Fixed Income Weekly

Treasury yields were lower again this week as flight to quality trade began to emerge, helping bonds repair the damage done in December. A short lived spike in rates appeared on Friday as the Treasury announced it will sell $118 billion in 3-, 5- and 7-year notes next week, but rates fell back to finish the week about 7 basis points lower across the curve.

A few negative developments in the credit space hurt spreads for the first time since last November when the problems with debt laden Dubai World were first made public. Cost of default insurance on a broad index of corporate debt rose 14% this week to a one-month high.

Greece announced plans to issue 3-5 billion Euros of five-year debt next week. Greece hasn’t issued any debt in the open market since spreads widened recently as investors grew weary about Greece’s heavy deficits. Ten-year Greek bonds currently trade about 320 basis points over German Bunds. US Treasury supply announcements move markets plenty, but the credit markets will be watching the results of this auction closely as sovereign debt problems become an even greater concern.

Banks have had a tough week, thanks to a proposal from President Obama aimed at limiting the risk of “to big to fail” financial institutions. Financials, by far the largest industry sector in the corporate bond market, will naturally feel the brunt of the damage if anything resembling what the President is proposing is enacted. The proposal focuses heavily on proprietary trading by FDIC insured institutions. Banks with large “prop trading” operations, (Goldman Sachs, Morgan Stanley, and other large banks), are leading the move downward.

Fannie and Freddie
We haven’t heard much on this front since the limit on aid that the Treasury could give the agencies was secretly raised from $300 billion dollars to infinity billion dollars on Christmas Eve. A recommendation was announced today by Barney Frank to “abolish” both of the agencies and replace them with something new. No comments were made detailing the reform, but as we have said a lot, the system is quickly moving toward being entirely FHA. This will likely turn out to be just another step in the same direction.


Have a good weekend.
Cliff J. Reynolds Jr., Investment Analyst

Weekly Roundup: IBM, GE, UNH, JCI, RJF

Tough week for equities, which are now on a 4.9% skid. Regulatory overhaul of U.S. financial institutions and speculation that China will rein in bank lending were in the spotlight this week. Several companies reported earnings that beat expectations, yet investors wouldn’t bid up prices – it’s fair to say many of those release quarterly results were priced for perfection. Here are some of the Approved List companies that reported earnings this week and their weekly gain/loss performance.

International Business Machines (IBM) -5.81%

• IBM reported solid fourth quarter results, but the fact the stock traded lower is testament to the view that all the good news is priced in.
• Although IT spending appears to be improving, customers’ appetite for expensive IT equipment remains weak.
• IBM’s largely counter- cyclical portfolio and more limited services margin expansion should be partially countered by improving revenue growth in 2010.
  

General Electric (GE) -0.21%

• Fourth quarter results continued the stabilizing process with better-than-expected cash flow, improved orders, and declining nonperforming assets.
• There are two ways to look at GE earnings. Optimists are quick to acknowledge the earnings beat and $16.6 billion in cash from operating activities in a difficult year. Pessimists would describe the results as tax-driven and of low-quality.
  

UnitedHealth Group (UNH) -0.48%

• Better-than-expected fourth quarter capped a solid year. Quarterly and full-year revenues increased by 7%, while operating margins declined on business mix changes and lower investment income.
• Prescription Solutions, the firm’s pharmacy benefit manager, was the star performer with full-year operating income increasing 90%. UnitedHealth is the least likely of the managed-care organizations to consider divesting its PBM.
• 2009 medical cost ratio was slightly higher than a year ago, but the firm had lower administrative costs as a percentage of operating revenue. Medical cost ratio was better than most peers, which is telling of UnitedHealth’s strong competitive position and sound understanding of underlying cost trends.
  

Johnson Controls (JCI) +0.38%

• Auto parts and building-systems specialist, JCI, reported record fiscal first quarter earnings thanks to spending on improving education and government buildings.
• School building projects had been stalled while waiting for government money, but projects are now being funded through bond issuance – a more traditional approach.
• The company raised its full-year profit guidance to reflect “cautiously optimistic” view on the auto sector and continued improvement in the building-systems division.
  

