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SGK Blog--Update March 27, 2015: Oil Rises on Saudi Airstrikes in Yemen 

Oil jumped in price approximately 5% on Thursday, its biggest daily gain in a month, after air strikes in Yemen by Saudi Arabia and its Gulf Arab allies sparked fears escalation of the Middle East battle could disrupt world crude supplies. The Saudi-led coalition launched more air strikes on Friday against the Yemeni capital, Sanaa, controlled by Shi'a Houthi fighters allied to Iran. Worries over the possible impact of the geopolitical tensions on the Bab el-Mandeb Strait, the closure of which could affect 3.8 million barrels per day (bpd) of crude and product flows, put oil prices on track for weekly gains. Brent was headed for almost a 5% weekly rise - the biggest gain since early February.  U.S crude was set for an almost 10% jump - the most since the start of 2011. But Yemen is a small oil producer, with an output of around 145,000 bpd in 2014 and analysts say the conflict there is very unlikely to hit Middle East fuel supplies. A bigger impact could come from a nuclear deal with Iran, which could result in a loosening of Western sanctions against Tehran and rising exports of its oil reserves. Iran has around 30 million barrels stored offshore ready for sale, oil that could flood an already saturated market. Although any deal with Iran would be unlikely to lead to higher Iranian oil exports before the second half of the year, it has still weighed on market sentiment. Thus there is the possibility of the Strait of Hormuz opening up which would offset the possibility of the Bab el-Mandeb shutting down. Oil prices finally retreated somewhat in Friday trading as worries began to recede over the threat of disruptions to Middle East supplies due to Saudi Arabia-led air strikes in Yemen. Goldman Sachs said the bombing of Yemen would have little effect on oil supplies as the country was only a small crude exporter and tankers could avoid passing its waters to reach their ports of destination. 

In other news, the U.S. economy expanded at a 2.2% annualized pace in the fourth quarter, led by the biggest gain in consumer spending in eight years. The revised increase in gross domestic product, the value of all goods and services produced, matched the Commerce Department’s previous estimate, according to figures issued Friday in Washington.  The report also showed corporate profits dropped in the last three months of the year, capping the worst annual performance since the recession. The rate of economic growth will prove hard to replicate this quarter as harsh winter weather, a stronger dollar, a port slowdown and a global oil glut translate into disappointing spending on the part of consumers and businesses.  Job growth -- one of the few economic indicators that charged ahead unabated in the first quarter -- will probably help support demand in the world’s biggest economy for much of the year. The median forecast of 83 economists surveyed by Bloomberg called for growth of 2.4% in GDP.  Projections ranged from 1.8% to 2.7%.  This is the final of three estimates for the quarter. An upward revision to consumer spending and exports was mostly offset by smaller gains in inventories, the report showed. 

For all of 2014, the U.S. economy grew 2.4% from the year before, the most since 2010 and following a 2.2% advance in 2013. Household consumption, which accounts for almost 70% of the economy, was revised up to show a 4.4% gain at an annualized rate in the fourth quarter, the most since the first three months of 2006.  It was previously estimated at 4.2%.  The update reflected bigger outlays on health care. For all of 2014, Consumer spending rose 2.5%, the most since 2006. The Commerce Department’s report also included data on fourth-quarter corporate profits.  Before-tax earnings fell 1.4% after rising 3.1% in the previous three months, depressed by declines among financial institutions and foreign affiliates. A 4% gain at an annualized rate in personal income made up for the drop in corporate earnings and helped propel gross domestic income up by 3.1%. For all of 2014, corporate profits were down 0.8%, the first decrease since 2008.  The outlook for 2015 has dimmed with the jump in the dollar. Bad weather and the stronger dollar are having an impact this quarter.  

Fed policy makers are keeping an eye on employment and inflation as they consider raising interest rates this year. Officials cut their economic growth estimates for this year and the next two, according to the FOMC’s quarterly Summary of Economic Projections. They also slashed their median estimate for the federal funds rate at the end of 2015 to 0.625%, compared with 1.125% in December forecasts.  Atlanta Fed President Dennis Lockhart and Chicago Fed chief Charles Evans, both of whom vote on policy this year, acknowledged last week that a stronger dollar was a headwind for growth. The biggest impact from the swing in the currency will probably be on trade as an appreciating dollar makes it difficult for some American producers to sell their goods to foreign buyers, who may consider buying cheaper products elsewhere.  At the same time, it also makes it less expensive for U.S. consumers to buy imported goods, giving U.S. companies even more competition.   

In other economic news this week, existing home sales for February came in at 4.88 million which was in-line with expectations while new home sales surprised analysts for the same month as they rose to 539,000 versus the expectation for 465,000. This was a shocker as most felt bad weather across the country would put a crimp in new home sales. Durable goods orders for February fell 1.4% while the figure excluding transportation fell 0.4%. Both were expected to be positive at +0.4% and +0.3% respectively. Initial weekly jobless claims for the week ending 3/21/2015 came in at 282,000 which was below the estimate. The University of Michigan consumer sentiment index for March came in at 93.0 which was above the estimate of 92.0.  Finally, the consumer price index or CPI was basically in-line with expectations at +0.2% with the core rate, which excludes food and energy, also coming in at +0.2%. These figures help reassure the Fed that inflation remains relatively muted.
SGK Blog--Update March 20, 2015: The Fed Is Out of Patience 

The Federal Reserve opened the door a crack to raising short-term interest rates by June, but Chairwoman Yellen emphasized that they were not impatient to do so.  The Federal Open Market Committee concluded that “it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.  This change in forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.”  The translation is that the Fed will continue to be data dependent and, assuming monthly payroll figures continue to grow nicely, will look to raise rates when inflation shows some signs of a heartbeat. 

Given that every single word the Fed writes is analyzed like an Ebola strain, the key figure to focus on going forward is “reasonably confident.”  Its last statement included the following: “the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.”  Thus, “patience” become the key word for months until now since it is not mentioned at all in the current press release.  What does “reasonably confident” entail?  Yellen was asked this directly and she politically answered that it involves no single data point or metric but something along the lines of the infamous Supreme Court phrase “I know it when I see it.”  The market liked what it heard reversing a negative market within minutes of the press release publication and ending the day up over 1% on the major averages. 

What did the market like?  We believe the market was pleased with the fact that the Fed was paying attention.  The market understands numbers and focusing forward guidance back upon a clear hurdle helped.  Unlike previous squishy statements like “for an extended time” (March 18, 2009) and “for a considerable time” (December 12, 2012) and the aforementioned “patient”, market watchers can focus on the consumer and producer price indices, GDP deflator and personal consumption expenditures for clues.

Second, and more importantly, they moved closer to the market’s point-of-view.  Yellen often mentions how inflationary expectations of the future can feed into current day inflationary pressures or non-pressure.  If people think inflation will be lower two, three or five years down the road, then that affects prices and purchasing patterns today.  Many survey-based indicators (those based on taking a survey like consumer confidence) had not shown a lot of inflationary expectations, but they also have not moved at all over the past few years.  That, according to the market and also apparently according to the Fed, was unrealistic.  Market-based indicators (those based on investors placing bets with real money) showed future levels of inflation stable to falling lower.  They are reacting to lower oil prices and virtually no real wage gains.  The Fed’s “dot plot” which shows their projections for the next 2-3 years now reflects much closer to what the market is betting on.  For 2015, the Fed now expects the economy to expand 2.3%-2.7% which down from the 2.6%-3.0% expected in January.  Forecasts for 2016 and 2017 were also lowered.  Also shaved were the Fed’s estimates of inflation and also how low the jobless rate can fall before it will theoretically start creating inflationary pressures.  The market has been skeptical of growth and price pressure since the middle of last year and even more so when oil prices began to plunge.  Futures markets continue to point to less than 50% chance of an increase by the June meeting. 

SGK Blog--Update March 6, 2015: Employment Jumps and the Fed Watches 

After Thursday’s initial unemployment claims figure, the market was expecting a subdued Friday payrolls report.  They were wrong.  Non-farm payrolls jumped by 295,000 in February, and the unemployment rate fell to 5.5%, the lowest in almost seven years.  The Labor Department revised January’s figures down to a gain of 239,000, but last month’s result blew away the consensus estimate of a 235,000 increase in a Bloomberg survey of economists.  February marked the 12th consecutive month that payrolls have risen by at least 200,000, the best run since a 19-month stretch that ended in March 1995.  Payrolls rose 3.1 in 2014, the most since 1999.  The increases last month included firms in retail sector which added 32,000 positions and the leisure and hospitality industries which saw 66,000 more jobs.  Hiring in the mining sector, which includes oil and gas extraction and related services,  fell by 9,300. 

Even with the strong headline numbers, the missing link continues to be faster wage growth.    The average workweek held steady at 34.6 hours for the fifth straight month, and average hourly earnings among private-sector workers rose 3 cents to $24.78.  That translated into a 2% year-over-year growth in wages which was below the 2.2% gain we saw back in January.  Thus, despite unemployment falling from 6.7% a year ago, there remains slack in the labor market.  The labor force participation rate fell to 62.8% last month from 62.9% in January and remains near the lowest level since the 1970s suggesting millions of Americans remain on the sideline.

The Fed remains stuck between a rock and a hard place.  These type of employment gains should have the Fed “normalizing” rates at a faster pace.  However, given that half of their mandate is stable prices, and with no inflation anywhere on the horizon, there is no pressure to raise their Fed funds target anytime soon.  Historically, the Fed has erred on the side of caution for employers and raised rates after inflation had taken hold.  At this point, we believe the Fed will follow the same path.  Futures markets continue to see a raise in September not in June—odds climbed to 55% after the employment report from 49% on Thursday afternoon.  This sets up a potentially market-moving event.  If the Fed governors follow-through with their rhetoric which points to a mid-year boost, the market will be surprised and not in a good way.  But we believe that the lack of wage pressure currently does not give Chairwoman Yellen & Co. the ammunition to pull the trigger just yet.  This means that the Fed governors are going to have to alter what they tell the markets in public speeches about monetary policy and especially in their wording of their post-Federal Open Market Committee meeting communiqué due March 18.  Stay tuned.

SGK Blog--Update February 27, 2015: Janet Yellen Speaks; Traders Pay Attention 

This week all eyes were on Fed Chair Janet Yellen as she testified before Congress.  Earnings, Greece, the Ukraine – all were swept aside momentarily as traders were glued to their TV sets or Bloomberg terminals waiting with baited breath for her to hint at pending rate hikes by the Fed.  She indicated the Federal Reserve is preparing to consider interest rate hikes "on a meeting-by-meeting basis," in speaking to a congressional committee on Tuesday, a subtle shift of emphasis that helps lay the groundwork for the Fed's first rate hike since 2006.  In remarks to the Senate Banking Committee, Yellen described how the Fed's rate-setting policy committee will likely proceed in coming months - first by removing the word "patient" in describing its approach to rate hikes, then entering a phase in which rate hikes are possible at any meeting.  That approach could open the door to an interest rate increase as early as June, though investors interpreted Yellen's testimony overall as likely indicating a later date for liftoff.  By the end of her two-hour appearance before the Senate Banking Committee, short-term rate futures contracts showed traders had shifted their expectations of an initial rate hike from September to October, according to data collected and analyzed by CME FedWatch.  Yellen, however, said that even as the Fed refines its language in coming weeks, investors should not construe that as a sign the central bank is wed to a rate hike at any particular meeting.  Rather, she said, when the word "patient" disappears it means the Fed will merely have full flexibility to act if its judges the economic data warrant it.  In our view, that is actually a good clarification.  Traders have been set to almost panic once the word patient is removed and we are sick of hearing the word continuously on CNBC candidly!

