Fixed Income Weekly

Sovereign Debt
Concerns over government debt levels are building across the globe, and the effects have been felt beyond the sovereign debt universe. Stocks, commodities and foreign currencies all suffered in the back half of the week, as risky assets were shed in favor of US Treasury and Agency bonds. It was nice to see Dollar hold up in the face of all this, considering the budget and debt issues we face domestically. The dollar index rose 1.68% during the last 3 days of the week, and gold fell 4.62% over the same period.

Several dealers sighted heavy buying on the longer end, an obvious safety trade, while yields on bills were actually higher for the week, as investors sought duration to gain from the rally in bonds.

To try and put the sovereign credit issues into perspective I built this table comparing CDS of some major countries with some more familiar US companies. There are some large discrepancies between credit ratings and CDS cost (BB- Venezuela at 1,055 basis points vs. BB- Turkey at 214 bps.). This should explain pretty clearly how little credit ratings are worth these days.


Have a good weekend.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks took a pretty good beating along with commodity prices as an ugly jobless claims report fostered concerns that even mild job growth will be delayed and hence that feeds into concern about final demand.

Financials, energy and basic material shares led the declines. People who have been late to the inflation trade, rushing in after commodity-related stocks were already up 85% from the March lows, have to be a bit annoyed to say the least. We cautioned against myopically moving into this trade after these runs – you had to begin a position 10 months back when few were thinking about it. Now these stocks are getting hammered. I think commodity-related stocks are a place to be over the next two years, but renewed economic issues are inciting a pullback – you’ve got to pick your spots in this market.

A renewed concern about sovereign debt default risks, which appeared to have been allayed for a couple of days, also worked as a cudgel on the riskier assets (stocks, commodities, high-yield corporates).

Better-than-expected factory orders (December) and same-store sales results (January) were not enough to offset the aforementioned issues. Same-store sales looked quite good, expanding on solid figures for December, after fifteen months of getting absolutely crushed. Apparel-store sales were up 6.4% from the year-ago period; luxury was up 10.9%; discount rose 2.9%; and wholesale clubs up 2.1%.

But the jobless claims figures and government debt problems took center stage.

On claims, the initial claims number moved farther away from the 400K level as it is back to 480K. The 400K number is key because it almost always accompanied by some level of job growth.

On the government debt issues, the problems are spreading and when it was just Greece the market could see a European Union bailout as not a huge deal. But the Europeans also have problems in Spain, which raised its budget deficit forecasts through 2012, and Portugal, which endured a failed bond auction yesterday (which means bids fell short of what they were offering). The European banks hold a lot of government debt and if these securities continue to erode then they’ve got another capital adequacy problem on their hands.

The European Central Bank (ECB) left its benchmark interest rate at 1%, a record low, and has indicated they’ll hold off from beginning to gently raise rates until they get more information on the economy and inflation – early indications for first-quarter growth in Europe is looking weak. The government debt problems are surely also a topic of conversation within the ECB.

The Bank of England left their rate unchanged at 0.50%, also a record low. The BofE did vote against extending its quantitative easing program (the bond purchases). Economists had expected them to pause. And that’s a key word: pause. I think we could find that the halt of QE is more temporary than permanent.

Market Activity for February 4, 2010
Jobless Claims

The Labor Department reported that initial jobless claims rose 8,000 to 480,000 in the week ended January 30 – economists were expecting a move down to 455,000. Initial claims remain sticky and that’s a concern. It was just a month ago in which it appeared the figure was headed to the 400K level – a level that is needed to offer a good confidence that monthly job growth is upon us. (I’ve been expecting some mild gains in payrolls to begin over the next couple of months, but this claims data is eroding the conviction of this call.)

The four-week average of initial claims rose 11,750 to 468,750.

Continuing claims also continue to rise. The standard claims (those traditional level of benefits that last 26 weeks) rose 2,000 to 4.602 million. The Emergency Unemployment Compensation (EUC) claims jumped 242,000 to 5.632 million – these are the claims that extend out to as long as additional 73 weeks. EUC claims have jumped 600K over the past three weeks.

So the jobless claims data have taken a turn for the worse. Prior to this deterioration that’s occurred over the past three weeks at least we had initials improving even if continuing claims kept moving higher. Now with both on the rise it does suggest that firms will hold off a bit longer before they begin to even mildly increase payrolls.

I will be very interested to see the long-term unemployment data in the employment release this morning. That number hit a new record of 29.1 weeks on average via the December jobs report. I was thinking that figure to begin a slow decline in tomorrow’s report; that’s looking increasingly unlikely.

Factory Orders

Factory orders rose 1.0% in December, following the same increase for November – the December increase was twice what was expected. This data includes both durable and non-durable manufacturing orders.

