early 90’s bear market in residential real estate. There are several signs that this bottom is sustainable and may soon turn northward. The National Association of Realtors’s (NAR) November Pending Home Sales Index (PHSI) showed a 7.3% jump from October, which also soared 10.4% from the month, prior. November’s 100.1 reading is the highest in a year and a half. Housing starts are also showing encouraging signs of life, with permits for single family homes rising nearly 25% year over year in November, albeit up from near catatonic levels. Apartment construction is on the rise as well. All this is welcome news for the construction industry, which has recently been showing signs of life.
The pendulum may simply be done swinging the other way. After valuations got so out of whack during the ’06-’07 market peak, home-buying affordability and the rent vs. own equation have seemingly never looked so favorable for purchasing. This may be part of the reason that speculators are snapping up homes in droves. A new report out by Hanley Wood’s Housing IntelligencePro, suggests that as much as 38% of houses purchased in 2011 were bought for cash. With apartment inventory low and rents on the rise, it seems that at least investors are recognizing value. The same cannot be said for first-time buyers who represent only about three of ten purchases in the market. That is down from a normal level of about four of ten (according to the NAR). Despite record affordability, potential new home owners would rather rent than risk the possibility of a decline in value. This scenario is likely to change if the economy continues to improve and values remain somewhat stable.
Consume-sume-sume; They’re Back in the Showroom
Well, consumers might not be ready to commit hundreds of thousands of dollars to buying a home, but it appears that they are, in fact, starting to let loose of the purse-strings for smaller purchases. A better jobs-picture and long awaited stability in home prices gave consumers confidence, helping make the 2011 holiday season a jingle-bell-ringing success. Most measures reported a 4% rise in sales compared to 2010 after initial predictions of an already modestly-optimistic 2.8%. Moods certainly did get Christmas-cheerier. The Reuters / U. of Michigan Consumer Sentiment Index rose to 74 in January and is now challenging the post crisis highs of 76 set in June 2011 and 77.5 set in February 2011. The Conference Board Consumer Confidence Index is showing a similar, optimism-inspiring pattern. Americans may have finally gotten their financial houses back in order, having paid down debt and added to their savings. After the personal savings rate hovered between 4 percent and 5 percent for much of the last 18 months, it declined to 3.5% by November. This differential seemed to have gone into spending. Consumer credit usage is up as well, a further sign of improved outlook. This improvement in consumer behavior might be smaller than a house, but it IS bigger than a bread-box. Larger purchase items, such as autos, furniture and appliances increased between 5%-10% year-over-year.
Is it a coincidence that the Case Schiller index, PMI and consumer sentiment data all seemed like they were turning positive 18 months ago, only to have since run out of momentum? Perhaps. But let’s revisit the timeline. In Spring 2010, the economy was beginning to firm and optimism was on the rise. Then the United States got hit with the Gulf oil spill and structural issue with EU debt began to surface. Investors and CFO’s alike recoiled from justifiably raw nerves. But alas, we did not fall back into the abyss of recession. Fuelled by substantial pent-up demand, the recovery resumed. Then tragedy struck the third-largest economy of the world in early 2011, literally taking Japan offline. The ripples are still being felt today. This economic shock dominoed into more concerns about European debt and threats to global growth. Add a near miss with the U.S. debt ceiling debacle this summer and fear took over the headlines and the emotions of the masses. But once again, the sky did not fall and at home, growth resumed. But what lies ahead for the U.S., Europe and the globe?
European Malaise Equals U.S. Hay-days.
It’s ironic that the Q3 sell-off in the U.S. was exacerbated by European debt concerns. As I see it, Europe’s problems will actually turn out to be a net positive to the U.S. in the near-term. You see, my macro level theme of the last several years is still in place. In the emerging regions, 10s if not 100s of millions of the world’s citizens are joining the consumer class as we speak. They want cars, air conditioners, hamburgers and smartphones. U.S. multinational corporations are poised well to meet this demand, which should stretch for years to come. With pristine balance sheets, loaded with cash and bargain-priced credit, these companies also have the advantage of operating amongst the broadest free markets in the history of mankind. European multinationals are as well, with just one exception. The U.S. multinational is operating domestically in a stable and improving economy. Their peers in Europe are mired in conditions and most importantly an emotional environment of uncertainty and instability…hardly an optimal position to aggressively compete. If I am correct, this will prove to be a tremendous advantage for the United States while the EU sorts out its sovereign debt mess. I predict this advantage will last years, not months, as Europe has no structure to deal definitively or swiftly with their problems. I truly see round after round of Band-Aids, duct tape and bubble gum fixes until the currency and the EU itself splinters or even worse, consolidates. (I will be commenting more on this paradigm in future commentary as it unfolds.)
The emerging economies of the world will continue to emerge whether developed countries excel or ebb. How laughable is it that we debate the success or failure of a year of Chinese growth amid a range of 6-11% GDP growth? Sounds like a win/WIN to me. As documented throughout this commentary, the U.S. is positioned well for some sustained incremental improvement. Just imagine if I am correct in spotting the end of the bear market in the residential real estate market and/or resurgence in consumer spending. The S&P 500 just broke a record in earnings last quarter… A RECORD! Yet the market needs to go up 25% to re-attain its prior high. And our economy has only begun to awake from its slumber. What would a revitalized construction industry, a drop of just one more percentage point in unemployment or a further increase in exports do to both the top and bottom line performance for these companies? Historically, rising consumer sentiment is highly correlated with an increase in stock multiples. Factoring improving sentiment, record earnings versus the alternative of getting 0.01% on your money at the bank, just how long do you think it will take for the U.S. stock market to regain its prior highs…if this time the recovery does not stumble? At North Pier, our PIERspective is; not long at all.