The Fed has been struggling in recent months to move away from the sort of forward guidance it has relied on through the crisis to influence market behavior, without at the same time triggering a market overreaction with each tweak to its policy statement.  Yellen's comments on Tuesday marked another step in that process.  "If economic conditions continue to improve, as the committee anticipates, the committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis," Yellen said.  "Before then, the committee will change its forward guidance.  However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the committee will necessarily increase the target range in a couple of meetings."  Whew!  Who would have thought the semantics were so darn important in this day and age!  Yellen's discussion of forward guidance was part of prepared testimony that included a broad overview of a U.S. economy that appeared to be surging forward with strong job growth and a continued post-financial crisis expansion - conditions largely consistent with a rise in interest rates later this year.  Analysts said the testimony did little to nail down the likely date of a rate hike, with her testimony and answers to questions veering between confidence in a "solid" recovery and continuing concerns about weak wages and other signs the labor market is not fully healthy.

Alabama Republican Senator Richard Shelby, the chair of the Senate Banking Committee, led a discussion that confronted Yellen with a broad set of concerns - from currency manipulation among U.S. trading partners to whether Congress should delve more deeply into the Fed's affairs.  Shelby has scheduled a separate hearing next week on Fed oversight, and challenged Yellen on the issue in his opening statement.  With a more than $4 trillion balance sheet from its various crisis-fighting efforts, "many question whether the Fed can rein in inflation and avoid destabilizing asset prices," Shelby said.  "I am interested to hear whether the current Chair ... believes the Fed should be immune from any reforms."  Yellen was adamant.  Pending legislation that would let the Government Accountability Office review monetary policy "would politicize monetary policy," Yellen said, and "beyond a shadow of a doubt" make the Fed less effective.  That is very true so we give her kudos on that one.  She was grilled repeatedly in front of House legislators, particularly Republicans, but she held up well under pressure. 

Just completing her first year as Fed chief, Yellen said she felt U.S. labor markets and other key economic indicators "have been increasing at a solid rate."  However, she said she still feels the job market is not fully repaired, and that the U.S. outlook remains somewhat clouded by a weaker-than-hoped-for global economy, stalled wage growth, and falling inflation.  None of those factors on their own may be enough to keep the Fed from raising interest rates later this year.  Rates have been near zero since the financial crisis hit in 2008, part of a record effort by the central bank to repair the damage of the Great Recession.  But the lack of inflation has made some Fed policymakers hesitant to commit to raising rates until they are more certain the United States is not headed down the same path as Europe or Japan, mature industrial economies that are struggling to maintain growth.  The Fed considers a steady 2 percent annual inflation rate a sign of overall economic health - consistent with its own ability to return interest rates to a normal level, and not so high or low that it distorts household and business spending and investment decisions.  Though the current weak prices are considered likely to be a temporary result of the collapse in oil prices, doubts remain.  Yellen's statement could set the stage for the Fed to remove the "patient" reference as soon as its next meeting in March, a step policymakers began discussing in January according to recently released Fed minutes.  Several policymakers, including some centrists on the committee, have said they feel an interest rate increase should be on the table by June, after the intervening Fed policy meeting in April.  The discussion of forward guidance in Yellen's testimony is an effort to extricate the Fed from a perhaps unforeseen constraint it created when the word "patient" was put in its statement in December.  Yellen defined patient as a "couple" of meetings, and policymakers soon became concerned, according to the most recent Fed minutes, that investors would view any removal of "patient" as a sign that interest rates would definitely rise two meetings later.

Yes there was other news this week, though not nearly as exciting as Janet Yellen’s testimony was!  J  We had a number of housing data points come out this week with all indications pointing to the housing sector remaining a source of strength for the U.S. economy.  Pending home sales for January were 482,000 which was just shy of the forecast for 495,000.  New home sales for January were right in line with expectations at 481,000.  The Case-Shiller 20-city Index of housing prices for December showed a 4.5% increase in year-over-year prices which was better than the forecast for a 4.3% increase.  Initial weekly jobless claims ending 2/21/2015 were 313,000 which was higher than the expected 282,000.  January’s consumer price index (CPI) dropped 0.7%, the most since 2008, compared to the forecast for a  0.6% drop.  When the volatile food and energy sectors are factored out, the so-call Core CPI, the rate actually rose in January by 0.2% which was just slightly above expectations.  There were no surprises in these figures so that lent support to the Fed’s view that inflation remains relatively tame.  Durable goods orders for January rose a healthy 2.7% largely on business demand for equipment such as machinery and computers.  This was the first increase in three months and exceeded the expectation for a 1.7% increase.  Excluding the volatile transportation sector, the January figure rose 0.3% relative to the expectation of a 0.5% rise.  Overall there were no real surprises with the data on the U.S. economy this week.

SGK Blog--Update February 20, 2015: Markets Climb as Focus on the Eurozone 

Eurozone leaders met on Friday to determine the fate of Greece’s request for a bailout extension.  Germany summarily rejected a request for an extension sent by Athens yesterday saying it “doesn’t offer a substantial proposal for a solution.  In reality, it aims for a bridging loan without meeting the terms of the [bailout] program,” according to Martin Jaeger, spokesman for Finance Minister Wolfgang Schӓuble.  The meeting in Brussels is an attempt to discuss the situation before Greece’s bailout expires at the end of the month.  That would leave the government without funding and its banks at risk of being completely cut off from the lending facilities of the European Central Bank (ECB).  If the banks get cut off, Greece would have little option but to leave the eurozone and abandon the euro as its currency. 

We have not seen the levels of panic in the markets over a potential exit that we saw in earlier years because the ECB has taken many steps to prevent such an environment.  First, they have committed to their own version of quantitative easing which is a sign to markets that ECB President Draghi is willing to bring out the “big guns” in order to keep the peace.  Second, previous “brinksmanship” has elicited a Little-Boy-Who-Cried-Wolf mentality among traders.  All those fires were put out, so why not this one?  Third, it would be surprising if newly elected Greek Prime Minister Tsipras did not use the results of the election to push for less austerity.  He believes he has a mandate to stand up to the EU powers and does not want to lose face with the Greek populace by appearing weak and conciliatory just weeks after taking power.  In early afternoon trading, the euro/dollar exchange rate was virtually unchanged intraday which suggests again that the powers in charge are likely to work out some sort of solution even if that means merely agreeing to meet again!  Preliminary reports from Bloomberg and Reuters News say that finance ministers may have reached an agreement that will extend rescue program by six months.  While details are sketchy, the late afternoon rise in the equity markets is a good sign that some deal has likely been reached.   

On the domestic  economic front, this week’s data did little to dissuade investors that the recovery is in full effect.  Wholesale prices fell in the U.S. thanks to plunging energy costs.  The producer price index fell 0.8% in January and was the largest decline since November 2009 when the new PPI series was created.  This followed a 0.2% decline in December’s figure.  Excluding food and energy, wholesale prices still fell 0.1% even though a Bloomberg survey of economists forecasted a 0.1% rise.  Year-over-year these so-called core prices are up 1.6%.  Jobless claims fell by 21,000 to 283,000 in the week ended February 14 according to the Labor Department.  The less volatile four-week moving average is down to 283,250, a three-month low.  Though labor markets continue to improve, the outlook in residential real estate remains a bit fuzzy.  Housing starts in January decline 2% to a 1.07 million annual rate according to the Commerce Department.  Permits, a proxy for future construction, also fell.  Granted, this follows a month of December which registered an almost seven-year high and comes during a time of the year which is heavily influenced by weather even though the data is seasonally-adjusted.  Tight credit also remains a headwind and uneven spikes in demand have pushed median prices higher over the past six-to-twelve months.

SGK Blog--Update February 13, 2015: Markets Climb as Ukraine Ceasefire Agreement Reached After Marathon Talks 

This week the attention of traders shifted from corporate earnings to the news being generated out of Europe. The leaders of Germany, France, the Ukraine and Russia pulled an all-nighter to come up with a ceasefire plan for the battle that has been raging and picking up steam in the Ukraine. While we have had ceasefires before, which have all crumbled, and there is no guarantee this one will hold, this negotiation seemed to have more urgency as the U.S. threatens to send weapons to the Ukraine to assist our NATO ally and the economic sanctions levied on Russia by the U.S. and the European Union continue to take their toll on the Russian economy. As of the time of this drafting, there has been no pullback of sanctions by either the U.S. or the EU as we await details of the truce to emerge and the various parties wait to see if the terms are honored.  

The situation in Greece at first seemed insurmountable as the rhetoric was flying back and forth between Greek and German representatives. In a speech before the Greek parliament, newly minted Prime Minister Tsipras actually took the step of saying Greece wanted war reparations for the four year occupation of their country by the Nazis. Talk about stoking nationalist fervor! (Not to mention ticking off the Germans!) While initially both sides seemed to dig in their heels with respect to their positions, with encouragement from non-EU parties such as British Prime Minister David Cameron, by week’s end both sides seemed to soften their stance and officials from Germany and Greece agreed to talk to each other ahead of the EU meeting of finance ministers next week. So there was at least some reason for optimism.  

The economic news here in the U.S. was somewhat disappointing as retail sales for January fell 0.8% and 0.9% excluding autos versus the expectation for declines of 0.4% and 0.4% respectively. Initial weekly jobless claims also rose to 304,000 for the week ending 2/7/2015 versus the expectation for 285,000. Business inventories for December also rose a paltry 0.1% versus the expectation for a 0.2% rise. The data was thin this week so markets were more focused on the data coming out of Europe which we highlight next. 

The euro-area economy picked up momentum at the end of last year, with Germany reasserting itself as the driver of growth, offsetting weakness in Greece and Italy. Gross domestic product rose 0.3% in the fourth quarter after expanding 0.2% in the previous three months, the European Union’s statistics office in Luxembourg said Friday.  Analysts surveyed by Bloomberg News predicted growth of 0.2%. The Greek economy shrank 0.2% which surprised analysts but is not shocking to us given the turmoil that has been going on there both leading up to and after the recent elections. The private sector had been picking up steam but a lot of decision making has been put off by businesses given the status of Greece remaining in the EU is largely an unknown at this time. While the currency bloc’s economy is overcoming its longest-ever slump, falling consumer prices and the rise to power of an anti-austerity party in Greece have increased the risks to growth.  To avert deflation in a region where consumer spending is bolstering the recovery, European Central Bank President Mario Draghi announced a 1.1 trillion-euro ($1.3 trillion) quantitative-easing package that has already pushed down bond yields and the single currency. The German economy, the region’s largest, expanded 0.7 percent in the fourth quarter, more than twice as much as forecast, while French growth slowed in line with economists’ projections.  As mentioned, the Greek economy shrank after three quarters of growth, and Italy’s stagnated after two consecutive quarters of contraction.  Growth in Portugal and the Netherlands was 0.5%, more than analysts anticipated. Spain, the euro area’s fourth-largest economy, reported on Jan. 30 that its economy expanded at the fastest pace in seven years in the fourth quarter, with GDP rising 0.7%. So the news on the economic front coming from Europe was mixed but overall it had a positive tone. This help lend stability this week to European bourses.
SGK Blog--Update February 6, 2015: The Stage is Set  

With Friday’s employment data the stage is set for the Fed to normalize interest rates in June assuming the strong jobs momentum continues.  Employers added 257,000 non-farm payrolls in January marking the biggest three-month gain in 17 workers.  December’s gain was revised upwards to 329,000.  The median Bloomberg forecast of economists called for only a 228,000 increase.  The unemployment rate actually climbed from 5.6% to 5.7%.  That tick higher is misleading because it actually means more individuals were actively seeking an entry into the labor force further underscoring the strength of the job market.