The orders for durable goods was up 1.0%, which is a significant improvement from the durable goods orders we received last week – that report showed orders rose just 0.3%. Orders for non-durable goods (those meant to last less than three years) also rose 1.0%.

Orders for non-defense capital goods ex-aircraft rose 2.2%, which followed a strong 3.2% increase in November. This figure is the proxy for business spending and we’ve seen a nice bounce over the past two readings.

As we talked about yesterday, what you watch for is this trend to extend through the first quarter. Firms spend unused annual budgets at year end, and this was very true last year as firms were especially chary with their cash for most of 2009. The likelihood that firms are going to go on a spending binge must be confirmed by a continuation of the trend. If it is, it will be very helpful for growth over the next few quarters as the economy will need all the boost it can get from the business side of things as high household debt levels and 10-17% unemployment/underemployment will dampen personal consumption.

Productivity

U.S. worker productivity rose at a 6.2% annual rate in the fourth-quarter, as estimated by the Labor Department’s initial look at the figure. This is a jobs-slashing productivity environment as output rose 7.2% (as firms do a little inventory rebuilding after cutting stockpiles at a record pace during the first half of 2009) and employees’ hours rose just 1.0%.

This is a great number that shows firms are going to be able to absorb higher input costs. Firms will enjoy very high margins and increasing profits for a spell. However, productivity improvements that are purely led by job slashing means trouble for end demand (where is incremental consumer demand going to come from in this environment?) and top line growth for businesses. Thus a durable profit growth story remains very much in question.

Everyone wants higher productivity levels, but the test is to get it when payrolls are on the rise. It’s a short-lived event when it occurs simply because of labor-market erosion.


Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks struggled after a disappointing profit outlook from drug giant Pfizer and a key gauge of service-sector activity continues to show end demand remains weak.

Financial shares led the market’s decline, but health-care was the second-worst performing sector on the Pfizer news, which stated 2010 earnings would be below consensus estimates. The firm did record awesome revenue growth, up 34%, thanks to the Wyeth acquisition. The problem looking ahead is the potential in the pipeline; it will have to be enough to overcome blockbuster drugs that will be running off patent – but that is hardly a new uncertainty.

The best-performer sectors were tech and consumer discretionary, the only two of the 10 major groups up on the day.

Last week we spent a little time discussing the jump in Greek government bond yields as default risk was on the rise. Well, they aren’t actually going to default, at least as the word is technically defined, but it was becoming increasingly evident that it would take some sort of EU bailout to keep their long-term government bonds yields in single-digit territory.
But sentiment has changed quite dramatically over the past two sessions as those Greek yields on now on the decline after the EU endorsed that government’s latest program to get their deficit/GDP ratio down to 3% by 2013 from the current 13%.

Now, it is fantasy to believe this will occur. First, it would take an extraordinary level of economic growth over the next few years for that to be possible. Second, implementing austerity measures on the spending side will prove more than difficult. The Greeks are used to a large welfare state and to accomplish this goal they’ll need to slash entitlement programs. This is about as unrealistic as it comes. Greeks don’t participate in the peaceful demonstrations we’re used to here; they take a slightly more aggressive track. Greek yields will rise again.

We’re not going to escape a full-fledged round of sovereign default risks before the global economy ultimately completes its mending process. Spain, Portugal, Greece, Russia (where I’m expecting the actual default to occur, ala 1998) are all on the soaring-yield and rising debt-financing cost chopping block. I’ll tell you, public finances here in the U.S. don’t look all that much better; we are on a dangerous road. Thankfully, we continue to enjoy this lasting benefit due our history of leading the global economy and the deep and liquid markets that are a result. But we better get ourselves on a more sensible path, and do it quick.

Market Activity for February 3, 2010
Energy Report

The Energy Department reported that crude supplies rose 2.32 million barrels last week (a gain of just 400,000 was expected). The price of crude for March delivery actually held in there pretty well considering such a larger-than-expected build in supplies, but there is a heavy future inflation hedge that’s still in play and it is keeping oil prices in the mid-$70 range – hovering at $76 as I type.

Gasoline supplies slipped due to rock-bottom refining rates. Refineries operated at 77.7% of capacity last week, a number below 83% is considered the floor during downturns – it takes a major hurricane to push rates below where they are now.

The low refinery output reflects the fact that demand remains weak. Gasoline consumption averaged 8.64 million barrels per day, the lowest since 2004. Total fuel (gasoline, heating oil and diesel) demand averaged 18.8 million barrels per day last week, 2% lower than the year-ago period when the economy was in a world of hurt and 10.5% below the norm of 21 million barrels/week.

Fuel demand is an important indicator to watch, as it is shows what’s occurring on the ground. I think too many people in the market place today are ignoring this very accurate barometer.