Raymond James Financial (RJF) +1.65%

• Fiscal first quarter profit fell 20% despite higher revenue and lower provisions for loan losses. Still, earnings beat analysts’ estimates.
  
• Nonperforming assets fell to 1.82% of total assets from 2.10%. With decent credit metrics and reserve levels, it seems like RJF will avoid the dilution that has plagued other banks that expanded aggressively over the past several years.
  

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks slid yesterday as jobless claims jumped, China continues to make gestures toward reining in stimulus, and the White House proposed new bank regulations.

President Obama’s announcement yesterday morning, proposing new rules designed to restrict the size and activities of the largest banks, led to concerns over the sector’s profit potential.

The White House proposal, on its surface and if passed by Congress, would force financial institutions to spin off operations and change their regulatory status. Dang, and it was just over the past two years in which the government “encouraged” banks like JP Morgan and Bank of America to buy the troubled investment banks Bear Stearns and Merrill Lynch – both of which engage in the politically disparaged proprietary trading.

Let’s hope this is more a diversionary tactic on the heels of the health-care rebuke via the MA election than anything else because this proposal is ill-conceived and terribly timed.

First, you never, ever offer such a proposal without international cohesion – unless your goal is to deliberately put your own financial industry at a global disadvantage.

Second, this is about as poorly timed as it gets. Proprietary trading is one area that is helping to ease the losses on the traditional banking side of things – sky-high loan delinquency rates. You want to watch credit contract for a long time, implement this proposal now. (Also, this is a reminder of why I keep harping on the consequences of intense government intervention and waves of populism. Do not underestimate Washington’s ability to royally screw things up.)

Finally, firms will always employ an army of lawyers to find regulatory loopholes and this does nothing to tackle the “too big to fail” issue. If Goldman Sachs simply de-banks (recall they, like so many others, scrambled to become bank holding companies little more than a year ago so they could get in under the TARP and it’s bailout funds), their counterparties along with the rest of the universe will still see them as TBTF.

None of this may even matter. The banks have already easily identified the rather conspicuous loophole. The key phrase in the President’s proposal is “operations unrelated to serving clients.” Well, proprietary trading can be done through hedge funds in which clients may now be permitted to invest. One supposes even a bank’s own employees can be termed “customers.” It seems as if the weak regulations are by design, which gives credence to the charge that this is purely a political move.

If you’re going to get serious about this thing, you state that only traditional banks – engaging in only the most conservative of activities – are the sole institutions that have government backing and the safety net. The rest can do whatever they please, but it must be clearly stated that they do not have a government safety net. If they fail, they go down. When you explicitly state that investments are walking the tightrope without a net, the market will do the regulating. When the government gets involved with its backstops and safety nets risk will not be assessed properly.

Anyway, the announcement had wide-ranging effects on the market. It wasn’t only financial shares that got hit, basic material shares were by far the worst-performing sector for the session – got clocked by 4.3%. The group was already getting hammered over news that the Chinese are planning to remove some stimulus measures; they endured another leg down after the President’s press conference. Sudden regulatory changes may be seen as damaging the fragile, nascent and thus far slight global expansion and that’s why commodity-related stocks took the brunt of the hit.

The broad market’s decline was the largest since the 2.81% loss on October 30. Still, for all of the commenting from the press that yesterday’s activity was a bloodbath, it was not. The S&P 500 is up 68% from the March low. We’re considerably past the point of a correction in my view, the 2.95% lost over the last two sessions is child’s play – has everyone already forgotten what a bloodbath truly looks like? Of course they have, that’s what a zero interest-rate policy does. If Washington is going to play a game of chicken with the market by traveling down the path of populism, we will be reminded of what a real sell-off feels like.

Market Activity for January 21, 2010

Jobless Claims

The Labor Department reported that initial jobless claims rose 36,000 (expectations were for a 4K decline) to 482,000 in the week ended January 16. This moves the figure back above the 480K level for the first time in five weeks, just when it looked like claims would remain below 450K and on their way to 400K. The four-week average of initial claims rose 7,000 to 448,250 – the first increase in nearly five months.

