U.S. stocks declined on Monday as the Sunday night (our time) sell off in China caused investors to rethink the rally. Speculation that the Chinese government will implement lending curbs resulted in a nearly a 7% decline in Shanghai, pushing that country’s main bourse into bear territory – down 22.8% since August 4. The Shanghai Composite bounced back a bit last night, up 0.6% after China’s main factory gauge posted a sixth-straight month of expansion.
One would have thought the encouraging economic data in the U.S. (Chicago manufacturing on the cusp of expansion mode, which we’ll get to below) to have offset the overseas event and provide a boost to our market. Is this a shift, or just a one day event?
The trend over the past few months has been that only a mild boost in economic data, off of very deep levels to boot, was needed to spark equity-investor euphoria. We’ll find out over the next couple of days whether or not something has changed here. This morning we get the ISM number for August, it will very likely move to expansion mode for the first time since last September. If this occurs and stocks don’t respond in kind, it will be a clear sign that something has changed.
Yesterday’s decline reduced the August gain, the sixth-straight monthly advance; still the S&P 500 added 3.4% last month. That followed a 7.41% advance in July; a virtually flat June, up just 0.2%; a May gain of 5.31%; and romps of 9.39% and 8.54% for April and March, respectively.
All but one of the 10 major industry groups declined yesterday, consumer staples being the lone sector to buck the trend.
Volume was actually pretty strong, by the standards of the past three months anyway, as more than 1.3 billion shares traded on the NYSE Composite – 13% above this summer’s average. Declining stocks whipped advancers by a five-to-one margin.
Market Activity for August 31, 2009
Chicago PMI
Chicago-area manufacturing activity for August, as measured by the Purchasing Managers Index, moved to the line of demarcation that divides expansion from contraction. The reading jumped to 50.0, following 43.4 in July. The reading for August is the highest since September, when Chicago PMI stood at 55.9.
The reading beat the expectation of a move to 48.0 and I certainly thought it would be another month before we got back to 50, which we stated after the latest factory reading out of Philadelphia on August 20. One would have thought this move to spark a rally in stock prices, but the market actually traded lower on the news before regaining some of those losses later in the session.
A boost in auto production will keep the Chicago reading going for a couple of months. The Chicago factory gauge is highly exposed to the auto sector and the increase in vehicle assemblies coming off of the plant shut downs that followed the GM and Chrysler bankruptcies is playing a significant role (big inventory reduction after “cash for clunkers” kicked car sales higher) However, after a couple of months, as we move to year end, the factory sector will need to find support elsewhere.
The boost in the new orders index to 52.5 from 48.0 was surely driven by the auto sector – first move above 50 in a year. Order backlogs also looked good, not yet in expansion mode coming in at 45.8 for August, but marking nice improvement from a very low reading of 32.1 in July.
The employment index remains in deep contraction, hitting 38.7, but has improved significantly from the cycle low of 25.0 in May. (And on employment, we get the August payroll data on Friday. While the weekly jobless claims data suggest monthly job losses will be worse than what we saw in July, the firming in the auto sector should keep factory employment losses milder than was the case just two months back – this sector showed the rate of decline in jobs losses slowed meaningfully during July and that should continue in August.)
The Commercial Hurt
Investors’ concerns seem to be growing regarding the impact commercial real estate losses will have on the banking system (this time more so with community and generally smaller banks than the big guys). Just as in the residential lending standards when credit was offered to just about anyone based on the assumption that home prices would rise without interruption, commercial lending standards appeared to assume occupancy and rental rates would not abate.
The commercial side always erodes, with a significant lag, when the economy turns down. You have manufacturing properties that go bust due to reductions in output, office properties that see both rental and occupancy rates head in the wrong direction and mall properties take a beating due to a higher level of joblessness. If this situation doesn’t go well it will erode bank-industry earnings power, offsetting the hugely positive impact of a massively upward sloping yield curve (a situation that allows banks to borrow near zero and lend money at much higher rates, effectively helping to offset mortgage and consumer credit woes). According to the FDIC, banks have $1.1 trillion in core commercial real estate loans on their books (and another $590 billion in construction loans); it’s likely the downturn in commercial real estate will be the next hurdle for the economy.