Mortgage Applications

The Mortgage Bankers Association reported that their applications index jumped 21.0% in the week ended January 29, following a 10.9% decline in the previous week. Both aspects of the report fueled the rise as purchases rose 10.3% and refinancing activity increased 26.3 – those figures followed -3.3% and -15.1%, respectively.

The rate on the 30-year fixed mortgage averaged 5.01% for the week, virtually unchanged for three weeks now.


Preliminary Jobs Reports

The Challenger Jobs Cuts Survey (from the outplacement firm Challenger, Gray and Christmas) showed there were 71,482 announced firings in January, which is 70.4% below the year-ago period when the economy was shedding 690,000 jobs per month. This missed expectations for a 72% decline, but that’s not important – we all know the massive slashing of a year ago is out of the way. From here we need to concentrate on job increases and we’ll need 100-150K per month just to keep the unemployment rate steady at 10% and 300k-plus/month to get it meaningfully lower a year from now.

Challenger did show that layoff announcements came in at 71,482 last month, which is up from the 45,094 in December and the highest level since August.

In a separate report, the ADP Employment Change Survey showed just 22,000 payroll positions were shed in January, which is better than the -30,000 economists had expected the report to show. ADP captures only private-sector employment. For tomorrow’s official Labor Department reading on the January employment situation economists expect to see an increase of 15,000 payroll positions.

ADP estimated that goods-producing industries cut 60,000 positions (25K within the manufacturing sector and 35K within construction) and service-providing industries added 38,000. Those figures, if accurate, would prove a pretty good improvement from the December results when goods-producing companies cut 80,000 positions and service-providers cut 4,000.

ADP had small firms (defined as having less than 50 employees) cutting 12,000 jobs; medium firms (< 500 employees) added 9,000; and large firms cut 19,000.

ISM Non-Manufacturing

The Institute for Supply Management’s service-sector index rose just into expansion mode for January, rising to 50.5 from 49.8 in December – a reading above 50 marks expansion. The number did come in just shy of expectations, which had the figure rising to 51.0.

New order rose to 54.7 from 52.0 and employment rose to 44.6 from 43.6, but these were the only sub-indices of the report that showed improvement. Backlog of orders slipped to 45.5 from 48.0; inventories fell to 46.5 from 51.5; and supplier deliveries remained unchanged at 50.5

The breadth of the report deteriorated, as just four industries reported growth in January. This is down from seven in December.

What respondents said:

• “Business is better, but not robust.” (Agriculture, Forestry, Fishing & Hunting)
• “Some client capital spend plans have been delayed until the 2nd or 3rd quarter.” (Professional, Scientific & Technical Services)
• “Outstanding production month, highest since March 2009, but still lower than December 2008.” (Wholesale Trade)
• “Commodity prices are starting to rise. We will be trying to mitigate inflationary price trends through longer contracts and value engineering.” (Accommodation & Food Services)

We’re going to need something considerably more substantial than this to keep things going. The data continues to suggest that end demand remains lackluster.

Cisco and Futures

Cisco Systems reported some really good numbers last night, profits up 23% and revenue up 8%, and Chairman/CEO Chambers was very upbeat about business spending trends.

We’ve spent a lot of time talking about how firms are likely to hold business spending to maintenance (replacement) levels in this environment. Well, Cisco is a main beneficiary of this maintenance spending (networking components, remote access servers, routers that direct data and voice traffic, etc.) and their numbers showed it.

It’s important to keep in mind that this rise in capital expenditures must be confirmed by the rest of the tech industry and followed up by a good first-quarter. You’ve got to get away from the end of the year to get a clear picture of what’s going on here because unspent annual budgets get spent in December – and this scenario probably occurred like no other as businesses were scared to let go of cash for much of 2009.

The news from the tech giant is not helping futures, which are down meaningfully this morning.


Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained ground for a second-straight session, fully erasing the declines of the previous two sessions. There was only one economic release, which wasn’t exactly bullish but it was headlined as being so and got credit for market’s gains. We’ll get to that below.

Maybe helping the market more than anything was the decision from the Reserve Bank of Australia to hold their cash rate (the equivalent of our fed funds) steady. Most economists believed they would hike for the fourth time in four months and that had the market a bit uneasy as China is also tightening policy in the region. Commodity prices rallied on the news.

Even so, basic material stocks, which usually trade in tandem with commodity prices, were the worst-performing sector for the session – up by just 0.39%. Health-care, industrials (fueled by an earnings report from Emerson Electric that easily surpassed expectations) and consumer discretionary shares led the advance – up 1.92%, 1.91% and 1.46%, respectively.

In a sign that economic activity isn’t exactly as robust as recent manufacturing data has suggested, UPS warned that the current quarter will be challenging and profitability will be just slightly better than a year ago – analysts were expecting a 13% jump. Total package volume rose just 1.4% last quarter. Factories have ramped up production as the inventory rebuilding process is underway, but that cycle is going to prove especially short-lived if end demand remains lackluster.