Continuing claims fell 18,000 to 4.599. That’s for the standard sort, the benefits that are good for the first 26 weeks. When those are exhausted Emergency Unemployment Compensation (EUC) kicks in to provide up to another 73 weeks of benefits. That’s right, another 73 weeks. These claims surged 613,000 for the week ended January 2 – there’s a two-week lag to the EUC claims. Standard claims have declined 2.3 million since peaking out last June. However, EUC claims have more than offset this move as they have jumped 3.2 million.

The data continues to paint the same picture that it has for a couple of months. While the pace of job firings has eased greatly, hiring has not begun to occur and a very disturbing level of long-term unemployment continues to grip the workforce.

Last week we mentioned that EUC claims halted their march higher for the first time since May. This offered some evidence that jobs have begun to pick up, but we expressed the caveat that the data in the following weeks must confirm this. Well, obviously the move in EUC failed to confirm that dip. Instead, those claims rose by the most since the program’s implementation in July 2008.

Philly Fed

The Philadelphia Federal Reserve Bank’s gauge of factory activity in the third Fed district posted its fifth-straight month of expansion in January, although the reading did decelerate to 15.2 from 22.5 in December.

In terms of the sub-indices, the new orders index slipped to 3.2 from 8.3 in December (a reading above zero marks expansion). Unfilled orders and delivery times both accelerated – unfilled orders rose to 3.6 from 1.7 and delivery times rose to 6.6 from 4.1. (These are two areas we’ve been keeping a close eye on because if they spend several months in expansion mode it illustrates that factories are getting stretched and may be forced to add workers. Among the several regional manufacturing readings, these two components have moved to expansion mode for two months now.)
The average workweek reading slipped but remained in expansion mode, coming in at 4.2 for January after 6.3 in December. (This another area to watch as a signal for future factory employment growth as current workers hours must rise and become stretched before firms will increase payrolls.)

The inventory index remained in contraction mode, but just barely as the -1.6 reading for January is the best number since November 2007.

The worst aspect of the report was the differential between prices paid and prices recieved. Prices paid continues to hugely outweigh that of price received, the former came in at 33.2 and the latter rose to just 2.7. This is not good for manufacturing profit margins. While they will be able to absorb these costs due to the massive reduction in payrolls (higher worker productivity via the slashing of employees), this could become a problem when hiring begins. It may even cause manufacturers to further delay new hires.

The Call – Part II

Earlier in the week we talked about the official date for which the NBER (National Bureau of Economic Research, the official arbiter of business cycle dating) will call the recession ended. While this announcement is not expected for sometime (the NBER generally take a considerable period of time before they call the official date), I have guessed they will state the recession ended in June; the St. Louis Fed staff believe it will be July. Overall, it’s meaningless, but it is interesting to talk about.

I bring this topic up again because Invictus (a blogger than keeps a close eye on the business-cycle dating committee) states that the NBER has posted some comments on their website that seem to raise some uncertainties as to whether they’re even planning to call the recession ended in 2009. I found his comments intriguing so I went to the site to see read the post. There one finds that the NBER doesn’t seem so sure the recession has actually ended via the statement: “In both recessions and expansions, brief reversals in economic activity may occur – a recession may include a short period of expansion followed by further decline; and expansion may include a short period of contraction followed by further growth (my emphasis).”

I continue to believe they will call the recession ended in 2009, but these posted comments do cause some doubt – they certainly had some kind of message they meant to relay by the posting. It is unclear as to whether the NBER views the unprecedented fiscal and monetary stimulus that has been by far the main reasons most economic indicators have begun to move higher, or at least halt their significant decline, as an invalid reason to state that the business cycle has truly troughed. Maybe they will wait an extended period this go around to make the call in order to see how the economy reacts to the fade out of fiscal stimulus. They are making things very interesting.

Below are the key indicators the NBER watches to make their call. While employment has halted steep declines and real retail sales have at least stabilized, industrial production is the only indicator that has shown a clear upward trend.

Have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks were headed for their worst session since mid-November until a little afternoon rally eased early-session weakness. Speculation coming out of China that they’ll rein in bank lending, along with an IBM earnings report that failed to confirm private-sector orders are rebounding, started things off on a bad note yesterday.