As usual, the real story lies behind the headline numbers.  It is nice that payroll gains have averaged 336,000 over the last three months, but if those jobs barely keep the employed “above water”, has there really been any progress?  One way to measure such a query is to look at the average hourly earnings.  A paycheck is great, but a salary that outpaces inflation and enables a worker to not only cover normal expenses but also have a little left over for savings or an impulse buy is even better.  Last month average hourly earnings jumped 0.5%.  That is the most since November 2008 when the country was in the midst of the financial crisis and the electorate had just elevated a first-term Senator from Illinois to the White House based on a campaign motto of “change”.  This represents a 2.2% year-over-year wage gain which is above any recent consumer or wholesale inflation measures and results in real growth.  That is why 1.05 million people entered the work force (and 759,000 found work)—because they wanted to get paid!  The participation rate, which indicates the share of working-age people in the labor force, rose to 62.9% in January from 62.9% in December.  Excluding government hiring, the figures were even better.  Private payrolls rose 267,000 last month after an advance of 320,000 in December.  Payrolls in health care and social services rose by nearly 50,000 while retailers increased their employee ranks by around 46,000. 

Consumer spending fell in December by 0.3%, the biggest decline since September 2009, after a 0.5% gain in November according to the Commerce Department.  Retailers had many pre-holiday sales in October and November which attracted the crowds but left little buyers for December.  A Bloomberg survey called for a 0.2% decline so a fall was not unexpected.  Plus, household spending rose in the fourth quarter overall according to the latest GDP report which showed consumption rising at the fastest pace since early 2006.  Cheaper gasoline is one explanation as well as more confidence by the consumer boosted by a better job market.

Today’s job report means that between now and the Fed’s next Open Market Committee meeting in March, each and every bit of economic data is going to be reviewed with a fine-tooth comb.  The Fed’s statements and speeches have pointed to a middle of the year expectation for its first interest rate increase since 2006.  If that is not going to happen, then that must be relayed to the markets, and the most appropriate time to do so would be at Fed Chairwoman Yellen’s press conference following the March 18th meeting.  Words like “considerable time” and “patience” would have to be stricken if indeed a hike was only three months away.  So between now and March there will be one more payroll report along with revisions to fourth quarter GDP, price measures like CPI and PPI, retail sales and, of course, various housing-related releases.  The markets will be paying much closer attention to these data points for any clues as to how the Fed will approach the biggest decision so far in 2015.

SGK Blog--Update January 30, 2015: Markets Remain Volatile in the Aftermath of East Coast Storm 

This week equity markets were largely focused on earnings, and an early week winter storm that had a lot of traders packing up and heading home early on Monday. The news of the Greek election not turning out the way anybody in Europe really wanted it to, except for the Greek population of course, was largely met with a collective shrug. Stock futures were off early Monday in the pre-market, but attention quickly turned to other matters when markets opened for trading on Monday.

In U.S. economic news, we had plenty to digest this week. Stocks were rocked in Tuesday trading on weak U.S. data – in particular the durable goods report for December. Equity declines were likely exacerbated by the fact that a lot of traders found themselves unable to make it to work in New York due to subway being closed based on the forecast for 2 feet of snow. Whenever volumes are particularly light as was the case Tuesday, stock market volatility usually is considerably higher and the market moves exaggerated. With that said, we need to dive into the data to determine the cause, irrespective of the size of the move.  

Orders for business equipment unexpectedly fell in December for a fourth month, signaling a global growth slowdown is weighing on American companies. Bookings for non-military capital goods excluding aircraft dropped 0.6% for a second month, data from the Commerce Department showed Tuesday in Washington. Demand for all durable goods - items meant to last at least three years - declined 3.4%, the worst performance since August. Slackening demand from Europe and some emerging markets is probably weighing on orders, making companies less willing to invest in new equipment. At the same time, brightening American consumer attitudes are leading to gains in purchases of big-ticket items such as automobiles and appliances that can ripple through the economy and underpin manufacturing. Bookings dropped last month for machinery, computers and commercial aircraft, Tuesday’s report showed. Demand for automobiles was one of the few bright spots. The December figures mark the longest streak of declines in orders for non-military capital goods excluding aircraft since the seven months ending in September 2012. The median forecast of 80 economists surveyed by Bloomberg estimated total durable goods orders would rise 0.3%, with projections ranging from a 3.5% drop to a 2% gain. Orders for non-defense capital equipment excluding aircraft were projected to rise 0.9% - so the actual results came as a real negative shock to the market, again on a day where half the trading community was working from home. Tuesday morning’s data were the latest hint at the trend in business investment before fourth-quarter gross domestic product figures were to be released Jan. 30 from the Commerce Department. The faltering demand has companies such as Deere & Co., one of our core holdings and the largest manufacturer of agricultural machinery, preparing to let go staff in Iowa and Illinois as the outlook for global orders weakens. The Moline, Illinois-based company plans to dismiss about 910 workers, according to a statement issued last week. 

It was not all doom and gloom Tuesday, consumer confidence in the U.S. increased this month as declining unemployment and lower fuel costs lifted Americans’ outlooks. The Conference Board’s consumer confidence index rose to 102.9 from a revised December reading of 93.1, the New York-based private research group said Tuesday. The latest figure was higher than the 95.5 median estimate in a Bloomberg survey of 77 economists. Also, purchases of new homes in the U.S. increased 12% in December to a 481,000 annualized pace from a 431,000 rate in the prior month, figures from the Commerce Department showed Tuesday in Washington. This exceeded the average estimate for an increase of 450,000. We had mixed economic reports on Thursday as initial weekly jobless claims came in at the lowest level in recent memory at 265,000 for the week ending 1/24/15 compared to the forecast for 301,000. Of course the Labor Department said basically the figure was skewed by the MLK Holiday and they had no idea to what degree! So we take that one with a bit of a grain of salt. The same day pending home sales for December were down a disappointing 3.7% versus the forecast for +0.6%. Providing a drag on stock markets and a boost to high quality bonds on Friday was the advanced figure for 4th quarter gross domestic product in the U.S. which came in at 2.6% versus the forecast for 3.2%. This was largely due to the fact that both government and business spending cooled during the quarter, even though consumer spending was higher than expected thanks to lower oil and gasoline prices.    

In other news, home prices in 20 U.S. cities rose at a slower pace in the year ended in November, a sign the industry struggled to find momentum even amid low mortgage rates. The S&P/Case-Shiller index of property values increased 4.3% from November 2013 after rising 4.5% in the year ended in October, the group said Tuesday in New York. The median projection of 28 economists surveyed by Bloomberg called for a 4.3% year-over-year advance. Nationally, prices rose 4.7% after a 4.6% gain in the year ended in October. Property prices slowed over the last year as home sales cooled, with demand stymied by sluggish wage growth and less household formation. More moderate price gains, combined with improvement in the labor market and low borrowing costs, may enable a wider swath of Americans to become buyers, providing a needed jolt to the industry. All 20 cities in the index showed a year-over-year increase, led by gains of 8.9% in San Francisco and 8.6% in Miami. Among cities whose annual growth rates climbed the most in November were Tampa, Florida; Atlanta, Georgia; Charlotte, North Carolina; and Portland, Oregon. Cleveland showed the smallest increase, at 0.6%. Economists’ estimates in the Bloomberg survey ranged from gains of 3.9% to 4.8%. The S&P/Case-Shiller index is based on a three-month average, which means the November figure was also influenced by transactions in October and September.  

The Federal Reserve finished their January meeting with their announcement on policy Wednesday afternoon. They maintained their pledge to be “patient” on raising interest rates and boosted their assessment of the economy and labor market, even as they expect inflation to decline further. “Economic activity has been expanding at a solid pace,” the Federal Open Market Committee said Wednesday when their statement was released in Washington. “Labor market conditions have improved further, with strong job gains and a lower unemployment rate.” Policy makers said inflation “is anticipated to decline further in the near term,” adding that price gains are likely to “rise gradually toward 2 percent over the medium term” as transitory effects of low energy prices dissipate. Fed officials are confronting divergent economic forces as they weigh the timing of the first interest-rate increase since 2006. Surprisingly strong job gains argue for tightening sooner, while inflation held down by a plunge in oil prices and a cooling global economy provides grounds for delay. The Fed acknowledge global risks, saying that it will take into account readings on “international developments” as it decides how long to keep rates low. We would take this latter point as being encouraging. It is the first time in a number of years they have given indication they appear to not just be operating in a vacuum of U.S. data, but they are also paying attention to events that transpire overseas. After all, it is a global economy. The Fed also dropped a clause from its December statement that the assurance of patience was consistent with a previous pledge to hold rates low for a “considerable time,” especially if “projected inflation continues to run below” the 2 percent target. The Fed has kept its main interest rate near zero since December 2008. All 10 voting FOMC members backed Wednesday’s policy statement, marking the first unanimous decision since June.
SGK Blog--Update January 23, 2015: The ECB Crosses the Rubicon

After months of waiting, European Central Bank (ECB) President Mario Draghi kept the markets waiting a little bit more. His 2:30pm local time scheduled conference was delayed…because the ECB elevators were running extremely slow. When he did arrive, he gave the markets what they were waiting for—quantitative easing (QE) for the eurozone. The central bank will purchase 60 billion euros a month in assets including government and private sector bonds starting in March and running through September 2016. That 1 trillion euro infusion is aimed at combating the dangerously low inflationary levels that are pressuring the region. The risks of EU institutional bonds will be shared among the eurozone central banks while purchases of other government bonds will not be subject to loss sharing. The ECB also lowered the interest rate it charges on its four-year loans to banks by 0.10 percentage point. The bank’s main lending rate remained unchanged at 0.05% while a separate rate on overnight bank deposits will earn a -0.20% meaning banks will be paying the ECB to keep its surplus funds there.

Unlike previous attempts to combat low prices through monetary policy, this week’s moves have the feel of a true buy in. There has been a lot of talk but little concrete results. Banks were not lending even though they were eagerly snapping up loans from the central banks. In a previous weekly note, we mentioned that one of the big differences between the U.S. Fed’s QE program and the ECB’s efforts was that the Fed offered a more proactive approach. Instead of waiting for the market to ask for funds, the Fed was actively and aggressively pumping liquidity into various markets.  Now, Draghi and the ECB will buy securities with maturities from two to thirty years. They will buy bonds with negative yields (e.g., Germany). The former “patient, heal thyself” approach has been replaced by “the cavalry is on the way.”

Not every country was comfortable with starting a bond buying program. We can only guess that Germany was one of this group. Draghi said a “large majority” was in favor of the program and after last week’s ruling from the EU Court of Justice which we discussed in our previous weekly report, the path was laid for QE to take place. The risk of losses on government bonds will not be shared because buying on such a large scale necessitated keeping risks largely with the individual banks. Greek debt will not be purchased quite yet given that the ECB bought so many in the 2010-2011 program, they are currently above the maximum share of a country’s debt they have set as a condition of QE.

