Daily Insight

U.S. stock indices bounced around between gain and loss on several occasions yesterday, but in the end closed roughly flat. The NASDAQ took the brunt of the damage, closing lower by nearly 1% as most technology shares were pressured by investors’ concern over the consumer as crude prices gained more ground.

Financial shares were the worst-performing sector, but the broad market managed a fractional gain thanks to a big day from the energy group -- industrial, basic material and utility shares also closed higher.

Volume was weak as just 1.1 billion shares traded on the Big Board, the lowest activity in about five weeks as investors seem willing to wait on the sidelines for tomorrow’s Fed announcement. The three-month daily volume average is roughly 1.5 billion shares.

UPS came out yesterday and lowered their earnings guidance for the second quarter ala the FedEx announcement last week. The two statements read the same as the dramatic jump in energy prices was too quick for the two logistic firms to match with fuel surcharges. They also both reported customer cutbacks in air shipments, which is their most profitable unit.

General motors also came out and stated -- as they too get crushed by higher fuel costs; their most profitable unit, truck and SUV lines, find very few buyers as gasoline has moved to $4 per gallon – that plant closings will be prolonged by an additional couple of weeks. This won’t help the manufacturing figures, but the sector is holding up relatively well nonetheless.

Manufacturing has been dealt a nasty combination from the housing correction and low auto sales environment, but factory output remains very near the expansionary level. This is a reality we’ve pointed out for months now, underlying economic strength remains, for if this were not the case the manufacturing readings would be pushing 45 on the ISM index rather than hovering right at the dividing line between expansion and contraction. Thankfully business sales remain on an upward trajectory and this has driven inventory levels near record lows. The production necessary to keep stockpiles from moving to new all-time lows (as a percentage of sales) is keeping factory activity from slowing too much. Still, if fuel prices are allowed to rise like this, you can bet this index will move to the mid-40s.

And speaking of higher costs, we’re seeing trends continue to point to a situation that the Fed may lose control of if they don’t take their heads out of their Keynesian textbooks and focus more on market realities.

We’ve talked about higher import prices for five months now. While consumer-level inflation remains somewhat tame, one cannot expect this to last forever, there is only so much strong productivity improvements can do to quell inflation as import and producer price gauges remain at harmful levels.

And it’s not just the goods’ prices that are rising but service costs, namely transportation costs, have soared as well as one would expect. The expense of shipping a standard 40-foot container from Asia to the U.S. has jumped 50% on average over the past 14 months. Air freight costs are up 16% in the past year, and that’s before surcharges have been tacked on to reflect the recent jump in energy prices. This is why consumers are pulling back from this form of shipping and UPS and FedEx feel the pain.

In terms of goods, iron ore and steel imports were up 46% in May (on a year-over-year basis), which is allowing domestic producers to raise prices by 36% -- according to Bloomberg News – without having to lose market share.

Meanwhile, the Fed fiddles. The irony is that a mild boost in the fed funds rate (the Fed’s benchmark rate) can actually fuel growth by lowering transportation costs via lower fuel prices. That’s opposite the conventional wisdom (higher rates boosting economic activity) but watch it work…if the Fed would only get to it.

They end their two-day meeting tomorrow. It would be great to see them begin to gently increase fed funds – the longer they wait the more abrupt and thus painful the rate hikes will be – but they won’t. They’ll ramp up the rhetoric in their statement tomorrow and then begin to boost fed funds in August on their way to 3.00% by year-end – that’s my call at least. If they do so, the dollar will get a boost, oil prices will come lower and a huge weight will have been lifted from the consumer, producer, and the market.

Have a great day!

Brent Vondera, Senior Analyst