Additional data on housing starts was also portrayed as putting pressure on stocks, but I’m not so sure about that one. While housing starts fell more than expected, the permits data showed a bounce back will take place in the subsequent months. Besides, does the market really believe that residential construction is making a comeback anytime soon? Doubtful, it’s hardly a secret that we continue to see 300k-plus in foreclosure filings per month, that’s a lot of supply on the horizon. The point is the market shouldn’t be caught off guard by weak home construction data. Besides, it means ZIRP’s longevity is extended and I haven’t seen a shift back to market fundamentals; the liquidity trade remains in play, so I doubt the housing number played a role.

If we’re going to base what drove the market lower on any single day you have to look at the internals. Since the commodity-related areas (such as basic material and energy sectors) along with tech led the decline, you’ve got to surmise that the weakness was about China and IBM’s results. (And the China story is getting interesting. Concerns that they really will begin to rein things in have increased this morning after a fourth-quarter GDP print of 10.7% -- the growth appears to be largely driven by the construction sector, fueled by significant credit expansion. How many times are we going to watch this trainwreck? First in Japan, then the U.S. – now China?

While the financials were the best-performing sector (health-care was the next best, although both were down), earnings reports out of Bank of America and Wells Fargo showed loan losses remain elevated and “will continue so for the next several quarters,” according to BofA’s Moynihan. Mortgage and credit-card delinquencies continue to present a problem – a problem that only a stronger job market can fully fix. BofA’s charge offs fell 12% from the previous quarter (that’s good), but Wells’ charge offs increased 6%. Both banks reported an increase in non-performing loans (payments late by 90 days), up 5% for BofA and 18% for Wells.

Market Activity for January 20, 2010
Mortgage Applications

The Mortgage Bankers Association reported that applications rose 9.1% in the week ended January 15, after a 14.3% increase in the week prior. But while the prior week’s rise was all due to refinancing activity, this latest week did have some purchases in it. Purchases were up 4.4% after a paltry 0.8% rise for the week ended January 8 – the chart below shows purchases continue to muddle around the cycle low. Refi activity rose 10.7% after up 21.8% in the previous week. The rate on the 30-year fixed mortgage fell to 5.00%.

Housing Starts

The latest housing starts figure dovetails that very low homebuilder confidence reading we mentioned yesterday. Builders broke ground on just 557,000 units at a seasonally-adjusted annual rate (SAAR) in December, which amounts to a 4% decline from November’s activity – the expectation was for starts to come in pretty much flat relative to November.

This latest data moves the figure back to the level that is just a tier above the all-time low of 479,000 units hit in April – the data goes back to 1959. Surely, the weather played a role in the decline. The permits data seems to confirm this, which we’ll get to below However, most of the new-home construction occurs in the West and South regions. While temperatures were below normal in the South (the largest new home market by region) and they did get some snow, it may not have been a large effect on overall starts.

The permits data, an indicator of future building, jumped 10.9% month-over-month to 653,000 units SAAR. That’s the highest reading we’ve seen since October 2008 and suggests that we’ll get some bounce in homebuilding activity in the current month and into February.

Regardless of whether the December building numbers were adversely affected by the weather or we get a two-month bounce back, builders will be forced to keep activity to a minimum for an extended period of time. The supply of foreclosures may just double the current amount of existing homes available for sale – and that’s using the low end of estimates.

So try as you will boys and girls of the Beltway, but even rock-bottom interest rates, tax-credit extensions and the Fed’s foray into the mortgage market will only delay the inevitable. You’re barking up the wrong tree, for until the job market comes rocketing back housing is going to remain on the mat – that’s what policy should be targeting, the job market.
(And I’m not talking about some short-term public works program or this monetary fantasy currently wandering through the blogosphere that recommends a quantitative-easing orgy, calling for the Fed to buy an additional $2 trillion in Treasury securities. As explained yesterday, I’m referring to elimination of the corporate income tax. And, as mentioned on several occasions, a winning energy strategy that creates high-paying manufacturing jobs in order to fill the gap from the 840,000 permanently lost auto-assembly jobs and most of the 1.3 million construction jobs that have been eliminated for a very long time.)

Producer Price Index

The Labor Department’s gauge of producer prices rose 0.2% in December (the expectation was for no change) basically all on the food component. Energy fell after a large increase in November. Prescription drug prices rose 0.8% for the month after a series of very tame monthly readings.