The initial result was exactly what both the ECB economists and market makers were looking for. Spanish bonds hit record lows. German government bonds, already at low levels, saw demand spikes. The euro fell to an 11-year low at one point versus the U.S. dollar. A less expensive currency will be a boon to the export-driven eurozone because it makes their goods less expensive to buyers from abroad. That is one way to import inflation which is exactly what Draghi is hoping for. The equity markets pushed higher with the Euro Stoxx index showing a 1.6% gain on Thursday.

SGK Blog--Update January 16, 2015: Markets Remain Choppy as Oil Prices Show Signs of Stabilizing 

Oil continued to be the story this week as the price declined to below $45 a barrel for the first time since 2009 as the U.S. pumped at the fastest rate in more than three decades and OPEC resisted calls to cut production. One would think this would be a net positive for the consumer so why are markets so volatile these days? Well anytime there is a shock to the system and a major commodity such as oil sees its price decline by approximately 50% in a matter of a few months, it creates uncertainty. As we have written many times in the past, stock traders hate uncertainty! With oil falling below $45 a barrel amid speculation that U.S. stockpiles will increase, this has exacerbated a global supply glut that’s driven prices to the lowest in more than 5 1/2 years. The issue is – what does this do to the earnings of companies in the energy and materials sectors? Combined that is not an insignificant portion of S&P earnings and it makes the overall earnings for the S&P 500 less predictable. Hence the uncertainty and the sell-off in equities. The United Arab Emirates, a member of the Organization of Petroleum Exporting Countries, will continue to expand output capacity, while shale drillers will probably be the first to curb production as prices fall, according to Energy Minister Suhail Al Mazrouei. The U.S. grade briefly traded above Brent for the first time since July 2013.  

In addition, copper has also declined to a 12-year low on concerns of a global slowdown dragging mining company stocks lower and sending the currencies of raw-materials exporters down as well as concern deepened that slowing global growth will curb demand. Copper for delivery in three months on the London Metal Exchange dropped as much as 8.7% to $5,353.25 a metric ton this week. This caused the yen to gain ground along with government bonds. The U.S. 10-year Treasury declined to a level we have not seen in quite a while as it actually dipped below 1.8% in Wednesday trading. Commodity prices are tumbling as a supply glut collides with waning demand, reducing earnings prospects for producers and increasing the appeal of bonds as inflation slows. Nickel also slid 4.6% and lead fell 3.8% to the lowest in more than two years so the trend for commodities continued heading south this week. 

Retail sales in the U.S. surprisingly slumped in December by the most in almost a year, reflecting a broad-based retreat that will probably prompt economists to cut growth forecasts. The 0.9% drop, the biggest since January 2014, followed a 0.4% gain in November that was smaller than previously estimated, Commerce Department figures showed on Wednesday. Last month’s decrease was almost twice as large as the most pessimistic estimate of 87 economists surveyed by Bloomberg. Initial weekly jobless claims for the week ending 1/10/15 were higher than expected at 316,000. The producer price index, a measure of inflation at the wholesale level, declined 0.3% in December although the rate excluding food and energy, the so-called core rate, rose more than expected at +0.3%. The consumer price index for December came in exactly as expected as did the core rate at -0.4% and 0% respectively. Both industrial production and capacity utilization for December were basically in-line with expectations at -0.1% and 79.7% respectively. One bright spot this week, the University of Michigan consumer sentiment survey for January was actually better than expected at 98.2 versus the expectation for 94.1. 

The World Bank cut its forecast for global growth this year, as an improving U.S. economy and low fuel prices fail to offset disappointing results from Europe to China. The world economy will expand 3% in 2015, down from a projection of 3.4% in June, according to the lender’s semiannual Global Economic Prospects report, released Wednesday in Washington. The report adds to signs of a growing disparity between the U.S. and other major economies while tempering any optimism that a plunge in oil prices will boost output. Risks to the global recovery are “significant and tilted to the downside,” with dangers including a spike in financial volatility, intensifying geopolitical tensions and prolonged stagnation in the euro region or Japan. The Washington-based lender upgraded its forecast for U.S. growth to 3.2% this year from a 3% estimate given in June. It reduced its projections for the euro area and Japan, citing lingering effects from the financial crisis and “structural bottlenecks.” It also cut its forecast for China, saying the world’s second-biggest economy is undergoing a “managed slowdown.” The World Bank is the latest institution to lower its global estimate amid a recovery that has repeatedly disappointed policy makers. The International Monetary Fund trimmed its 2015 outlook in October to 3.8%, citing weak demand and residual debt from the financial crisis. The IMF plans to update its global forecast next week. 

On a brighter note this week, Mario Draghi won a legal endorsement for the bond-buying plan he designed to save the euro, potentially easing resistance to a similar program that could be announced as soon as this month. The Outright Monetary Transactions program that the European Central Bank president pushed through in 2012 won the conditional backing of Advocate General Pedro Cruz Villalon of the EU Court of Justice in Luxembourg, who said the measures are “in principle” in line with the bloc’s law. “The ECB must have a broad discretion when framing and implementing the EU’s monetary policy, and the courts must exercise a considerable degree of caution when reviewing the ECB’s activity,” Cruz Villalon said in a non-binding opinion today. Such advice is followed by the court in a majority of cases. The opinion could ease pressure on ECB President Draghi days before he meets with his Governing Council to consider a separate so-called quantitative-easing package to quell the threat of deflation in the euro area. Opponents of QE had raised legal concerns as one objection. 

Apparently for central banks, the road to normal is proving to be quite bumpy! Stunning monetary-policy shifts in Switzerland and India sent markets on wild rides in Thursday trading, highlighting Federal Reserve Chair Janet Yellen’s November warning that “normalization could lead to some heightened financial volatility.” Following Thursday’s wake-up calls, the Swiss franc surged as much as 27% against the dollar, moving more like the Ukrainian hryvnia than the seventh-largest reserve currency. Mumbai’s benchmark stock index posted its biggest gain in more than a year. In India, Reserve Bank Governor Raghuram Rajan cut his key interest rate for the first time in 20 months. Six hours later, Swiss National Bank President Thomas Jordan abandoned a three-year-old cap on the franc’s gains. Both decisions were unscheduled and, in Switzerland’s case, unexpected. The lessons for investors: central banks are no longer aligned and again a source of volatility rather than calm in financial markets. Also, forward guidance has its limits as policy can shift abruptly when economic conditions change and officials still like the odd surprise. The risks were emerging even before today. Investors are bracing for the first U.S. interest rate increase since 2006 and the European Central Bank is set to decide it will buy government bonds for the first time. The euro has weakened 14% the past year against the dollar on the back of the divergence trade. Before that came the “taper tantrum,” when hints of tightening from the Fed in 2013 roiled bond markets worldwide. 

Jordan dismantled the franc’s 1.20 per euro ceiling a week before the ECB’s expected announcement of quantitative easing. That move would intensify upward pressure on his currency, rendering the cap untenably expensive. Rajan acted after a weakening of inflation gave him room to support an economy growing half the pace of four years ago. Since the financial crisis erupted in 2008 and the world tumbled into recession, major central banks have deployed ultra-easy policy in the form of near-zero interest rates and cheap cash that Deutsche Bank AG estimates totaled $10 trillion. The unity and abundance of liquidity becalmed markets, yet now frictions are emerging that will likely roil them. The SNB noted the end of solidarity was one reason to discontinue the cap, saying division is “a trend that is likely to become even more pronounced.” As the Fed readies to tighten monetary policy, deflationary forces mean the ECB is looking to ease anew. The Bank of Japan has already done so. Rajan’s action also contrasted with recent rate increases in BRIC counterparts Russia and Brazil aimed at supporting exchange rates. Less noticed Thursday, Indonesia’s central bank kept its rate unchanged. As they grapple with turns in their economies, central banks also may struggle to control the message, something they’ve prided themselves on during the crisis. Forward guidance may need to be increasingly taken with a pinch of salt. Just this week, the SNB indicated its cap was here to stay, with Vice President Jean-Pierre Danthine saying, “it must remain the pillar of our monetary policy.” A U.K. lawmaker called Bank of England Governor Mark Carney an “unreliable boyfriend” for sending mixed messages on rates. In the end, central banks showed that they still have the power to stun. That may happen again at the ECB next week after markets sneered at the suggestion President Mario Draghi may limit quantitative easing to 500 billion euros ($586 billion). Stay tuned! 

SGK Blog--Update January 9, 2015: New Year Positive for Job Growth  

The Labor Department reported that nonfarm payrolls rose 252,000 in December following 50,000 of upward revisions to the previous two months.  The November surge was revised to an even more impressive gain of 345,000 which undoubtedly helped the holiday season be merrier for many families.  The median forecast in a Bloomberg survey of economists called for a 240,000 advance with a gains ranging from 160,000 to 305,000.  The industries which benefited the most were factories, health care providers and business services.  For 2014 in total, payrolls grew by 2.95 million, the most in 15 years.  The unemployment rate, which is derived from a separate Labor Department survey of households not businesses, fell to 5.6% in December from 5.8% in November.  This decline seemed positive on the surface but dig a little deeper and some issues arise.  Employment in the household survey rose by 111,000 but the labor force shrank by 273,000 making the ratio seem better than it was.  Plus, the participation rate, which indicates the share of working-age people in the labor force, fell to 62.7% from 62.9% marking a new three-decade low.

The real head-scratcher revolved around wages.  The nonfarm work week managed to stay steady at 34.6 hours, a posts-recession high.  However, those longer hours did not translate into higher pay.  Average hourly earnings fell by 0.2% versus the consensus for a 0.2% gain.  That meant wages year-over-year rose by 1.7%, barely ahead of some inflation measures.  Policy makers, especially Fed Chair Janet Yellen, want to see workers gaining ground against any rise in the general level of prices.  Since late 2012, year-over-year average hourly earnings have fallen in the range of +1.8% to +2.3%, so is this new data point a trend or an outlier?  Eventually, we will likely see wage pressure emerge sometime later this year.  Why?  We saw more part-time workers be converted to full-time workers in the latest survey.  Plus, with average hours worked at high levels, historically this has suggested employers will hire more workers rather than run their current employees into the ground or entice them to continue working hard with higher pay.  Another issue the Fed will have to deal with is the long-term unemployed.  Those out of work for more than 26 weeks comprised about a third of all unemployed.  A long time out of the workforce means skills deteriorate and make it harder for a worker to be reintroduced.

These issues are a challenge, but still pale in comparison to Europe’s issues.  The European statistics office confirmed on Wednesday that prices in the 18 countries that use the euro were 0.2% lower this past December than in December 2013.  The last time prices fell was October 2009 when the euro zone, and the world, was in the midst of the worst recession since the Great Depression.  One antidote which the market is expecting is massive bond buying in the form of quantitative easing.  European Central Bank staff presented policy makers with models for buying as much as 500 billion euros at this week’s Governing Council meeting in Frankfurt according to sources that spoke with Bloomberg reporters.  Governors took no decision on the design or implementation of any package after the meeting.  The next Governing Council meeting is scheduled for January 22nd where many market watchers anticipate some announcement will be made.  The euro, which has plunged versus the dollar recently, traded a bit higher yesterday.  With Greek elections scheduled for January 25, the markets will want some indication that the central bank is ready, willing and able to make a move to help the currency and the various economies in the bloc should the results lead to volatility.  European Central Bank President Mario Draghi has warned of deflationary risks and wants the bank to expand its balance sheet toward 3 trillion euros from 2.2 trillion euros now.  Another complicating factor is that a European Court of Justice is expected to offer its opinion on previous bond-buying purchase programs on January 14.  Should that decision deem any bond-buying illegal, we are certain to see a reaction and it will likely not be positive.