I should make it clear though that trouble in the commercial side of real estate does not have quite the economic impact a downturn in the residential side does as the latter can have a profound impact on consumer activity. Still, losses in commercial loans does affect the availability of credit as capital ratios are diminished.
FDIC “loss shares” – Another Crutch
And speaking of the banking industry, through deals known as loss shares the FDIC is agreeing to absorb losses in portfolio loans of banks that have gone under in order to encourage other banks and private equity firms to come in and buy up the failed lenders. As the WSJ reported, the FDIC is agreeing to pick up more than 80% of future losses for most assets and 95% of losses on the rest – that is, it will cover 80% on the first $xx billion of losses (the actual amount depends on the institution) and 95% of losses above that given threshold. The loss exposure the FDIC will assume may skyrocket due to commercial real estate losses touch on above.
This means you’ll have private equity (PE) investors (also encouraged now that regulators have reduced capital standards on private-equity purchases of failed banks) willing to come in and take over a bank, buying up the assets and capturing potentially large profits over time. As the FDIC will assure against most losses, it’s a great risk/return picture for PE investors. But this is not the way the game is supposed to be played and something will crack. We continue to prop up an array of markets and that just cannot go on without cessation.
(I want to make clear, the FDIC will never have a funding problem, simply because if things get bad enough, Congress will inject as much cash that is needed into the agency – and Congress has already passed $100 billion in emergency funding for the agency.)
Taxpayers will be on the hook for these losses and that very likely means much higher tax rates to come. Also, there is a moral hazard issue if the industry cares little to rework troubled loans because the government is massively subsidizing the losses, making the potential losses even greater. It all comes down to how long it takes the economy to bounce back in a sustained manner. My concern is that increased government involvement delays a sustained economic expansion. We shall see.
Have a great day!
Brent Vondera, Senior Analyst
One would have thought the encouraging economic data in the U.S. (Chicago manufacturing on the cusp of expansion mode, which we’ll get to below) to have offset the overseas event and provide a boost to our market. Is this a shift, or just a one day event?
The trend over the past few months has been that only a mild boost in economic data, off of very deep levels to boot, was needed to spark equity-investor euphoria. We’ll find out over the next couple of days whether or not something has changed here. This morning we get the ISM number for August, it will very likely move to expansion mode for the first time since last September. If this occurs and stocks don’t respond in kind, it will be a clear sign that something has changed.
Yesterday’s decline reduced the August gain, the sixth-straight monthly advance; still the S&P 500 added 3.4% last month. That followed a 7.41% advance in July; a virtually flat June, up just 0.2%; a May gain of 5.31%; and romps of 9.39% and 8.54% for April and March, respectively.
All but one of the 10 major industry groups declined yesterday, consumer staples being the lone sector to buck the trend.
Volume was actually pretty strong, by the standards of the past three months anyway, as more than 1.3 billion shares traded on the NYSE Composite – 13% above this summer’s average. Declining stocks whipped advancers by a five-to-one margin.
Market Activity for August 31, 2009
Chicago PMIChicago-area manufacturing activity for August, as measured by the Purchasing Managers Index, moved to the line of demarcation that divides expansion from contraction. The reading jumped to 50.0, following 43.4 in July. The reading for August is the highest since September, when Chicago PMI stood at 55.9.