UPS is a key barometer of activity as it is the biggest package-delivery firm to businesses and consumers. For the fourth-quarter, the company reported an operating profit (excluding extraordinary items) of 75 cents/share. That’s down from Q4 2008’s 83 cents. Total package volume rose just 1.4% and average daily volume was flat. International volume jumped 12% last quarter, but was helped by an air-cargo capacity squeeze that prompted a shift to UPS. As a result, the company voiced uncertainty as to whether those volume gains were permanent.
(That squeeze resulted from China’s stimulus-induced volume pick up following the total collapse of trade that occurred a year ago. Carriers will have the resources in place now to more appropriately managed the increase in orders, but with China now tamping its stimulus measures one can see orders waning in the back-half of 2010.)

Market Activity for February 2, 2010
2011 Budget

The Obama Administration unveiled its 2011 budget plan on Monday (government’s fiscal year ends in September) and its proposed $3.8 trillion in spending – it was just a couple of years ago in which the federal budget was $3 trillion and you don’t have to go back that far for a $2.5 trillion budget, that was 2004. That means federal government spending has risen at more than twice the rate of economic growth. So federal outlays as a percentage of GDP will come in at 26.2% (a postwar record – man, there have been a lot of those made lately), which is up from 22% in 2004 and 20% in 1995 ( that final number is in line with the 40-year average).

But this is not the ratio that causes problems, at least directly. The ratio that hampers economic growth is the government revenue (taxation)-to-GDP ratio – a higher figure obviously saps more capital from the private sector and does damage to economic growth over time. That figure ran between 18-20% over the past quarter century – and proved to be a growth-inducing/prosperity-driving level, but sits at just 15% currently. Thus, we have an outlay (spending)-to-GDP ratio of 26% and a taxation-to-GDP ratio of 15% -- uh, something has to give and I’m going to guess it ain’t gonna be the spending side, not with more boomers hitting “retirement age” and sending SS and Medicare outlays soaring. No, the government will seek to boost that taxation-to-GDP ratio well above the 18-20% range in the coming years in order to keep up with spending.

You know I keep referring to business anxiety and caution – businesses know what occurs when the government goes hog wild on spending, or at least more hog wild than normal. And that is exactly what the outline of the budget lays out. Various tax rates are going up.

On Monday I went into another one of these rants as to why the nascent economic rebound will not be durable, but rather extremely transitory in nature. As I’ve also done on a couple of occasions, I laid out a scenario in which none of my major concerns come to fruition by writing this: But even if we forget about real estate and loan quality realities and assume that a spectacular events occurs: the government comes out and states that the two top federal income-tax brackets (60% of which is small business ) will not increase in 2011; the capital gains and dividend tax rates won’t increase by 86% and 166%, respectively; the tax deferral on overseas profits will remain in place; and private equity isn’t burdened (the carried interest tax) with the proposed tax rate increase to 35% from 15% -- hence, this weight of uncertainty is removed from the economy’s shoulders. Even if the spectacular were to occur, Washington gets a clue, we still have the Fed in front of us.

Well, after reading the outline of this budget, we have more than just future Fed tightening to worry about because if this budget is passed all of those various tax rates are going higher. The only aspect that’s different now that we’ve seen the budget proposal is the cap gains and dividend tax rates apparently won’t rise by 86% and 166%, respectively – they’ll rise just 33% each, which means after-tax potential returns will shrink by that amount. So it could have been worse, but it is far from optimal and we need optimal right now.

To ultimately get things right, we will have to reform and contain the largest budget problems our government faces: the entitlement programs. We can start by raising the “retiremenet ages” for those 50 and younger and in one stroke of the pen erase much of our long-term funding deficits.

In addition, we will have to engage in pro-growth policies. This means getting off of this idea that government can create growth and jobs and getting to the things that actually do – greatly reducing various tax rates and making the tax structure much more efficient. One key rate is the corporate income tax, which needs to be eliminated – remember, corporations don’t directly pay taxes, people do; these costs are passed on to the consumer. Eliminate the tax and watch U.S. firms bring overseas jobs back home, along with the capital they have sitting overseas so it doesn’t get taxed at 35% -- the highest rate among OECD members. Further, watch international firms bring factories and corporate headquarters to the U.S. like never before. That would bring the job growth we need; the lasting job growth we need.

That is the way you boost government revenues, by expanding the tax base, not by raising tax rates. Increase tax rates on the wealthy and they’ll simply find ways to avoid those taxes. Increase taxes on business by eliminating the deferral on overseas income and they’ll shift more jobs overseas.



