The Federal Reserve raised the Discount Rate Thursday evening after the close of New York trading and the Tout TV crew immediately shifted into Oh My God! mode. Maria Bartiromo was in a tizzy trying to figure out what it all meant (as if there was any chance of that), the S&P futures traded down and the Fast Money crowd regaled us with tales of how they had perfectly anticipated such an action and positioned their portfolios accordingly. Asian markets traded down overnight and Europe opened weak and tentative. The Squawk Box crew picked up where the airheads of the night before left off with Carl “I Make Maria Bartiromo Look Smart” Quintanilla pondering the ramifications of the Fed move on the Tiger Woods apology later that morning. The drama continued to build through Squawk on the Street and the S&P 500 traded down 6 points in the first half hour. And then…..well then CNBC had to find something else to hold their audience because the market didn’t cooperate. The market traded higher before noon and closed modestly higher on the day. Must see TV it wasn’t.
The market’s reaction to the discount rate hike was muted because it will have little effect on the real economy and it was not unexpected despite the apparent shock of the CNBC brain trust. The Fed had telegraphed the move the week before and has been saying for months now that they would be unwinding the extraordinary lending measures they put in place during the financial crisis. As we no longer appear to be in a financial crisis that would seem appropriate and indeed should be good news for markets. The only uncertainty surrounding the move concerns whether the Fed has a clue as to the true state of the economy and therefore whether the economic recovery can proceed absent extraordinary measures. While no one should ever believe the Fed has a clue, it appears that market confidence in the recovery is growing.
Borrowing by banks from the Federal Reserve has been falling for some time and the Fed is able to unwind their extraordinary lending facilities because banks have rebuilt their balance sheets through the wonders of a steep yield curve. Borrowing short and lending long is hugely profitable when you have a central bank that keeps short term rates at zero, savers be damned. Of all the myriad programs enacted over the last two years to address the recession, the one that punishes savers so the banks can book profits to cover the losses generated by the fallout from the last time the Fed did this has probably been the most effective. Or at least it has if you define effective as ensuring that those at the top of the inflation pyramid stay at the top. Of course it does tend to turn ordinarily mild mannered grandmothers into frothing at the mouth tea party activists, but as economists are fond of reminding us, there is no such thing as a free lunch.
The raising of the discount rate, like most actions by the Fed, is more of a market following move than a leading one. Long term Treasury rates have been rising since October and with large budget deficits as far as the eye can see, that seems unlikely to end anytime soon. Because they started at such low levels, the rising rates do not threaten the economic recovery yet, but if the Fed falls too far behind the curve, the bond vigilantes will surely let them know. And by the way, the bond vigilantes are now a more politically correct, multi-ethnic group with a distinctive Asian flavor and they are rapidly losing their appetite for US debt. The Chinese and Japanese both reduced their Treasury holdings last month.
But the interest rate concerns are something for the future. For now, the economic recovery continues apace although there are worries that some indicators are peaking. The Leading Economic Indicators were up last month but the rate of increase is moderating. Several of the underlying statistics which make up the LEI are no longer improving. In particular, money supply and jobless claims are not only no longer improving, they are turning negative. The money supply figures don’t concern me too much since we need to stabilize the dollar at some point anyway and we’ll never do that if we just keep printing too darn many of the things, but the jobless claims data is very worrying. If this recovery is to be sustained, employment will have to improve. There are some forward looking indicators - the employment components of the ISM and Fed surveys are positive - that point to future employment growth, but layoffs continue to be a problem.
There are still a number of positives for the markets and they shouldn’t be underestimated. As noted above, the banks have booked some great profits over the last year and have ample funds to lend when businesses decide to borrow again. If the last recession is any indication that won’t happen for some time yet but when it does I suspect the Fed will discover how tough it is to control lending by offering the banks piddling returns on excess reserves. In the meantime, companies - especially large ones - have lots of cash on the books to fund investment and more likely M&A activity. The companies that make up the S&P 500 have $2.1 trillion in cash on their balance sheets and the majority of them added to cash in the last year. They accomplished that by slashing investment and employment and through other measures such as cutting dividends. Now, half of CEOs in a recent survey expect to increase investment over the next year.
70% of the CEOs also said they expect employment at their companies to remain stable which is good news on the layoff front but not so encouraging when it comes to reducing the 9.7% unemployment rate. There is somewhat of a disconnect between most not expecting to hire and half expecting to raise investment - wouldn’t that raise hiring at the firms that produce the capital goods that are the object of the investment? - so it could be that employment improves quicker than they expect. More important is why these CEOs are reluctant to hire and the reason is pretty clear. Uncertainty over government economic policy was a major factor in the economy last year and until there is more clarity on issues such as health care reform, which affect the cost of hiring, I would not expect a big drop in the unemployment rate. John Chambers, CEO of Cisco Systems, recently said of their hiring plans:
"Going forward "” assuming government regulations that favor job creation, economic growth, exports and innovation "” we would continue to add, balanced around the world."
On the issue of economic policy, I don’t expect much change in this election year. Democrats are on the defensive and despite the recent bravado of the White House on health care reform, seem unlikely to chance passing anything substantive this year. Whether that is a mistake or not is up for debate but politicians are not risk takers and the bigger risk for most Democrats is in passing something their constituents don’t like. Doing nothing may not please the base of the party but like the Republican base, the Democratic one doesn’t represent anything close to a majority of voters. In a year that seems poised to produce lots of mad independents at the polls, doing nothing is the lower risk trade.