The reading beat the expectation of a move to 48.0 and I certainly thought it would be another month before we got back to 50, which we stated after the latest factory reading out of Philadelphia on August 20. One would have thought this move to spark a rally in stock prices, but the market actually traded lower on the news before regaining some of those losses later in the session.A boost in auto production will keep the Chicago reading going for a couple of months. The Chicago factory gauge is highly exposed to the auto sector and the increase in vehicle assemblies coming off of the plant shut downs that followed the GM and Chrysler bankruptcies is playing a significant role (big inventory reduction after “cash for clunkers” kicked car sales higher) However, after a couple of months, as we move to year end, the factory sector will need to find support elsewhere.
The boost in the new orders index to 52.5 from 48.0 was surely driven by the auto sector – first move above 50 in a year. Order backlogs also looked good, not yet in expansion mode coming in at 45.8 for August, but marking nice improvement from a very low reading of 32.1 in July.
The employment index remains in deep contraction, hitting 38.7, but has improved significantly from the cycle low of 25.0 in May. (And on employment, we get the August payroll data on Friday. While the weekly jobless claims data suggest monthly job losses will be worse than what we saw in July, the firming in the auto sector should keep factory employment losses milder than was the case just two months back – this sector showed the rate of decline in jobs losses slowed meaningfully during July and that should continue in August.)The Commercial HurtInvestors’ concerns seem to be growing regarding the impact commercial real estate losses will have on the banking system (this time more so with community and generally smaller banks than the big guys). Just as in the residential lending standards when credit was offered to just about anyone based on the assumption that home prices would rise without interruption, commercial lending standards appeared to assume occupancy and rental rates would not abate.
The commercial side always erodes, with a significant lag, when the economy turns down. You have manufacturing properties that go bust due to reductions in output, office properties that see both rental and occupancy rates head in the wrong direction and mall properties take a beating due to a higher level of joblessness. If this situation doesn’t go well it will erode bank-industry earnings power, offsetting the hugely positive impact of a massively upward sloping yield curve (a situation that allows banks to borrow near zero and lend money at much higher rates, effectively helping to offset mortgage and consumer credit woes). According to the FDIC, banks have $1.1 trillion in core commercial real estate loans on their books (and another $590 billion in construction loans); it’s likely the downturn in commercial real estate will be the next hurdle for the economy.
I should make it clear though that trouble in the commercial side of real estate does not have quite the economic impact a downturn in the residential side does as the latter can have a profound impact on consumer activity. Still, losses in commercial loans does affect the availability of credit as capital ratios are diminished.
FDIC “loss shares” – Another Crutch
And speaking of the banking industry, through deals known as loss shares the FDIC is agreeing to absorb losses in portfolio loans of banks that have gone under in order to encourage other banks and private equity firms to come in and buy up the failed lenders. As the WSJ reported, the FDIC is agreeing to pick up more than 80% of future losses for most assets and 95% of losses on the rest – that is, it will cover 80% on the first $xx billion of losses (the actual amount depends on the institution) and 95% of losses above that given threshold. The loss exposure the FDIC will assume may skyrocket due to commercial real estate losses touch on above.
This means you’ll have private equity (PE) investors (also encouraged now that regulators have reduced capital standards on private-equity purchases of failed banks) willing to come in and take over a bank, buying up the assets and capturing potentially large profits over time. As the FDIC will assure against most losses, it’s a great risk/return picture for PE investors. But this is not the way the game is supposed to be played and something will crack. We continue to prop up an array of markets and that just cannot go on without cessation.
(I want to make clear, the FDIC will never have a funding problem, simply because if things get bad enough, Congress will inject as much cash that is needed into the agency – and Congress has already passed $100 billion in emergency funding for the agency.)
Taxpayers will be on the hook for these losses and that very likely means much higher tax rates to come. Also, there is a moral hazard issue if the industry cares little to rework troubled loans because the government is massively subsidizing the losses, making the potential losses even greater. It all comes down to how long it takes the economy to bounce back in a sustained manner. My concern is that increased government involvement delays a sustained economic expansion. We shall see.
Have a great day!
Brent Vondera, Senior Analyst
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