Daily Insight

U.S. stocks gained some good ground Tuesday, erasing Friday’s decline, on what many were calling the Scott Brown rally. A vote for 41 more than it seemed to be for Scott Brown means the most economically damaging aspects of Washington’s agenda will be blocked – either in absolute terms via the elimination of 60 in the Senate or via the message it sends to those up for re-election later this year.

We didn’t have much by way of data yesterday, but what we did get wasn’t pretty; nevertheless, the market was able to shake off a U.S. homebuilders confidence reading, which is all but floored and another on European investor sentiment by way of the ZEW index on economic growth expectations – that reading dipped more than expected..

Health-care shares led the advance on bets that the outcome of the special election Senate seat in Massachusetts will go to Scott Brown and foil additional government involvement in the sector, among other things. While a Brown victory will result in some gridlock – and may even offer some focus on pro-growth measures -- rather than adding trillions to an already bloated budget, it is still unclear how the health-care legislation will ultimately turn out. It remains unclear how tax rates will change. Nevertheless, the GOP win in a state like MA will surely shift some yea votes to nays as politicians really begin to worry about November 2010. Enough to erase even the 51 Senate votes needed via the reconciliation process? We’ll see.

Basic material and tech shares also outperformed the market. Interesting to see commodity-related material stocks gain ground on a session in which the U.S. dollar advanced -- that’s become an unusual event over the past couple of years. The dollar was the benefactor of increased concerns over the euro’s value. That ZEW index didn’t help and there are still many questions about the state of things in Greece. The EU continues to state that they won’t backstop any major trouble Greece may run into if they more or less default, they’re likely to get tested on that statement. If things get nasty, they’ll have to offer something – Greece can’t go to the IMF for help without EU nations offering support. For now Greece says it is going to get things done in the capital markets. That would be the best route, even as it costs them in higher interest payments.

Market Activity for January 19, 2010
Foreign U.S. Security Purchases

The Treasury Department reported that international demand for longer-term financial assets jumped in November, ending a four-month period of weakness. Net buying of stocks and corporate, agency and government bonds rose $127 billion – largest increase since October 2007. (I guess government and agency bonds are effectively the same now with Treasury’s December 24 decision to provide an unlimited backstop to future Fannie and Freddie losses over the next three years, but the data separates the two so we will too.)

Net buying of Treasury notes and bonds by foreigners totaled $118.3 billion in November (all-time record for one month) after a $38.9 billion increase in October – the UK was the largest buyer of Treasury securities for the month, followed by Japan; the Chinese were net sellers. Net buying of agency bonds totaled $5.9 billion after declining $5.4 billion in October. Foreigners sold a net $4.6 billion in corporate bonds -- the second-straight month of decline; foreigners have been net sellers for seven of the past eight months. Net purchases of U.S. stocks totaled $9.7 billion after increasing by $10.3 billion in October – foreigners have been net buyers of U.S. stocks since March.

Based on the rise in yields during December, we should expect to see a large pull-back in Treasury purchases in the next report. Concerns within the bond market over the durability of this expansion will keep money flowing into the Treasury market for a while still, but if policymakers don’t get things right – speaking both of fiscal and monetary policy – the question over the next couple years is at what price investors be willing to buy U.S. government debt. If the economy shows considerable weakness in 2H 2010 then other problems will take over, which means demand for Treasuries won’t be a problem. But this isn’t a winning strategy. At some point we’ll have a durable expansion that takes hold (the timeline will depend on policy). Even when this good news occurs, we’ll have funding issues when investors demand higher yields.

NAHB Housing Market Index

The National Association of Home Builders index of builder confidence fell to 15 this month, following December’s slip to 16 from 17 in November. Readings below 50 mean that most respondents view conditions as poor.

I’m not sure if the index is going to test the all-time low hit in January 2009 but this thing remains just about floored from a historical perspective – NAHB began looking at builder confidence in 1985. Builders are still competing with foreclosures coming back onto the market and that’s not going to change anytime soon.


The report’s look at buyer traffic slowed to a 10-month low, falling to 12 from 13 – the record low of 7 occurred in December 2008. Factors such as consumers’ concerns about job security and the future trajectory of economic growth appear to be overwhelming the extension of the home-borrowers tax credit.