The outcome of the midterm elections could also have an effect on the markets this year, but it is too early to make any prognostications. Republican are giddy right now with visions of retaking Congress dancing in their heads but November is still nine months away and a lot can change between now and then. It is said that the market likes gridlock and so if polls continue to show a preference for Rs the market will probably take that as good news. Personally, I am of the opinion that gridlock was fairly attractive in the mid 90s when our demographic problems were further in the future but not nearly as attractive now that the baby boomers are actually ready to retire. Big changes are needed or our economy faces years of subpar growth. Eventually we will have to address our long term fiscal situation; better to do it now rather than wait for the market to force our hand a la Greece.
For now the cyclical recovery in the economy and the markets continues. M&A activity is picking up as it usually does at this point in the cycle. Simon Properties made an offer for General Growth last week despite the fact that GGP is in bankruptcy and saddled with a lot of poorly performing malls. Walgreen acquired Duane Reade, the NY pharmacy chain. Schlumberger is apparently preparing a bid for Smith International. Bank consolidation will continue as the strong absorb the weak mostly through the FDIC. Health care is another industry with a lot of cash on hand but deal activity may be muted until reform issues are clearer.
The Fed’s move to begin the end of easing is not cause for alarm and does not signal the end of the bull move in stocks. The best indicators of future activity are still signaling growth ahead. The steep yield curve and tightening spreads in the corporate bond market point to significant future growth. Yes there are still weak spots such as employment and they are cause for concern but for now the momentum is still on the side of improvement.
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Attention Chicago readers: I will be in your fine city from March 4th to March 11th to visit my daughter, who recently transferred to the School of the Art Institute of Chicago. I would like to organize a meet up while I’m there with any who are interested in discussing economics, markets and whatever else strikes our fancy. Since I haven’t been to Chicago since The Fridge was still playing for the Bears I would appreciate any input concerning a casual location to discuss, debate, eat and drink. E mail me at info@alhambrainvestments.com if you want to join the discussion and/or if you have suggestions.
Weekly Economic and Market Review
Another week of good economic reports with a few questionable ones thrown in for good measure. The Empire State and Philly Fed surveys were both better than expected and pointed to future growth in manufacturing. Both reports had positive indications in the inventory component with the Empire State survey showing an end to destocking and the Philly report showing actual accumulation which would seem to indicate that manufacturers are fairly confident about future activity. Both reports also showed rising employment. Housing starts were better than expected in January at an annual pace of 591,000. That’s up 21% from last year but still a long way from the 1 to 1.5 million needed to keep up with new household formation once the inventory is worked off. Permits were down month over month but still up almost 17% from last year.
Import and export prices are heating up. Import prices in January were up 1.4% from December and 11.5% from last year. The only good thing I can find in that is that the rise is entirely due to raw materials rather than finished goods. Whether those raw materials prices get passed through to consumers depends on productivity. If users of raw materials here are able to keep producing more with less labor they can absorb the price increases. Obviously this isn’t good for the job market. Export prices were also up but not nearly as much. Hmmm….price of imports rising rapidly and price of exports rising less rapidly. That does not sound good for profit margins.
Industrial production was up again last month. This was a stronger report though than last month when most of the gain was from higher utility output and was due to cold weather. Gains were strong in manufacturing, particularly in auto and related industries. Producer prices confirmed the trend in import prices with prices rising 1.4% month over month. The year over year rate is now 5% up from 4.7% in December. The Consumer price report on Friday indicates that the price increases are not being passed on to consumers. The worst report of the week was the jobless claims numbers - again. New claims totaled 473k, up from 440k the previous week. There were some problems with the data this week but I don’t know how to assess them. The lousy weather meant that 4 states were estimated including Texas and California. There was also a holiday in there that slowed up reporting. Bottom line: I have no idea what this number means, but I will take it negatively until proven otherwise.
Market action last week reflected the relatively good economic news. The S&P 500 rose 3.13% with foreign markets also performing well. Europe tended to outperform on the week even though the Greece situation remains unresolved. Commodities were generally higher even as the dollar remained strong. The dollar index seems to have run out of gas on Friday by the way, closing basically on the low of the day after an early rally. That generally indicates at least some near term exhaustion. REITs were higher on the week with the Simon Property/General Growth news. Treasury yields continued to rise and bonds generally performed poorly although high yield was an exception.
Selected Charts
The S&P 500 is basically in the middle of the same range it has occupied since November. My target is still the 1200-1250 range.
The dollar looks tired on a short term basis, closing on the low Friday. A correction of the recent uptrend is due and would not surprise. Whether it is anything more than that is a big question. I suspect we may get some kind of range bound market.
Commodities had a good week but are still in a range bound market. Any breakout is probably dependent on the direction of the dollar.
The British pound looks to be heading back to its low. And deservedly so. And by the way, good call Doug T.
Regional Banks are still trending nicely upward.
Biotech has also held up well in the correction and is on the verge of a breakout....maybe. As you can see the etf has failed here a couple of times already. Third times a charm?
Housing stocks are also acting pretty good. I bought LEN for our Global Opportunities portfolio recently.
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