The year-over-year figure jumped to 4.4%, a big turnaround just two months following what was an eleven-month streak of decline. But these latest figures are against very easy year-ago comparables. The PPI figures should ease about six months out, before they eventually shoot higher, as the comps are not so easy by June. This is similar to the declines we saw for the eleven months that ran December 2008 through October 2009. Many people were calling this deflation; it was not in the specific sense of the term. It was just that the figures were being compared to very high year-ago levels that resulted from the commodity-price spike of summer 2008.

Overall, even though the Fed likes to minimize the food and energy components, these will be the ones to watch for signs that inflation will become a problem down the road. The Fed is so wrong. Their recalcitrance is going to get them, and the rest of us, into trouble again. They continue to believe that so long as the unemployment rate remains well above average, there is little to no chance that inflation can occur, particularly their core rate look – which excludes food and energy. But the inflation that will take hold over time will be of the commodity-push variety, not the wage-push that the Fed myopically watches for. Therefore, the core rates are not the measures to focus on. Again, it is food and energy prices. The core rates become much less meaningful in an environment such as the one we find ourselves.

I must make it clear that it may take some time for the official inflation gauges to move meaningfully higher in a consistent manner, remember credit is still contracting and that means trillions of dollars the Fed has pumped into the system remains fallow. When credit begins to expand, which I suspect is still a ways away, that money will move into the system and if the production of goods isn’t there in a commensurate way to absorb this money (which I think is unlikely) that’s when inflation begins to become a major problem. We’ll continue to very closely watch credit activity.

Some Common Sense

The Federal Housing Authority (FHA) is struggling with a 14% delinquency rate and is in the process of making some changes to deal with this. They’ve been leaned upon, along with Fannie and Freddie (the three accounted for 90% of home loans during most of 2009), to resuscitate the housing market as the FHA has guaranteed more than 30% of new home loans.

As a result of these default rates, the FHA is raising the premium charged to insure mortgages to 2.25% from 1.75%. They will also raise the down payment requirement to 10% for those with credit scores below 580. Borrowers with FICO scores above 580 will still only have to put down 3.5%. Subprime is defined as a credit score below 650, so this new rile isn’t exactly stringent

Frankly, I would argue that sub-580 FICO shouldn’t even qualify for an FHA backed mortgage and they should boost their down-payment requirement to 10% for all – I know, cruel thought. But look, down payments are necessary and if you don’t have at least 10% then sorry you’ll just have to take some time to save it – like most people used to do before all common sense was thrown out the window. A return to common sense would put the market on a more solid foundation as borrowers are able to withstand home-price declines and still have some equity in their home.

The FHA change is a minor one, but should help their solvency. It will have some level of negative effect on the housing market in the short term, but sometime you just have to deal with reality. When we mask problems, history continues to show that more result – and the economic damage that everyone must endure becomes increasingly acute.


Have a great day!

Brent Vondera, Senior Analyst

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

Healthcare sector trending up

Sentiment towards healthcare stocks has dramatically improved as it became clear that any reform was unlikely to impinge industry profitability as much as originally thought. Today, however, the sector surged as investors speculated the bill might be scrapped altogether (see more here).

Overhaul or not, healthcare firms are in solid position for 2010. Removing the uncertainty that has been a major overhang on valuations in the sector is an obvious positive going forward. The uncertainty has led to the industry’s cheapest valuations in decades; for example, Johnson & Johnson (JNJ) trades at 14 times earnings, while its 10-year average exceeds 20.

Additionally, the sector has never had more cash relative to their market capitalization then they have today. Healthy balance sheets provide financial flexibility for stock buybacks, dividend payments, and acquisitions.

Pharmaceuticals expect game-changing clinical trial data throughout 2010 and positive results could go a long way in shifting negative sentiments surrounding the industry’s drug pipeline. Even more, the number of drug approvals by the FDA are moving higher, which has historically led to increased pharmaceutical sales.

Healthcare companies are also doing a good job of meeting earnings estimates thanks to cost-cutting and revenue growth, partly due to the weak U.S. dollar and significant overseas sales. Meeting (or exceeding) earnings estimates should help lure investors back to a sector known for steady reliable profits.

