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After six straight weeks of decline, stocks finally managed to post a positive return last week. It wasn’t much and the late week rally resulted from hope that the Europeans would find a way to further the delay the inevitable Greek default that all but the truly delusional know is coming but after six weeks of market waterboarding, it at least allowed us all to take deep breath. As I write this the only agreement in Europe is for more talks about more talks so the idea that this is the beginning of anything more than an exhausted bounce seems far fetched.
As I said last week, this transition will take some time and I think a best case scenario would see us end the transition no lower than we are now. That doesn’t rule out further downside by any stretch but I don’t think the economic situation is so dire that a return to bear market status is warranted yet. The global economy is definitely slowing but there are still plenty of positives out there. Quite possibly the best news is that the US Dollar has stabilized and commodity prices are starting to come down. We can’t count on any more “stimulus” from government - thank goodness - but lower commodity prices will eventually provide what government cannot.
Here in the US, the urgency of the fiscal debate was highlighted by the fact that Obama and Boehner went golfing Saturday. I can’t think of a better metaphor for the budget debate than chasing a ball around a well defined layout. Neither side has managed to get outside the boundaries of their chosen political ideology to offer anything resembling a creative solution to our fiscal difficulties. Any solution will amount to no more than a political mulligan intended to clear the hazard of the next election. A deal will get done because it is in the best interests of both parties to play it safe and lay up rather than break out a fairway wood and go for the green.
The play it safe and get a deal done route will probably be enough to allow the economy to muddle through but it won’t be enough to allow the economy to reach its potential. For investors, that likely means mediocre returns with more growth scares down the road; a volatile market where avoiding the downdrafts becomes more important than ever. The end of QE II and fear of a false austerity in a budget deal are the proximate causes of the recent pessimism but neither is particularly worrying to this observer. Neither government spending stimulus nor Federal Reserve bond purchases are responsible for what recovery we have enjoyed - both in my opinion muted the recovery - and therefore their end should not be feared. While sentiment has turned negative quickly in this correction it is not yet dour enough to warrant deploying our cash reserve. Patience, investors, patience.
Overall the economic news last week would have to be considered mixed but two reports on manufacturing raise concerns that this is more than just a minor slowdown. The slowdown in manufacturing is particularly concerning since that sector has led the recovery but if the glimmer of hope in housing starts and building permits turns out to be the beginning of a trend, the concerns may turn out to be overblown. Manufacturing is still an important part of the US economy but make no mistake, it is construction activity that has been missing from the recovery so far. And that may be starting to change. More on that later.
The retail sector continues to reflect the strains on consumers from higher energy and food prices. The Goldman and Redbook reports both showed slower growth in same store sales of 2.5 - 3% year over year. Both reports though were upbeat about June and if commodity prices continue to correct they may be right to be optimistic. The national retail sales report showed a decline of 0.2% but most of that was concentrated in autos. Ex-autos and gasoline, sales were up 0.3%. Year over year total sales are up 7.7% (not adjusted for inflation). So despite the rise in gas prices and prices in general, US consumers continue to do what they do - shop. It’ll be interesting to see what they do with the extra income if commodity prices continue to fall. My guess is that it will be directed to savings or paying down debt. Either would be better for the long term health of the economy than buying more stuff they don’t need.
The slowdown in sales showed up in the inventories report which showed a build of 0.8% and because sales were up less, a rise in the inventory to sales ratio to 1.26. The build in inventories slowed from last month’s 1% rise. This would seem to explain, at least partially, the slowdown in manufacturing. If sales don’t pick up soon, I would expect the inventory build to continue slowing and further production cutbacks. The slowdown in manufacturing was reflected in the Empire State and Philly Fed surveys, both of which dropped dramatically into negative territory. New orders dropped significantly in both surveys but shipments and employment at least remained positive in the Philly version. These surveys do tend to be volatile - they both dropped into negative territory for a month last year too - so don’t read too much into this yet. I suspect we’ll get at least one more negative month and maybe an ISM under 50 before the slowdown is over but recession usually requires a reading under 45.
Last week’s bad news on manufacturing was balanced somewhat by better news in other areas, particularly housing. Mortgage applications were up strongly probably due to lower rates while housing starts rose 3.5%. Building permits were even stronger rising 8.7% which bodes well for future building activity. Gains were in single family and multi family building. I continue to believe the housing market is at or near the bottom. With rents rising and vacancy rates falling, new construction may be concentrated in multi family dwellings but from the standpoint of the economy that really doesn’t matter. We need people swinging hammers and it makes little difference whether they are swinging them at houses or apartment buildings.
The inflation numbers last week were a bit better and I expect them to continue to moderate over the coming months. Oil prices dropped again last week and agricultural commodity prices appear to have peaked for now. It’s also good news that the Senate last week voted to end ethanol subsidies. It didn’t pass the House and Obama promised a veto but there is at least hope that we can end this stupid, wasteful program that also raises agriculture prices.
Jobless claims dropped a bit, down to 414k. That’s still too high but at least they appear to be going in the right direction again. The lower claims over the last month was a contributor to a 0.8% rise in the LEI last month as well. The rise in building permits will help next month’s reading. The mid month reading on consumer sentiment was down slightly no doubt due to the recent spate of negative economic news.
The economy has clearly slipped over the last few months as I’ve pointed out in these weekly updates repeatedly. There are several culprits including the effects of the earthquake and tsunami in Japan but another contributor has been the negative effect from QE II. With the end of Fed meddling now in sight and Japan appearing to at least stabilize, those drags may soon end. There are still other risk factors, most prominently a slowing of the Chinese economy and the Greek debt tragedy, but I think the most likely outcome is continued growth rather than a new recession.
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