SGK Blog--Update January 2, 2015: Greece Makes Headlines; Market Reaction is Muted 

Greece leant over the precipice Monday when Prime Minister Antonis Samaras fell short of a parliamentary supermajority to elect his candidate for the country’s largely ceremonial presidency. That forced a new parliamentary election next month pitting Samaras, who came to power in 2012 after initially challenging the terms for Greece’s 240 billion-euro ($293 billion) rescue package, against Alexis Tsipras of the Syriza party, who never stopped challenging them.  Investor reaction to the Greek parliament’s failure to pick a president traced the familiar north-south divide. Greek stocks and bonds plunged and markets were buffeted in Italy, Portugal and Spain, while funds flowed into Germany, Europe’s biggest economy and hard-money bastion. Yet look closer and Italy, the euro zone’s second most-indebted country after Greece, is nowhere near a fiscal calamity. Ten-year borrowing costs are hovering around 2 percent, compared to over 7 percent at the height of the European debt crisis, and Tuesday Italy auctioned 10-year government bonds to yield less than 2 percent for the first time on record. What is different this time around? When Greece hurtled toward bankruptcy in early 2010, the European Union had no way of helping countries in need. When Greece toyed with quitting the euro in late 2011, and held a stalemated election in May 2012 before Samaras put together a unity government after a second election six weeks later, it had only a temporary bailout fund. Now, it has a full-time aid fund in the 500 billion-euro European Stability Mechanism and a central bank tiptoeing -- amid opposition from Germany -- toward large-scale bond purchases. It also boasts success stories: Ireland, Portugal and Spain have been weaned off financial aid. The risk is less a splintering of the 18-nation euro zone -- it will become 19 on Jan. 1 when Lithuania joins -- than a protracted phase of subpar economic growth that leaves a generation scarred by unemployment and tempted by political extremism, especially in the south. Stocks sold off to a greater degree on Tuesday, especially in Europe, while money flowed into higher quality assets such as U.S. Treasuries, perhaps in a delayed reaction as the Greek news set in. Concerns rose that it may cause a delay in the European Central Bank’s goal of buying sovereign bonds. If Greece is not going to play by the rules of reform and their future in the euro zone is once again marred by uncertainty, why would the ECB invest in their bonds at all? The timing could not be worse in our view as all eyes have been focused on the ECB and when they may commence their sovereign asset purchase program.

There was not much data out on the U.S. economy this week so we will focus on a key housing report and the important information contained in that. U.S. single-family home prices' rate of increase decelerated in October compared to the stronger-than-expected rise seen in the previous month. Data released from the S&P/Case-Shiller U.S. National Home Price Index indicated that both the 10-city and 20-city Composites had year-over-year deceleration in the rate of growth in October. The composite index of 10 metropolitan areas gained 4.4 percent year-over-year, slowing from the 4.7 percent rate recorded in September. The 20-city index saw a similar slowdown, rising 4.5 percent year-over-year in October, compared with the prior month's 4.8 percent growth. Over the last 12 months, Miami and San Francisco saw prices rise 9.5 percent and 9.1 percent, respectively. Prices rose faster in October for eight cities including Tampa, Denver, and San Francisco. However, Las Vegas saw a decline of 1.2 percent, making it the leader of declining annual returns. “After a long period when home prices rose, but at a slower pace with each passing month, we are seeing hints that prices could end 2014 on a strong note and accelerate into 2015," said David M. Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices. "Two months ago, all 20 cities were experiencing weakening annual price increases. Last month, 18 experienced weakness. This time, 12 cities had weaker annual price growth, but eight saw the pace of price gains pick up. Seasonally adjusted, all 20 cities had higher prices than a month ago.” So overall, this was a pretty good indication that the housing sector is maintaining price gains in this moderate interest rate environment.    

The Conference Board’s consumer confidence index increased to 92.6 in December, the New York-based private research group said on Tuesday. Greater opportunities to land a job and persistent declines in the cost of gasoline are making Americans feel more hopeful about the economy. While the gain was less than forecast, the gauge is close to the seven-year high reached two months ago. Perceptions of current economic conditions advanced to the highest since February 2008. Gasoline prices that have fallen every day since the end of September left extra cash in people’s wallets heading into the holiday gift-giving season. More consumers said they planned to buy appliances and new cars, reflecting the strongest employment gains since 1999 and record stock prices that kept households upbeat about their incomes, Tuesday’s report showed. 

Manufacturing in the U.S. cooled in December, settling into a more sustainable pace of growth as the year drew to a close. The Institute for Supply Management’s factory index dropped to a six-month low of 55.5 from 58.7 in November, a report from the Tempe, Arizona-based group showed Friday. The reading in October matched a three-year high. Figures greater than 50 indicate growth and the median forecast in a Bloomberg survey of economists called for a December reading of 57.5. A slowdown in orders growth indicates companies are beginning to scale back capital spending plans as overseas markets slow and lower oil prices hit American oil producers. At the same time, U.S. factory floors will probably stay busy early this year as employment gains and cheap gasoline boost consumer spending. Next Friday we will get the all-important December employment report which will be a good indicator as to whether or not the U.S. economy will maintain its momentum heading into 2015.
SGK Blog--Update December 19, 2014: Santa Claus Rally  

Janet Yellen should have shown up at the post-Federal Open Market Committee meeting press conference dressed as Santa Claus.  She and her fellow Fed governors provided the markets with a gift this week which pushed indices higher.  Not only did they keep the long-debated reference to “considerable time,” they also determined they could “be patient in beginning to normalize the stance of monetary policy.”  Some officials worried that removing the “considerable time” phrase would frazzle markets and signal a sooner-than-expected rise in rates.  The added “patience” component helped push the Dow Jones Industrial Average up 288 points on Wednesday and 421 points on Thursday, the best point performances this year.  No imminent rate hike continued to feed the markets which have been addicted to easy monetary policy.  That, plus the fact that next year, the Open Market Committee will replace three “hawkish” members by relatively more “dovish” voters ignited more “risk on” trades.  It was interesting that three members of the committee dissented against the statement and included both hawks and doves.  Minneapolis Fed President Narayana Kocherlakota is strongly opposed to any rate hike given the absence of price pressures.  Meanwhile, Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser both believe a rate hike should be moved forward.  This is worth noting because the last time the Fed had a three-person dissent was in 2011.  One key which marked former Fed leader Ben Bernanke’s terms was the consensus reached at these meetings especially in light of the massive market volatility at play during the 2008 crisis.  Not every meeting was unanimous—Mr. Fisher being a notable outlier—but between the Fed statements and speeches given by governors at various events, the message was mostly uniform.  If we are indeed approaching a time when rates would have to be raised for the first time since 2006, not having everyone on board would send a tricky message to markets at a very crucial time.

The Fed also updated the so-called “dot chart” which plots individual Fed governor projections for the coming years.  Fifteen of seventeen officials said they expected to raise rates in the coming year.  The median estimate put rates at 1.125% by the fourth quarter of 2015.  For 2016, that rises to 2.5% and 3.625% in 2017.  Officials project GDP growth of 2.6%-3.0% in 2015 and unemployment at 5.2%-5.3% by year-end.  Their statement emphasized the better employment picture: “Labor market conditions improved further, with solid job gains and a lower unemployment rate” which sits currently at 5.8%.  On Thursday, initial jobless claims fell by 6,000 to 289,000 in the week ended December 13 according to the Labor Department.  Claims have been below 300,000 for 13 of the past 14 weeks.  The number of people continuing to receive jobless benefits fell sharply by 147,000 to 2.37 million in the week ended December 6.  Most of the firings we have seen over the past year has been related to business-specific issues—mainly mergers or cost-savings initiatives—rather than general economic fears.  The last few weeks of the month get distorted due to seasonal patterns so the coming weeks will not carry the same weight as the last few in the eyes of investors.  The bottom line is that job growth is alive and well across most of the U.S.

SGK Blog--Update December 12, 2014: Oil Retreats on Lowered Outlook from OPEC

OPEC cut the forecast for how much crude oil it will need to provide in 2015 to the lowest in 12 years amid surging U.S. shale supplies and reduced estimates for global consumption. The Organization of Petroleum Exporting Countries lowered its projection for 2015 by about 300,000 barrels a day, to 28.9 million a day. That’s about 1.15 million a day less than the group’s 12 members pumped in the month of November, and the 30-million barrel target they reaffirmed at a meeting in Vienna on Nov. 27. The impact of this year’s 40 percent price collapse on supply and demand remains unclear, OPEC said. There are really two sides to this story. While it is painful to watch the prices of energy stocks decline on the increased volatility, the decrease in the price at the pump could not come at a better time from the standpoint of the consumer, especially given we are in the thick of the Holiday shopping season.  

On that note, the figures for U.S. retail sales came out for the month of November and they were stronger than expected. We can attribute this to continued low interest rates (Americans like to finance expensive purchases!) and the “tax cut” or “wage increase” attributable to lower gasoline prices. For November, retail sales came in at +0.7% versus the expectation for +0.4% and, excluding the robust auto segment, the figure was +0.5% versus the expectation for +0.2%. Weekly initial unemployment claims for the week ending 12/06/2014 came in almost exactly as expected at 294,000. The good news on the U.S. economy helped lend some support to U.S. equity markets in trading on Thursday. 

Stocks resumed their selling globally Friday while money flowed into high quality bonds after November Chinese factory production slowed more than estimated. Data showing a 7.2 percent gain from the year before missed the 7.5 percent median estimate in a Bloomberg News survey. U.S. equities briefly pared losses as a report showed consumer confidence improved this month.  The Thomson Reuters/University of Michigan preliminary December index of consumer sentiment increased to 93.8 from 88.8 last month.  The median projection in a Bloomberg survey of 69 economists called for an advance to 89.5. A separate report showed wholesale prices fell more than forecast in November, led by the biggest drop in energy costs in more than a year, signaling inflation pressures remain weak even as the world’s largest economy is expanding.  The 0.2 percent decrease in the producer-price index followed a 0.2 percent advance in the prior month, the Labor Department data showed. Oil at a five-year low and slowing overseas markets will subdue prices in the production chain that feed into the cost of living.  Persistently weak inflation has allowed Federal Reserve policy makers, who are scheduled to meet next week, room to keep interest rates near zero after ending monthly asset purchases in October as the economy strengthens. 

SGK Blog--Update December 5, 2014: Here and There   

Here: The economy creates 321,000 jobs in November.  There: Eurozone gross domestic product rose a measly 0.2% in the third quarter.  Here: Average hourly earnings rise 0.4%, the biggest gain since June of last year.  There: The annual rate of inflation was 0.3% in November, a far cry from the European Central Bank’s (ECB) target of just below 2%.  Here: The Institute of Supply Management’s non-manufacturing index rose to 59.3 in November, the second highest level since August 2005.  There: Eurozone unemployment is 11.5%.  In terms of developed countries, it is hard to paint a more contrasting picture than the economic conditions of the United States and 18-country eurozone.  Though not every state in the union is doing great, as a whole, the U.S. has not only recovered from the 2008 financial crisis and 2009 recession trough, but is now clearly in the picking-up-steam recovery mode.  Meanwhile, our friends across the pond are still trying to get their engine started and even workhorse Germany has not been strong enough to lift the entire continent to higher ground.