Pending Home Sales

The National Association of Realtors (NAR) reported that pending home sales (contract signings to finance an existing home purchase) rose 1.0%, exactly in line with expectations. This follows the large 16.4% (which was revised lower, initially printed -16.0%) decline in November.

So not much of a bounce, and the data suggests that January/February existing home sales won’t rebound much off of December’s 16.7% slide – a plunge that erased the single-family existing home sale gains (at an annual rate) of November, October and part of September. Existing home sales are officially counted when contracts close, and since it takes 4-6 weeks to close a contract this pending figure is a good indication of what will occur over the next two readings.


In terms of region, contract signing were strongest in the Midwest, up 5.2%; followed by the Northeast, up 2.3%; the South saw signings rise 2.2%; pending home sales fell 3.8% in the West.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks recouped more than half of the losses over the prior two sessions as a very good looking ISM report, which was on the heels of solid-to-strong manufacturing data out of China, India, Australia, the UK and Euro zone, fueled some investor optimism. These global factory gauges illustrate the inventory rebuild that is underway after stockpiles had been slashed – at record rate here in the U.S. and I suspect the same was true for the European economies.

When investors get stoked about growth, basic materials, energy, financial and tech lead the charge and that’s what happened yesterday. Safe havens such as health-care and utilities were the under-performers, but managed some upside as all 10 major industry groups gained ground.

The dollar lost ground, ending a four-session winning streak. There haven’t been many sessions when both stocks and the dollar have advanced, as the only thing that helps the old greenback these days is worry – the run for safety.

Volume was weak again as only the more negative sessions have brought volume to normal levels. Roughly 990 million shares traded on the NYSE Composite yesterday, 15% less than the six-month average.

Fourth-quarter earnings are holding up reasonably well, although you’d think firms could muster something more by the way they’ve slashed expenses via payrolls (it’s another indication that this is not a normal rebound – but then again the recession wasn’t normal, being a balance sheet, or credit-induced, economic downturn rather than the typical cyclical sort). Ex-financial profits are up 14.7% with 40% of S&P 500 members in thus far. That’s down from 21% at this time last week, but it’s holding double-digits so we’ll take it.


Market Activity for February 1, 2010

Personal Income and Spending

The Commerce Department reported that personal income rose 0.4% in December (+0.3% was expected) following an upwardly revised 0.5% (initially printed as a 0.4% rise) in November.

The segments of the report that really matter, compensation and wage and salaries from private industries, rose 0.1% each. Goods-producing industries’ payrolls decreased $5.2 billion after a $2.9 billion increase in November. On a percentage basis, this segment saw wages and salaries fall 0.5% for the month. Service-providing industries increased payrolls $11.5 billion after a $22.3 billion increase in November. In percentage terms, this segment saw wages and salaries rise 0.3% in December. Over the past year, total private-sector wages and salaries are down 3.1%.

Other private-sector components:
Proprietors’ income rose 0.8%, fueled by an 18.7% rise in farm income; nonfarm proprietors’ income rose 0.2%. Personal income from assets rose 0.6% in December -- interest income was unchanged for a third-straight month and dividend income rose 1.8%; interest income is down 3.9% over the past 12 months and dividend income is off by 14.8%. Rental income rose for an eighth-straight month (clearly helped by volume as more people are pushed into renting, not from higher rents as those have been falling – still this number appears off as we know vacancy rates are elevated). The figure rose 0.7% for December and is up 21.1% year-over-year.

Again, government transfer payments helped the income figure advance as they rose 0.6% in December and are up 13.7% over the past year. Government spending continues to help personal consumption account for 72% of GDP. As we’ve mentioned on a number of occasions, that component is going to move back to its historic average of 66% over time – the government can’t keep this level of spending up forever and households need to pare debt-to-income ratios. Government transfer payments as a percentage of disposable income continues to hover near the record high hit in August – the record is 20.2%, it came in at 19.5% for December.

In total, personal income is up 0.5% over the past year.

On the spending side, personal consumption rose 0.2% after a strong 0.7% increase in November – a gain of 0.3% was expected, but the prior month’s reading was revised up by more than this miss. Spending for goods fell 0.4% as durable goods rose just 0.04% and consumption of nondurables fell 0.6%. Consumer outlays for services rose 0.5%.

The cash savings rate (a percentage of disposable income) rose to 4.8% in the final month of the year, up from 4.5% in November. This number will continue to trend higher as the damage done to stock and home prices along with consumers’ uncertainty regarding the job market and less access to credit will usher in a another cycle of cash savings. The figure won’t necessarily increase each month, but I believe it will get to 6.0-6.5% and hold there for a couple of years – past that point it will depend on interest rates, the higher they go the higher the cash savings rate will climb. The 50-year average is 7.0%.