Though the stocks rallied significantly in the second half of 2009, they remain attractive. The worst case scenarios for the majority of the sector are off the table. Now investors can focus on long-term fundamentals and trends such as an aging population, significant international exposure, and financial flexibility to grow and return value to shareholders.
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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks fell on Friday, and were heading for their worst daily performance since November but a relative rally in the final hour of trading pared the losses. The most well-rounded manufacturing report we’ve received yet, in my view, couldn’t offset an earnings report from JP Morgan that reminded traders consumer credit quality is probably quite a ways from improving.

Industrial production (IP) was of little help, even though the report showed activity advanced for a sixth-straight month. All of the gains came from utility production. Without abnormally cold weather IP would have likely halted its streak.

As we’ve been talking about for a while, what’s-bad- is-good has been the traders’ mentality as it indicates ZIRP live on, so maybe it was the well-balanced factory number that shook traders a bit. I’ve got a feeling though the retail banking side of the JP Morgan report is what did it. This situation isn’t good for anyone because it shows deep problems that exist and relays the message that it will take much longer than is normal for a durable recovery to materialize. Debt levels are way too high and impossible to manage around for too many people at the current rate of joblessness.

Just looking at the headline profit number out of JP Morgan it appeared they knocked the cover off the ball, but it was all on higher investment-banking fees – thank you ZIRP, say the banks. If not for the Fed at zero, corporate refinancing and securities trading activity would not be robust enough in the current environment to offset serious retail banking weakness.

And JP did warn on the retail banking side as consumer-credit problems persist. Their card-services division’s fourth-quarter losses were artificially low due to a payment holiday the bank implemented. This only means you’ve delayed things. Chairman and CEO Jamie Dimon told investors that the unit’s losses will continue through 1H 2010, even before setting aside more money to cover losses. He mentioned that proposed credit-card legislation will add to these losses and if the unemployment rate doesn’t reverse course fast, they’ll have to add meaningfully to loan-loss reserves. (Adding provisions to loan losses subtracts from profit.) Dimon also expressed concern about a double-dip – the economy falling back into recession a few quarters out.

Market Activity for January 15, 2010
Consumer Price Index

The Labor Department reported that CPI for December rose 0.1% (+0.2% was expected). Core CPI, ex food and energy, was up the same and in line with expectations. From a year-over-year perspective, consumer prices as measured by this gauge are up 2.7% -- the second month of increase after eight months of decline as those readings were being compared to very elevated levels due to the commodity-price spike of summer 2008. The core rate was up 1.8% after a 1.7% in November – both of these y/o/y readings were in line with expectations.

The owner equivalent rent component, the largest component of CPI as it makes up 24% of the index, came in unchanged (up just 0.7% over the past year). Recreation, which makes up 6% of CPI, was down 0.4% (also down 0.4% year-over-year). The transportation component, which accounts for 15% of CPI, rose 0.4% (up 14.4% y/o/y) -- pushed higher for the month by a 0.3% increase in vehicle prices and a 0.2% rise in gasoline. Food and beverages also makes up 15% of the gauge, and that component rose 0.2% (down 0.4% y/o/y).

Overall, CPI continues to print pretty harmless results and an environment in which credit continues to contract will keep the traditional inflation readings from getting out of control for a while.

Those are the official figures, the what is seen. Let’s focus for a moment on what is not seen, as the 19th century French economist Frédéric Bastiat would put it

While the vast majority of economists focus on the CPI (or even narrower versions such as core inflation readings, which exclude food and energy prices – the Fed’s preferred gauge), it’s not all about official inflation data. One must also be cognizant of cost volatility that arises from the Fed’s willingness to implement exceptionally easy monetary policy for extended periods of time. While the official inflation gauges will eventually reflect mistaken Fed policy, global trade and high rates of productivity via massive payroll reductions may just keep a lid on these conventional inflation measures for some length of time. Certainly too, as mentioned above, credit contraction has put a ceiling on the inflation gauges.

But the costs of goods such as energy, building materials, essential metals and certain foods presents a sort of shadow inflation. Another key point is that wild swings in commodity prices, such as the volatility we’ve witnessed over the last several years, make it very difficult for businesses to manage and hedge around. These are large costs that are not fully captured by the official inflation readings. When commodity prices are left to rise as high as traders care to push them (as the markets respond to careless Fed policy), the deeper the economic damage we face on the back side of it.