Domestically, today’s employment report was above-expectations.  Not only did the monthly nonfarm payroll figure from the Labor Department beat expectations, but previous month’s numbers was revised higher as well.  Estimates of 100 economists surveyed by Bloomberg had this month’s range of an increase stretching from +140,000 to +306,000.  The revisions added 44,000 jobs to payrolls in the previous two months.  With the labor force participation rate holding steady at 62.8%, most of the focus turned to wages.  Fed Chair Yellen has made it a point that adding jobs was good but not good enough.  Workers must feel like they are making progress by seeing their real wages rise.  With average hourly earnings rising to $24.66 in November from $24.57 in October,  and that represented a 2.1% rise over the past 12 months.  Since this rise is higher than most inflation reports which are slightly below 2%, real wages are indeed rising slowly but surely based on this one report.  The key is if this will become a trend.  The unemployment rate, which is derived from a survey of households versus the payroll report which comes from businesses, held at a six-year low of 5.8%.  With the holiday gift-giving season underway, UPS, the world’s biggest package delivery company, plans to hire as many as 95,000 workers to deliver of 580 million packages this month.  Thus, such a strong report could not have come at a better time.

Meanwhile, overseas, ECB President Mario Draghi spent Thursday coming up with excuses.  The central bank kept interest rates unchanged at 0.05% at its meeting in Frankfurt.  The deposit rate remained at -0.2% as a dis-incentive for banks to hold money at the ECB and instead lend it out for investing and job creation.  Clearly, that is not happening.  The numbers below show that the situation is not only bad but also getting worse:

Bloomberg consensus: 10/13/2014     GDP 2014: 0.8%/GDP 2015: 1.3%/Inflation 2014: 0.5%/Inflation 2015: 1.1%

Bloomberg consensus: 11/17/2014     GDP 2014: 0.8%/GDP 2015: 1.2%/Inflation 2014: 0.5%/Inflation 2015: 1.0%

ECB consensus: 9/4/2014                   GDP 2014: 0.9%/GDP 2015: 1.6%/Inflation 2014: 0.6%/Inflation 2015: 1.1%

ECB consensus: 12/4/14                     GDP 2014: 0.8%/GDP 2015: 1.0%/Inflation 2014: 0.3%/Inflation 2015: 0.7%

IMF projection: 5/5/2014                    GDP 2014: 1.1%/GDP 2015: 1.5%/Inflation 2014: 0.9%/Inflation 2015: 1.2%

IMF projection: 11/4/14                      GDP 2014: 0.8%/GDP 2015: 1.3%/Inflation 2014: 0.5%/Inflation 2015: 0.9%

The ECB started a targeted long-term loan (TLTRO) program which raised 82.4 billion Euros in September, a number that was far below estimates.  Next week will be the second installment and officials are expecting more banks to step up but there is no indication they will.  The pressure mounts further because this is the only announced significant funding program that can change the picture in the near term.  The ECB has also started buying asset-backed securities and covered bonds in an effort to provide more liquidity.  The problem is that pool is far too thin to provide the necessary boost the market needs.  These instruments have assets that serve as ready collateral to support their prices.  That in itself provides a limit—the assets themselves—and curtails the firepower.  Conversely, government bonds are “open ended” meaning sovereigns can raise unlimited funds because they can levy taxes on anything they want.  That’s a big bazooka.  As we have pointed out previously, the difference between the U.S. Federal Reserve’s QE programs and the ECB is that the Fed did not wait for banks to ask for loans, they flooded the market with massive funds sending a “shock and awe” factor to the markets.  The markets are clearly waiting for the ECB to begin a QE program which targets the deep and liquid market of European sovereign bonds.  And waiting.  And waiting.  Draghi said yesterday that the governing council will decide “early next year” whether its current policies are sufficient to raise inflation toward its target.  The council has discussed “various options of QE” but it will not happen because as one analyst from HIS Global Insight said, “There is clearly still appreciable reluctance among some ECB’s Governing Council members to engage in full-blown QE”.  In other words, that “some” is one:  Germany doesn’t want to do it.  In listening to the press conference which followed the ECB meeting, it was clear that the ECB was just stalling for more time and even threw in another problem: oil prices, which will cover more in the next section.

The real solution, which Draghi has repeatedly commented upon, is for structural change.  An article in today’s Wall Street Journal highlights how complex this is for France in particular.  President Francois Hollande touted job reform in his election campaign yet there are more job seekers now than when he took office in May 2012.  Job-preservation agreements were meant to cut working hours and wages during tough times in exchange for preserving the worker’s job position.  Yet, companies are still forced to abide by a 35-hour workweek and other nationally enshrined labor rules.  Thus, an employee who refuses to cut back hours can demand severance thereby adding costs to employers.  As a result, only a handful of firms have fully implemented the agreements.  Until each firm and region can gain more flexibility, this will not change.  The situation happens over and over again in many parts of the eurozone putting more pressure on monetary policy to save the day.  Next year, the ECB goes from twelve monetary-policy sessions to eight, so each meeting, with the next on January 22nd, will take on even more importance.

SGK Blog--Update November 26, 2014: U.S. Economy Expands 3.9% in Third Quarter 

The economy in the U.S. expanded more than previously forecast in the third quarter, reflecting bigger gains in consumer spending and business investment and capping the strongest six months of growth in a decade. Gross domestic product, the value of all goods and services produced, rose at a 3.9 percent annualized rate, up from an initial estimate of 3.5 percent, Commerce Department figures showed Tuesday in Washington. The median forecast of 81 economists surveyed by Bloomberg called for a 3.3 percent gain. After the 4.6 percent increase in the second quarter, it marked the biggest back-to-back advance since late 2003. The improving economy has been helped by a strengthening labor market and gains in consumer and business sentiment which help underpin consumer spending. The outlook for growth supports the Fed’s recent decision to complete its bond-buying program, and central bankers continue to monitor economic progress while deciding when to raise interest rates for the first time in the recovery. Economists’ estimates in the Bloomberg survey ranged from 2.8 percent to 3.8 percent. The report wasn’t universally positive. Revised data for the second quarter showed the previously estimated increase in wages and salaries was cut almost in half and corporate profits last quarter rose less than in the prior three months. Consumer spending, which accounts for about 70 percent of the economy, grew at a 2.2 percent annualized rate in the third quarter compared with the previously estimated 1.8 percent. The improvement was spread across durable and non-durable goods, including recreational vehicles and restaurant meals. 

Home prices in 20 U.S. cities advanced at a slower pace in the 12 months through September as the housing market continued to make gradual progress. The S&P/Case-Shiller index of property values increased 4.9 percent from September 2013, the smallest gain since October 2012, after rising 5.6 percent in the year ended in August, the group reported Tuesday in New York. Nationwide, prices rose 4.8 percent after a 5.1 percent year-to-year increase a month earlier. Housing prices have cooled this year as more properties are put up for sale and investors retreat to the market’s sidelines. Slower appreciation will probably help foster a pickup in homeownership, particularly among first-time buyers and people having trouble obtaining credit, once wage growth becomes more pronounced. 

Consumer confidence unexpectedly declined in November from a seven-year high as Americans became less upbeat about the economy and labor market. The Conference Board’s index of consumer sentiment fell to 88.7 this month from an October reading of 94.1 that was the strongest since October 2007, the New York-based private research group indicated this week. The figure last month was weaker than the most pessimistic estimate in a Bloomberg survey of economists. The decline this month interrupts a steady pickup in sentiment since the middle of the year and shows attitudes about the economy would benefit from faster wage growth. At the same time, further confidence will probably be underpinned as stocks rally to a record, the labor market closes in on its best year since 1999 and gas prices drop to levels unseen since November 2010. The median forecast in the Bloomberg survey called for a reading of 96. Estimates of 75 economists ranged from 93.5 to 99 after a previously reported October index of 94.5. The Conference Board’s measure averaged 96.8 during the last expansion and 53.7 during the recession that ended in June 2009. The Conference Board’s index of consumer expectations for the next six months decreased to 87 this month from 93.8. The gauge of present conditions barometer dropped to a four-month low of 91.3 from 94.4. The share of Americans who said business conditions were good decreased to 24 percent, the lowest in three months.  

This report was somewhat at odds with other readings on sentiment. The Thomson Reuters/University of Michigan preliminary November gauge reached a seven-year high, while the weekly Bloomberg Consumer Comfort Index rose last week to the highest level since January 2008. The Conference Board’s data showed Americans’ assessments of current and future labor-market conditions weakened. The share of Americans who said jobs were currently plentiful fell to 16 percent from 16.5 percent. The share that said jobs were hard to get was little changed at 29.2 percent after 29 percent in October. A smaller number of consumers expected more jobs to become available in the next six months as the share fell to 15 percent from 16 percent. The share of respondents in the Conference Board’s survey that said they expected their incomes to rise in the next half year also decreased, to 16.3 percent this month from 16.7 percent in October. Thus, the actual average worker is a little more pessimistic looking ahead than some of the recent data would indicate.  

On Wednesday we received negative news on the jobs market when the weekly initial unemployment figures were released. For the week ending November 22, initial weekly claims were 313,000 versus the expectation of 288,000 and the prior week’s 292,000. Both personal incomes and personal spending came out below expectations as well. Personal income for October was +0.2% as was personal spending, whereas the forecast was for +0.4% and +0.3% respectively. The personal consumptions expenditures index or PCE for short is one of the preferred inflation measures used by the Federal Reserve. It came in at +0.2% which was just slightly above the expectation for +0.1% but not enough so as to cause concern.  Durable goods orders rose +0.4% in October beating expectations but the figure excluding transportation came in far weaker than expected. It declined 0.9% versus the expectation for a 0.5% increase. The decline was due to the fact U.S. businesses ordered less equipment such as machinery and electrical gear. Both new and pending home sales for October also came in below expectations at 458,000 and -1.1% versus forecasts for 470,000 and +0.5%. The data for both Chicago PMI, a measurement of manufacturing activity in that region, and the University of Michigan’s consumer sentiment survey for November were also weaker than forecast at 60.8 and 88.8 respectively. Overall it was not a great week for U.S. economic data – hopefully it is not a sign the economy is cooling just as we enter the important Holiday season.
SGK Blog--Update November 21, 2014: Markets Still Setting Highs as Holidays Approach   

Housing data took center stage this week. Sales of existing homes for October rose to a 5.26 million annual pace, the strongest since September 2013 according to the National Association of Realtors. The median forecast of 78 economists in a Bloomberg survey called for a 5.15 million pace with the range stretching from 5.05 million to 5.27 million. September’s number was revised higher. The median price of an existing home was up 5.5% to $208,300. With the available inventory of homes falling 3%, it would take 5.1 months to sell those houses compared to 5.3 months at the end of September. Total sales improved in three of four regions last month led by a 5.1% gain in the Midwest. Foreclosures and other distressed property sales accounted for 9% of the total last month while the share of properties sold to first-time buyers was 29%, nearly unchanged from the month prior. While the number is good, it is still too early to call it healthy. The 13-year low of 4.11 million was reached in 2008, but we remain far from the record 7.08 million in 2005.   We do not need a return to 7+ million to be healthy, but limited wage gains, growing student dent and still strict lending standards are providing headwinds, especially for the first-time buyer crowd. What is sign of future hope is residential construction permits climbed in October to a six-year high according to the Commerce Department. Plus, the National Association of Home Builders/Wells Fargo builder sentiment gauge advanced to 58 in November, matching the second-highest level since 2005, and up significantly from 54 in October. Readings above 50 indicate good market conditions. The nine-year high of 59 was reached this past September. Of course, builder enthusiasm does not always translate into sales as some realtors claim it takes 2-3 written contracts on one house before a buyer gets the financing to actually buy the property thanks to tighter standards.