The inflation gauge that is tied to the personal income and spending data (known as the PCE Deflator) is up 2.1% over the past year. This remains a benign level of increase, but it is a pretty dramatic shift from the five-straight months of decline that ran May through September.

ISM Manufacturing

The Institute for Supply Management’s factory index jumped to 58.4 in January (highest reading since August 2004) from 54.9 in December. The estimate was for a print of 55.5. A reading above 50 marks expansion and anything close to 60 suggests pretty robust activity. Breadth looked good as ISM stated 13 of the 18 industries they track reported growth, that’s up from nine in December.

New orders remained hot, accelerating to 65.9 from 64.8; backlog of orders jumped 6 points to 56.0; supplier deliveries is running hot now, hitting 60.1 from 56.8; employment rose to 53.3 from 50.2 – a meaningful print above 50 so let’s hope we get some manufacturing employment pick up, but don’t expect it just yet.

The inventory data remains in contraction mode, but improved to 46.5 from 43.0 – this is above the 25-year average of 44.7.

Customer inventories fell to 32.0 from 35.0 -- this is the lowest reading for the segment on record (although data on this one only goes back to 1997); it says that respondents believe their customers’ inventory levels are too low. This is good in terms of expecting a large inventory build, and a substantial catalyst for GDP. However, in this time of heightened business caution it may also suggest that firms will keep stockpiles at very low levels until they see a durable uptrend in end demand – until the jobless rate moves down to at least 8%, which is above the high point during the normal recession, a sustained upward trend in end demand remains quite precarious.

Price paid by factories is getting hot again, shooting up to 70.0 from 61.5 in the prior month. If firms don’t have an ability to raise prices, then this event is going to hit margins and that also increases concerns that job growth will be too tame to bring the jobless rate lower – adds just another uncertainty onto the shoulders of business decision makers. Adjusting for the wild swings over the past 15 months or so (the highs on the prices paid index put in during 2008 due to the commodity-price spike and the lows put in due to the collapse of business activity in early 2009) prices paid has averaged 62.3 over the past 10 years.

In summary, this was a very good report and this activity should help to foster at least some manufacturing job growth a few months out. Still, this is a function of the inventory swing, a mild build in stockpiles (boosted by auto assemblies) from record levels of inventory slashing during the previous quarters. Not to beat a dead horse, but end demand remains crucial and firms have to have more confidence about the future if we’re going to see a meaningful degree of hiring to ensue.

Construction Spending

Finally, in the final release of the day the Commerce Department reported that construction spending fell for a 13th time over the past 15 months, down 1.2% in December. Residential got clocked, falling 2.7% for the month and down 10% over the past year. Nonresidential, the commercial side, fell 0.5% and is down 9.8% over the last 12 months.

The overall reading would have been worse if not for the 1.1% increase in public sector residential construction. For all of 2009, construction spending declined 12.4%. Private sector spending fell 18.8%, while government construction spending rose 3.7%.

Look for the public sector to offset the private sector weakness but the help will prove temporary and may very well extend the housing construction slump as we do not need more units at this time -- foreclosures will add heavily to supply over the next year. Not all of the public-sector expenditures are on buildings, highways are included in the figure, but they are less than 10% of the total.

Around the World

In a surprise move the Reserve Bank of Australia decided to hold their benchmark interest rate (known as the cash rate) steady at 3.75% -- all economists surveyed by Bloomberg had expected the central bank to raise for a fourth time in four months.

Australian policymakers stated they wanted to wait and see how the economic expansion plays out a bit before raising again – likely a very good decision. Also China is playing a role here as they’ve signaled some further tightening will ensue. The Australian economy has benefited mightily from China’s construction boom and increased lending restrictions will surely tamp that activity a bit.

Have a great day!

Brent Vondera, Senior Analyst

January 2010 Recap

January was a difficult month for stocks as market participants weighed the impact of U.S. bank regulation, Chinese monetary policy, and Greece’s financial health.

Economic data for the labor market as well as housing demand was underwhelming, while fourth-quarter GDP – showing the U.S. economy grew at a 5.7% annual rate – lacked evidence of sustainable growth. Corporate earnings largely exceeded expectations, but investors seemed to "sell the news" and take profits rather than bidding up shares further.

Domestic equities fared better than their overseas counterparts. The hottest international asset classes of 2009 felt the most pain in January, with ETFs covering emerging markets and the MSCI Pacific Ex-Japan losing roughly 7-8% in January. This can be attributed to the pre-emptive removal of stimulus in China that included increased rates for short-term bills and higher reserve requirements for banks. There have also been rumors that the central banks ordered banks to stop lending.

The Technology and Materials sectors, which were also red-hot in 2009, posted the biggest monthly losses of the S&P 500 sectors. The next weakest sector was Telecom, where mounting price competition in wireless services is creating significant threats to profitability. Verizon cuts the price of calling plans with unlimited talk, which is likely to force AT&T to cut rates as well. The competition between wireless carriers was previously built around what handsets were available and for what price, but the competition between services costs is a definite negative.