As unpleasant as it is this is a necessary condition for a rebound in housing to take hold. We have too much supply out there, particularly when factoring in all of the foreclosures that will be hitting the market, and building more houses right now isn’t going to help the matter.

The government is attempting to thwart the foreclosure process via their programs to modify home loans in order to keep people in their houses. This only delays the process, besides according to the Fed’s latest data on the issue, 57% of modified mortgages are now in default a year later.
The market will find equilibrium, but it must be allowed to find that point. We keep targeting housing, but artificially propping it up will do zero good – heck, we can’t even keep a rebound going with rock-bottom interest rates. Pro-growth policies must be implemented in order to get job growth rolling again. It doesn’t take a stroke of genius. Reduce tax rates on income and capital, even hold them steady; just don’t increase the view that they are going higher. Eliminate the corporate incomes tax, it’s ultimately borne by the consumer anyway and we hardly need more layers of taxation. Eliminate it and watch both domestic and foreign firms open more plants and offices in the U.S. The increase in tax revenue via job creation will more than make up for the corporate tax receipt loss. When the labor market begins to recover in earnest, that’s when a lasting housing rebound will begin. Follow this up with sound monetary policy and a strategy to keep the spending side of the budget moored to growth rates and the rest will take care if itself.

The Call

Yesterday while talking about the Industrial Production number I failed to mention something of interest noticed on Friday. Blogger Invictus mentioned that the St. Louis Federal Reserve Bank’s economic research site was no longer indicating recession on their latest Industrial Production chart – you know, the shaded vertical bars that indicate recessionary periods. Their chart has the shaded area coming to a halt a few months back. While we’re pretty confident the recession ended in 2009, data charts generally don’t show a recession has ended until the NBER officially announces the start of a new business cycle expansion. (NBER is the National Bureau of Economic Research, the official arbiter of dating business cycles.)

Anyway, according to Invictus, the St. Louis Fed staff believes July is the date NBER will call the recession officially ended, which prompted them to cease the shading.

Maybe some remember that we called June to be the date at which NBER will state the “Great Recession” ended – I noted this in one of the letters last summer. NBER watches significant changes in five areas (real GDP, real income, employment, industrial production and retail sales) before calling a recession or expansion has begun. Meaningful changes in employment, IP and real GDP match up very nicely for the NBER to call the recession’s end in June. It’s important to note that IP remains below 2004 levels and the labor market is very fragile, but the changes are meaningful and that is all that matters. While income and retail sales are unlikely to show consistent improvement for some time (incomes rarely trend higher until we’re well into an expansion and retail sales are going to be pressured by debt pay downs), I think NBER will focus more on the other three data sets.

The NBER is notorious for waiting a rather long period of time before officially calling a change in the business cycle. According to the group, the recession started in December 2007 but didn’t officially state this until November 2008.

I continue to believe that this will be the shortest expansion since the two-quarter long 1980 expansion (a brief increase in economic activity that was made possible by a respite in the Volcker Fed’s strict tightening campaign; Volcker & Co. quickly resumed the policy by eventually sending fed funds to as high as 20% by January 1981). The average length of expansion via the three business-cycle upswings we’ve enjoyed since 1983 is eight years – by far the longest average duration of successive expanding business cycles in the postwar era. I give this expansion four-five quarters.

Futures

Stock-index futures are down this morning – maybe some buy on the rumor (ahead of the MA election) and sell on the news action here. More likely, continued comments out of China that they’ll begin to restrict lending is causing some boosting concerns that global recovery will have one less crutch of support. The market is so mercurial in this regard I feel like an idiot even stating such things. One minute it’s all hopped up that the expansion is for real and the next that it isn’t.

Anyway, other things may also be playing a role in the pre-market weakness. IBM’s numbers out last night were not that great. While earnings expanded 9% from the year-ago period, revenues was flat. Also, CEO Loughridge stated that while they see encouraging signs they want to see this confirmed by first-quarter results. Since their fiscal year 2009 improvements were boosted by public-sector expansion – private sector businesses all showed a decline for the year -- some degree of validation is prudent.

Have a great day!

Brent Vondera, Senior Analyst