Any sales of homes are predicated on a healthy job market. Jobless claims fell by 2,000 to 291,000 in the week ended November 15 according to the Labor Department. This was the 10th straight week that claims have been lower than 300,000—that has not happened since 2000. Thus, it is apparent firms are holding onto more workers in order to meet rising demand rather than firing them. The four-week average of claims climbed to 287,500 which is still considered a good number.

The pricing environment remains benign. Wholesale prices in the U.S. according to the Labor Department, rose 0.2% in October. Excluding the more volatile and food and energy sectors, the measure rose 0.4% after no change a month earlier. Therefore, the so-called core rate rose 1.8% year-over-year. Consumer prices rose slightly last month as well. The core consumer price index, which excludes food and energy, rose 1.8% from October 2013 while the overall index was 1.7% higher over the past year.  The average price of a gallon of regular unleaded gas was $2.86 as of November 18 according to auto club AAA. That was the lowest figure since November 2010. We will comment below in the Performance section how these trends affect today’s markets.

SGK Blog--Update November 14, 2014: Consumer Confidence and Retail Sales are on the Increase 

Consumer confidence rose more than forecast in November, reaching a seven-year high and indicating Americans will be in the mood to step up holiday spending. The Thomson Reuters/University of Michigan preliminary sentiment index increased to 89.4, exceeding the highest estimate in a Bloomberg survey and the strongest since July 2007, from a final reading of 86.9 in October.  The median projection called for a gain to 87.5. A stronger labor market, cheaper fuel costs, and near-record stock prices are brightening consumers’ spirits as the busiest time of the year for retailers gets under way.  Bigger wage gains would probably drive sentiment and boost household spending, which accounts for almost 70 percent of the economy. The lower cost of gasoline is analogous to giving every American a tax cut heading into the holidays! Estimates in the Bloomberg survey of 71 economists ranged from 85.9 to 89.  The index averaged 89 in the five years before December 2007, when the last recession began, and 64.2 in the 18-month contraction that followed.  

The increase in confidence this month follows a rebound in retail sales in October.  Purchases rose 0.3 percent as 11 of 13 major categories showed gains, indicating broad-based growth, figures from the Commerce Department showed today. The gauge of Americans’ expectations about the economy six months from now climbed to 80.6 in November, also the highest since July 2007, from 79.6 last month. The gauge of current conditions, which measures Americans’ views of their personal finances, jumped to 103, the highest in more than seven years, from 98.3. They have gauges for everything these days! Today’s figures are in line with other recent measures of sentiment.  The Bloomberg Consumer Comfort Index was the second-highest since January 2008 in the week ended Nov. 9 as Americans grew more upbeat about the economy. The Conference Board’s measure of confidence climbed last month to a seven-year high as consumers’ expectations for the next six months rose to its highest since February 2011.  

Employment on track for the best year in 15 is helping to underpin Americans’ spirits.  Employers have added an average 228,500 workers a month to payrolls so far this year, the strongest pace since 1999.  Economists surveyed by Bloomberg from Nov. 7-12 project the economy will add an average of 225,000 workers a month to their payrolls this year. A report yesterday from the Labor Department showed the number of unemployed vying for each available job is dropping.  About two jobless workers were pursuing each opening in September, the fewest since early 2008 and down from almost seven in July 2009. Bigger wage increases are probably in store for Americans, who are also finding relief at the gas pump. The average nationwide cost of a gallon of regular fuel was $2.91 yesterday, the cheapest since December 2010 and down from a 2014 high of $3.70 in April, according to figures to AAA, the biggest U.S. auto group.  

The drop in gasoline prices helps explain why households are more sanguine about inflation.  Consumers expect inflation to be 2.6 percent higher five years from now, matching the smallest increase since September 2002.  Further declines in the expected rate of inflation represent a risk to the outlook for demand should consumers hold back on purchases in anticipation of even lower prices. Longer-term inflation expectations as measured in the survey are at the lower end of the range that they’ve been in over the past decade. We do not want to see a persistent decline in inflation expectations below this range.  

While the news here in the U.S. was generally upbeat, the same cannot be said for information coming from overseas. Italy’s economy shrank in the third quarter pushing the nation into a fourth year of a slump that has complicated Prime Minister Matteo Renzi’s efforts to revive growth and keep public finances in check. Gross domestic product fell 0.1% from the previous three months, when it declined 0.2%, the national statistics institute Istat said in a preliminary report in Rome Friday.  That matched the median forecast in a Bloomberg survey of 22 economists.  Output was down by 0.4% from a year earlier. GDP in the euro region’s third-biggest economy has fallen in all but two of the last 13 quarters as the jobless rate rose to the highest on record.  Renzi is relying on estimated 0.6% growth next year to rein in a public debt of more than 2 trillion euros ($2.50 trillion) and preserve a tax rebate to low-paid employees aimed at reviving consumer demand. The Bank of Italy said yesterday in a report that the country needs to avoid a “recessionary demand spiral” due to the “persistence of economic difficulties, which have been exceptional in terms of duration and depth.” Italians rallied in Rome last month to protest an overhaul of labor market rules that Renzi proposed to make it easier for businesses to hire and fire workers.  The premier has repeatedly said the plan is a way to attract investments and that its framework will get parliamentary approval by year’s end before being fully implemented in 2015. Well we wish him luck in that department! 

Credit growth in China weakened last month, adding to signs that the world’s second-largest economy slowed further this quarter and testing policy makers’ determination to avoid broader stimulus measures. Aggregate financing in October was 662.7 billion yuan ($108 billion), the People’s Bank of China’s said in Beijing yesterday, down from 1.05 trillion yuan in September and lower than the 887.5 billion yuan median estimate in a Bloomberg survey of analysts.  Earlier this week, reports showed deceleration in industrial output and fixed-asset investment. The evidence underscores concern that, outside the U.S., the global economic outlook is deteriorating.  For Premier Li Keqiang, the question is whether to stick with targeted liquidity injections or embrace nationwide monetary or fiscal easing that reignites the risk of a jump in debt. The key in our view is not to further expand credit, given the weak credit demand, but to lower funding costs. A benchmark interest rate cut is likely more urgent. The central bank has added liquidity while refraining from broad-based interest rate or reserve requirement ratio cuts.  China’s benchmark money-market rate fell for a second week on speculation it will conduct more targeted fund injections.

SGK Blog--Update November 7, 2014: Unemployment Drops to Six-Year Low Near End of Earnings Season 

We will touch briefly on this week’s election results.  After the 2012 election we wrote three paragraphs in this space about what the results meant.  In retrospect, that was a waste of three paragraphs, and this time we will listen to our own advice from our November 5, 2010 weekly email: “Generally, mid-term elections result in subsequent gains for the market and even split party control of Congress has positive historical results.  Regardless, past results are no guarantee of future results and we stress that interest rates and earnings are much more important than anything that Capitol Hill does on a daily basis.”   How did the markets react?  A “calamitous” 0.01% fall in the S&P 500 on the day of elections, and a “whopping” 0.57% gain on the day after.  In other words, investors saw no real change in market direction based upon how many votes went to either major party on Tuesday.  This has been one of the most unproductive Congresses in memory, and the consensus on Wall Street is that trend will not end anytime soon.  

The employment picture got more data points this week.  According to the Labor Department, employers added 214,000 non-farm payrolls for October and September’s figure was revised higher by 31,000.  The consensus figure was for an advance of 235,000 but with the six month average job growth at 235,000 and the three month average at 224,000, a miss below the consensus figure is not a big issue since we remain well into the 200,000+ number for the ninth consecutive month.  A survey of households revealed that the unemployment rate fell to 5.8% last month from 5.9% the previous month.  The 5.8% figure is the lowest since July 2008.  Job growth was broad-based with retailers, restaurants and factories all adding to positions.  The labor force participation rate also crawled higher to 62.8% from 62.7% in September.  These numbers show that job creation has not been a problem recently and with initial jobless claims falling to 278,000 in the week ended November 1, companies are firing less and less.  The one criticism that can be levied revolves around wage growth.  Average hourly earnings rose 0.1% in October from the prior month.  That means wages were up 2% over the past twelve months.  With the consumer price index up 1.7% over the past year and the personal consumption deflator higher by 1.4%, both proxies for inflation, workers are indeed making some ground in “real” gains.  But the progress has been uninspiring and slower than trend considering the recession officially ended six years ago and we recently have had so many months of payroll growth.  This means that the slack that has been present in the labor market is just now beginning to lessen.  The Fed mentioned this last week when they referred to an “underutilization of labor resources” that is “gradually diminishing.”  The greatest fear for the Fed is a repeat of the horrible mistake of 1937 when, during the depression, the central bank increased interest rates to fight inflation before the economy was fully recovered thus crushing the nascent recovery and further worsening the situation.  This exact problem is happening in Sweden.  Sweden’s central bank, the Riksbank, is the world’s oldest yet that experience did not prevent them from raising rates in 2010 and 2011 only to turn around and aggressively start cutting them shortly after.  That country has now experienced falling prices in 16 of the pasts 24 months and last week cut their interest rate to 0% to counter the deflation.  The Fed fears following in these same footsteps.    

Meanwhile, U.S. manufacturing expanded in October according to the Institute of Supply Management (ISM).  It’s factory index rose to 59 last month, matching August as the highest figure since March 2011.  A reading above 50 indicates expansion.  The new orders measure rose to 65.9, the second highest level since August 2009.  Even though the majority of the U.S. economy is related to services not manufacturing, this gauge shows that the slice devoted to factories hit on all cylinders in October.  In contrast, European manufacturing barely grew last month as output in France and Italy contracted.  This shows that U.S. managers are confident enough in the future to keep their production lines going hoping to capture some of the demand created by a stronger job market, relatively cheaper gasoline and near rock-bottom interest rates on everything from cars to houses.  Additionally, the ISM services index also released this week showed growth with a 57.1 reading for October.  While that was lower than September’s 58.6 figure, it exceeded the 54.4 average for the first six months of the year.  The services survey covers industries such as retailing, health care, agriculture and finance among others and make up 90% of the U.S. economy.

SGK Blog--Update October 31, 2014: Fed Bets on Job Gains, Unshaken by Global Market Turmoil

On Monday, the European Central Bank and the European Banking Authority announced the results of a nearly yearlong effort to assess the finances of 150 banks. Past efforts have not been credible, largely because in the past they did not disclose their methodology or much detail on the results. It did not help that several banks they had passed previously soon ran into financial difficultly and a number actually failed. So this time around, they were determined to get it right. They identified 13 banks that needed to come up with an additional $12 billion in extra capital. Overall, 25 failed the more rigorous stress tests, modeled after ours here in the U.S., but 12 of these banks had already taken steps throughout the year to raise capital to fund the shortfall. To pass the tests, banks had to show they had ample capital to survive a crisis that would cause Europe’s economy to fall 7% below current forecasts and the unemployment rate to rise to 13%. This was important because for the European Central Bank (ECB), this marked the final milestone before they take over supervision of major eurozone banks on November 4th. Turning the ECB into the currency union’s bank watchdog is a key step to setting up a so-called eurozone banking union. We have been arguing for years this would be in important step for the European Union. The hope of course is that moving control over important banks out of national hands will prevent the kind of banking crisis that rocked Ireland, Spain and Cyprus in recent years. 