The only S&P 500 sector to post a gain was the Healthcare sector. The stunning Republican victory for the Massachusetts Senate seat squashed the likelihood of the healthcare reform bill passing in its current form, sending Healthcare stocks soaring.

Yields pulled back in January from the end of the year selloff, and the curve set an all time record for steepness at 288 basis points on Jan 11 as expectations for a Fed rate hike in the first half of 2010 chilled out. The Barclays Aggregate Bond Index was up 1.53% after losing 1.56% in December, with no help from credit spreads, which actually had their worst month since Feb 2009.

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Peter J. Lazaroff, Investment Analyst
Cliff J. Reynolds, Jr., Investment Analyst

Daily Insight

U.S. stocks fell for a second session as disappointing results from the tech sector offset the best GDP print since 2003 and substantial improvement in factory activity within the Chicago region. It wasn’t exactly the profit, or bottom-line, results that caused the concern but comments from executives explaining that business spending has yet to really rebound and that will hamper top-line growth if caution persists.

We’ll just have to wait and see if this move lower is something meaningful or another one of these sort of mini-corrections as they’ve been called (you can’t exactly call a paltry 6% slip a correction, terming them dips is more appropriate) that attracts subsequent buying. As you all know, I’ve felt this market is over-bought and sentiment is over-bullish for a few months now. Maybe investors are beginning to wonder if expectations got a bit ahead of realities. We do know that balance sheet, or credit induced, recessions are quite different than the typical cyclical downturn. Certainly, things take longer to play out as both households and institutions need to deleverage and as we’ve gotten to this level in stock prices traders kind of take time to look down and ask: Now what? I think this week will offer us a good indication of how the markets will trade over the next couple of months.

Tech, materials, energy and industrials led the session’s decline. Consumer staples, telecom and health-care shares were the relative winners, but all 10 major industry groups declined on Friday.

Commodity-related shares, what had been one of the hottest sectors, has corrected pretty nicely. Over the past few weeks, even though we like these areas (basic materials and energy) over a two-year horizon, we’ve caution about becoming too myopic with this trade. We’ve seen a lot of performance chasing here over the past couple of months, but you really had to build a position back in March and April of last year when few people were thinking about the inflation trade. We continue to like the inflation trade (basic material and energy) along with tech and industrials, the former on a two-year horizon and the latter for the next decade, but you’ve really got to pick your spots in this market – particularly so with regard for inflation trade.

For the week the broad market lost 3.9%, the S&P 500’s worst week since the one that ended on October 30. For January, the S&P 500 slipped 3.7%; the Dow Industrials lost 3.46%; the Dow Transports got hit by nearly 5%; the NASDAQ got whacked by nearly 5.4%.

Market Activity for January 29, 2010
Fourth-Quarter GDP – The First Look

The Commerce Department reported that the economy grew at a 5.7% real annual rate in the final three months of 2009 – much better than the 4.6% expected. This marks the second-straight positive reading as it follows the 2.2% rise in the third quarter. This first look at Q4 GDP is what’s called the “advanced” reading. That’s because we’ll get two more primary revisions to the number. We’ll watch those revisions with caution as the prior quarter’s reading initially came in at 3.5% but was revised all the way down to 2.2% by time of the final revision.

As we’ve been talking about, the reading was fueled by the change in inventories. The gross private investment component of GDP (of which inventories are a key part) jumped 39.3% at an annual rate, which means private investment accounted for 67% of the rise in GDP; inventories alone accounted for 60% of the GDP increase. Inventories did fall in the quarter but only by $33.5 billion. Since stockpiles fell $139.2 billion in the previous quarter (and for context they fell at a record rate of $160.2 billion in the quarter before that), the lower rate of decline added to GDP, massively. All it takes is for inventories to fall at a slower rate in order to contribute to growth.

If one likes to take inventories out of the equation to get a true look at domestic demand, GDP rose 2.2% -- that number is known as real final sales; its long-run average is
2.7% and normally runs at 4-6% coming out of recession.

In terms of contributing components:
Inventories led the way adding 3.39 percentage points (ppt). The next in line was personal consumption, the largest component of GDP, contributing 1.44 ppt of the 5.7% GDP reading. (Personal consumption continued to account for 71% of GDP. That number will be coming back down to the historic average of 65-66% as households begin in earnest to reduce their historically elevated debt/income ratios. The government is delaying this adjustment as transfer payments currently account for a record percentage of personal income. But this level of government spending is not sustainable and thus the adjustment will eventually take place and will weigh on economic growth a couple of quarters out.) Investment on business equipment and software added 0.81 ppt (we’ll watch to see if we get more than just maintenance business spending in the quarters ahead). Net exports (exports minus imports) added 0.50 ppt. Even residential fixed investment (home building) added 0.14 ppt.