The Fed can do something about this risk by gently tightening monetary policy. Even a mild exhibition that shows they are serious about future inflation, specifically the rising prices that may result from a downed currency, would send a message and remove the green light from accumulating commodities and selling the dollar. Of course, the housing market likely cannot withstand mortgage rates that are even 0.75-1.00 percentage points higher. Thus the Fed is choosing to err on the side of future inflation; I think this is a mistake because the downside that still needs to occur in housing is going to eventually occur anyway.

Empire Manufacturing

The New York Federal Reserve Bank’s measure of factory activity within the second Fed district posted a great number for January. Empire manufacturing printed 15.92 for the month after a disappointing 4.50 in December. While the reading has printed higher number over the recent past – hitting 33.4 in October and 22.3 in November – the internals of this latest report were the best we’ve seen yet.

New orders jumped to 20.48 from 2.77 in December; delivery times rose to 6.67 from -2.63; unfilled orders surged to 2.67 from -21.05; the average workweek (hours worked) jumped back to positive territory hitting 5.33 from -5.26 in December.

The only disappointment came by way of the inventory reading that still shows substantial contraction. Thursday’s business inventories reading was a good one, but the rebuilding surely isn’t universal.

The figures we’ve been watching most closely are delivery times, unfilled orders (for evidence that current employees are becoming stretched, which it what it will take to force new hires) and inventories (for a pick up in business confidence). We’ll take two out of three for now.

The report also offers an attachment called the Capital Spending Survey. When manufacturers were asked about their capital spending plans 6-12 months out, 44% indicated they expected to increase spending relative to levels of the past 6-12 months, 44% indicated it would stay the same and 12% indicated a decline. Since the previous 12-month period saw the largest capital spending declines in the postwar era, I’m not sure this is saying much. Seventy-nine percent noted the expected increase reflected investment that had been postponed during the recession. The most commonly cited factor behind increased investment spending was a need to replace IT and other capital equipment – 82% of respondents.

This is in line with our expectation that firms will manage capital spending to maintenance levels and not much more over the next year.

Industrial Production

The Federal Reserve released their industrial production number for December, showing a 0.6% increase – the sixth-straight positive reading. However, the pick up was completely due to colder weather as the utility component accounted for 97% of the rise in the total index.

Manufacturing production slipped 0.1%. This component makes up 79% of the IP index. This is not what the other manufacturing surveys have shown as most pointed higher in December – although most of the regional factory gauges are solely based upon what respondents are saying rather than pure degrees of improvement. Industrial production is about absolute improvement.

The utility component, which accounts for a little more than 10% of the index, surged 5.9% in December. (This was the second-highest utility production increase since records began in 1939 – second only to the 7.0% jump in November 1989 and wildly above the monthly average of 0.4%; it has weather-related increase written all over it.) Mining, the third component of the index, rose 0.2%.

To offer a little clarity here, the manufacturing component was held back by a substantial 2% decline in construction-supply production. Other areas of the business side and the consumer-related markets looked pretty good. The construction area is going to weigh on things for a while.

Capacity utilization (proportion of plants in use) rose, but will remain below average for an extended period unless business and consumer activity surges in the coming months and put idled resources to work. The overall figure rose to 72.0% from 71.5% in November.

Again, it was all from the utility component where the utilization rate jumped to 82.9% from 78.4% -- 87.7% is the long-term average. Manufacturing capacity utilization ticked up just slightly to 68.6% from 68.5% -- the long-term average is 80.8% and the current 68.6% remains the second-lowest level on record outside of the recent lows it is now bouncing off of. Mining rose to 85.7% from 85.5% -- close to the long-term average is 87.3% as commodity prices have been hot, save the last two weeks.

Futures

U.S. stock-index futures are down this morning as disappointing earnings results out of China, Europe’s ZEW – a gauge of investor expectations -- fell, and an inflation report out of Britain showed the largest monthly jump on record has traders pulling back just a bit.

Not much by way of data today, all eyes will be on that Senate race in Massachusetts.


Have a great day!


Brent Vondera, Senior Analyst