Auto and parts purchases subtracted 0.57 ppt from the personal consumption segment; nonresidential structures (commercial building construction) subtracted 0.52 ppt from the private investment segment.

The government component was not a player, actually subtracting 0.02 ppt. Non-defense spending rose a large 8.1% at an annual rate, but it was weighed down by a 3.5% decline on the defense side and a slight decline in state and local government spending. Many are expecting government to be a big contributor to the economy, and I suspect we’ll see a big quarter here from the public sector over the next couple of quarters. But we shouldn’t forget that reductions in state and local spending will loom large over the next year or two. For now, most of the money the federal government is pumping into state and locals is helping to fill budget gaps. But when this money runs out a couple of quarters down the line, they will be forced to engage in austere spending restrictions – unless Washington chooses to engage in yet another massive “stimulus” program and delay the inevitable that much longer.

So a 5.7% print is good, but it is quite shy of the growth level that has been recorded coming out of the prior three worst recession of the postwar era. One quarter removed from the 1957-58, 1974 and 1981-82 recessions (and this latest GDP number is one quarter removed from the last negative print, which was the second quarter of 2009) GDP averaged 8.6% at a real annual rate. So by comparison, this is a weak reading. To get to the 7.8% growth rate, which is the average 12-month growth one-quarter removed from the worst postwar recessions, we need 8.5% GDP readings for the next three quarters. But 5.7% is 5.7% and since we endured four-straight quarters of negative GDP, the longest recession in the postwar era, we’ll take it without much complaint.

Chicago PMI

The Chicago Purchasing Managers Index showed that factory activity in the largest manufacturing region was pretty hot, beating expectations by 4.3 points and the highest reading since November 2005. The January reading for Chicago PMI came in at 61.5 after a downwardly revised 58.7 in December – initially posting 60.0. A number above 50 marks expansion.

New orders accelerated to 66.4 from 64.4; order backlogs rose to 54.3 from 52.0; inventories jumped 10 points to 48.7; employment rocketed to 59.8 from 47.6 (the sector needs this in a big way); suppliers deliveries fell to 55.3 from 57.0 – but who cares with these other solid-to-strong readings.

So here we go, the economic bounce we’ve been talking about is here; enjoy it while it lasts. My view is that this will be a transitory expansion, lasting no longer than 4-5 quarters. I’ve explained why I feel this way on several occasions; the most in depth explanation was laid out in the first letter of the year, but here are a couple main reasons.

This looks to be purely an inventory led recovery as firms must restock after the record slashing that has taken place over the previous quarters. But with businesses likely to remain cautious, a function of high uncertainty with regard to future tax rates and coming regulations, a meaningful job-market recovery will be unusually dilatory – hence, a durable increase in end demand will prove challenging. Also, it is going to be tough for credit to expand. Even when loan demand rebounds a bit, very poor credit quality and the likelihood that home prices will endure another leg down (doing additional damage to the non-performing loan scenario) will hamper the supply of loans.

But even if we forget about real estate and loan quality realities and assume something spectacular occurs: the government comes out and states that the top federal income-tax bracket (60% of which is small business ) will not increase in 2011; the capital gains and dividend tax rates won’t increase by 86% and 166%*, respectively; the tax deferral on overseas profits will remain in place; and private equity isn’t burdened (the passive income tax) with the proposed tax rate increase to 35% from 15% -- hence, this weight of uncertainty is removed from the economy’s shoulders. Even if the spectacular were to occur, Washington gets a clue, we still have the Fed in front of us.

Bernanke & Co, as if anyone needs reminding, has the fed funds rate floored at unprecedented low levels. Say the economy were to vigorously bounce in the coming five-six quarters, the FOMC will have to raise rates in an aggressive manner. And Fed tightening almost always results in recession – the only exception is 1995 when the economy barely escaped a negative GDP reading. But that period saw the Fed raise fed funds from 3% to 6% and household debt/income stood at 85%, not the present 125%. This time they will go from effectively 0 (which means the banking sector has been subsidized like never before) to who knows what under the best growth potential scenario. This may explain why I’m skeptical of a durable recovery under either a weak or robust economic circumstance.

* Those 86% and 166% increase numbers I mentioned with regard to capital gains and dividend income are based on the latest leaks from policymakers that they are thinking about raising the cap gain to 28% (which jibes with their constant talk of returning to 1990s tax rates) and 39.6% on top rate incomes – if the Bush tax rates are allowed to expire the tax on dividend income will rise from a straight 15% to the investor’s marginal income tax rate.


Have a great day!


Brent Vondera, Senior Analyst