When the Federal Open Markets Committee met this week, they basically left policy unchanged – perhaps disappointing some traders that were hoping for a more dovish outlook given recent volatility in markets. Federal Reserve officials dismissed recent turmoil in global financial markets, and focused instead on “solid” employment gains that will keep them on a path toward an interest-rate increase next year. A majority of U.S. policy makers at their meeting Wednesday also set aside concerns, both among their own members and in financial markets, about too-low inflation, voting to proceed with plans to end their third round of asset purchases. The Federal Open Market Committee maintained its commitment to keep interest rates low for a “considerable time.” The committee cited “solid job gains and a lower unemployment rate” since its last gathering in September. It said “underutilization of labor resources is gradually diminishing,” modifying earlier language that referred to “significant underutilization.”  

Non-farm payroll gains have averaged 227,000 this year, heading for the best showing since 1999. That has helped push the unemployment rate down to 5.9 percent in September, just 0.4 percentage point above the top end of a range Fed officials consider full employment. Such indicators of a strengthening economy outweighed policy makers’ concerns about decelerating inflation. Oil prices are down about 17 percent this year, partly due to weaker global growth prospects. Inflation expectations, measured by yield differences on U.S. Treasury notes and government inflation-linked bonds, signal inflation could remain below the Fed’s 2 percent target for several more years. The personal consumption expenditures price index rose just 1.5 percent in August from a year earlier, the 28th month in a row it has been below 2 percent. Policy makers want to maintain a minimum level of inflation, because falling prices can encourage businesses and consumers to delay spending in the expectation of further price declines, reducing demand. “Although inflation in the near term will likely be held down by lower energy prices,” the FOMC said in its statement, policy makers determined that the risk of inflation remaining “persistently below 2 percent has diminished somewhat.”  

The economy in the U.S. expanded more than forecast in the third quarter, capping its strongest six months in more than a decade, as gains in government spending and a shrinking trade deficit made up for a slowdown in household purchases. Gross domestic product grew at a 3.5 percent annualized rate in the three months ended September after a 4.6 percent gain in the second quarter, Commerce Department figures showed Thursday in Washington. It marked the strongest back-to-back readings since the last six months of 2003. The median forecast of 87 economists surveyed by Bloomberg called for a 3 percent advance. Growing oil production is limiting imports and contributing to a pickup in manufacturing, allowing the economy to overcome slowing growth in overseas markets from Europe to China. At the same time, job gains and cheaper gasoline are giving American consumers the confidence and the means to spend, brightening the outlook for the holiday-shopping season and helping explain why the Federal Reserve ended its bond-buying program in their announcement Wednesday. Another report Thursday showed jobless claims rose by 3,000 to 287,000 in the week ended Oct. 25, in line with the median forecast of economists surveyed by Bloomberg, according to the Labor Department. The four-week average, a less volatile measure than the weekly figures, declined to 281,000, the fewest since May 2000.  

The economy’s second quarter’s 4.6 percent jump in gross domestic product reflected a rebound from a 2.1 percent slump in the first quarter that partly reflected a harsh winter. Now the economy appears to be maintaining a pretty good pace off of that rebound. Consumer spending, which accounts for almost 70 percent of the U.S. economy, climbed at a 1.8 percent pace last quarter after growing at a 2.5 percent rate in the previous three months, the Commerce Department report showed. The gain in household consumption compared with a 1.9 percent median forecast in the Bloomberg survey. Purchases added 1.2 percentage points to growth. Improving consumer sentiment may help lift the biggest part of the economy this quarter. Confidence this month jumped to a seven-year high coming in at 94.5, according to figures from the Conference Board, and this compared to an expectation for a figure of 87.2 and September’s figure of 89.  

The Bank of Japan surprised markets overnight Thursday by boosting stimulus measures and this lifted global equity indices and U.S. S&P 500 futures in pre-market trading Friday. Their central bank raised its annual target for monetary expansion to 80 trillion yen ($724 billion) from as much as 70 trillion yen. Additionally, Japan’s Government Pension Investment Fund (GPIF) said it will put half its holdings in local and foreign stocks, double previous levels, and invest in alternative assets. While this is only one fund and may not seem significant on the surface, they are taking their allocation to Japanese stocks to 25% from the previous 12% level and they are increasing their exposure to foreign stocks, including U.S. equities, to 25% as well from the previous 12% level. This fund has $1.2 trillion in assets so this news, combined with their central bank stimulus, sent their Topix index along with the Nikkei 225 index soaring overnight. 

Finally, in other U.S. economic news, we saw early in the week weakness in durable goods orders for September as that figure came out at -1.3% versus the expectation for +0.6%. Excluding transportation, the so-called core rate, it came out at -0.2% versus the expectation of +0.5%. The Case-Shiller 20-city Index of home prices for August rose 5.6% which was relatively in-line with expectations. This showed that despite some volatility in recent housing figures, the recovery in home prices remains intact. On Friday figures for personal income and personal spending for September at +0.2% and -0.2% respectively were below expectations. This does raise concerns as to whether the pace of growth can continue here in the U.S. without a substantial improvement in employment. With wage gains just barely keeping pace with inflation and home prices cooling, this clearly dampened consumers thirst to spend money, at least in the month of September. Finally, the Chicago purchasing managers index or PMI came out well above expectations at 66.2 showing a pick-up in manufacturing in that region while the University of Michigan consumer sentiment survey also came out Friday slightly above expectations at 86.9.

SGK Blog--Update October 24, 2014: Earnings Make Headlines  

Most of this week’s news surrounded quarterly earnings reports from companies. However, there was economic data which was released and will play a role in how the Federal Reserve reacts going forward. The Conference Board’s index of leading indicators climbed 0.8% in September after an unchanged reading in August. The gauge measures the outlook for the next three to six months and shows that, in general, the environment remains positive. The Labor Department released consumer price data for September which showed a moderate inflationary environment. The index rose 0.2% or 1.7% in the 12 months ended in September, the same as in the year ended August. Excluding food and energy, the so-called core measure advanced 0.1% and also climbed 1.7% year-over-year. The current figures remain close to the 2% level the Fed is looking for. However, disinflationary trends are becoming more evident. The average cost of a gallon of regular gasoline fell to $3.09 according to AAA, the biggest U.S. motoring group. That is the lowest level since 2011. Food costs actually rose 0.3% but the bull market in such commodities is likely over. The trade weighted dollar is gaining strength versus other currencies which makes exports more expensive to overseas buyers and lowers the price of imports brought into the country. With inflation in the eurozone running closer to 0.3%, the fear is that such disinflationary pressures will make their way to our shores. That matters because the Fed will become more and more reluctant to raise its target rate for overnight loans through their main tool, the Fed funds rate. The interest rate futures market has for some time expected the first rate increase to happen in the second half of next year and not in the first half as implied by the latest Fed minutes. So far, they have been right while the Fed’s economic crystal ball seems a little cloudy.

In terms of domestic housing, another key economic data point, we received two pieces of housing data this week. Existing home sales rose 2.4% to a 5.2 million annual rate according to the National Association of Realtors on Tuesday. The median price of an existing home rose 5.6%, and distressed sales, comprised of foreclosures and short sales, account for only 10% of the total. On Friday, new home sales data was released from the Commerce Department. These sales rose 0.2% to a 467,000 annualized pace from a 466,000 rate in August. The median sales price of a new home dropped 4% from September 2013 to $259,000. New home sales are tabulated when contracts are initially signed making them a timelier barometer than existing home sales which are totaled when the transaction actually closes. Home buyers got a piece of good news when regulators proposed that banks did not have to require 20% down payment on a transaction if the bank decided to package that loan into a mortgaged backed security. This requirement has been sighted as one of the main reasons why the private MBS market has had such a hard time recovering and why real-estate groups and consumer advocates have argued that credit for mortgages has been too tight. Banks either had to require the 20% level or hold 5% of the risk from the mortgages they packaged which ultimately frightened off many institutions. New rules proposed by Federal Housing Finance Agency also are attempting to expand credit by allowing giants Fannie Mae and Freddie Mac to guarantee loans with down payments of as little as 3%. Might this lead to the same problems which were are the root of the 2008 financial crisis? Potentially. As long as private lenders can verify the ability to pay the loan and ensure that the debt-to-income ratio does not exceed 43%, the regulators argue the previous requirements are unnecessary. Regardless, the potential for unforeseen consequences remains high: What happens if someone loses a job? Who is going to bail out the firms that go under—the government or the public? No rules have been changed yet, but it is imperative that regulators do think through all the potential outcomes of changing the market.

Meanwhile, across the Atlantic Ocean, on Sunday the European Central Bank (ECB) will release results of their latest and greatest stress tests. The tests, administered by the European Banking Authority, will determine how lenders can weather differing degrees of economic downturn. The previous stress tests were deemed failures because their results were soon discredited when banks that passed the test only weeks later were forced into the arms of bank regulators for not having enough capital. The ECB will begin to oversee eurozone banks on November 4 which is seen as a key moment because it will be a pan-European authority with regulatory power over individual private, national banks for the first time. However, even that power is limited. The ECB can tell a bank it needs to inject capital, but it cannot promise that a government will do so if the bank cannot or is not willing. Many analysts also blame these tests as the reason why recent ECB quantitative measures have been met with ho-hum responses. Banks are afraid to reach for more lending if the results show they are undercapitalized. Bottom line: be prepared for some fireworks from Europe come early morning Monday trading.

SGK Blog--Update October 17, 2014: Earnings Season Kicks Off While Indicators Point to Slowing International Growth 

The week started out on a sour note as late day selling on Columbus Day drove the major averages further into the red for the month of October – putting the Dow into negative territory for the year. Trading is typically light on a pseudo holiday but all the same stocks did not react well to the fact that the bond market was closed for trading. What prompted the selling Monday? Clearly mutual funds were hit by redemptions as a lot of the decline occurred in the last hour of trading. This is part of the reason we are thankful here at SGK we do not have to manage a mutual fund as frequently the timing of investor redemptions in mutual funds is terrible. The other factors were simply a carryover from the prior week. Fed officials said over the weekend that the threat from an international slowdown may lead to rate increases being delayed. The remarks highlighted mounting concern over the improving U.S. economy’s ability to withstand foreign weakness and a strengthening dollar. The International Monetary Fund cut its forecast for global growth the prior week and said the euro area faces the risk of a recession. The IMF also said that the chances of equity losses in 2014 have risen and stock valuations may be “frothy.” European Central Bank President Mario Draghi indicated the prior week that there are signs the euro-area’s economic growth is slowing and policy makers must lift inflation from an “excessively low” level. So we witnessed a sell-off the previous week that carried over to trading on Monday, in a market that clearly showed signs that liquidity was lacking as stocks could not take direction from the bond market due to the holiday.

Markets continued the negative trend in Tuesday and Wednesday trading before stabilizing Thursday and rebounding in Friday trading. So what drove all the volatility this week? Before we get to the economic data, it would appear judging from the way the U.S. ten year Treasury bounced around during the week that some of the volatility was driven by hedge fund trading, in addition to the aforementioned mutual fund redemption activity. Many hedge funds had been producing sub-par results on a year-to-date basis so a number of the top hedge fund managers had simply gone long the equity market. They had finally thrown in the towel and adopted the “why fight the tape” philosophy. When that directional movement rapidly reversed course, we witnessed a large amount of selling take place to try to get in front of the tape as they say. Hedge funds will tend to use leverage to enhance returns so when the trend starts to move against them it can result in a rapid amount of sell orders hitting the market all at the same time. The flip side of that trade is if they shifted strategy and went short the market then they were again caught off guard by some of the better U.S. economic data on Thursday/Friday and some comments from the Fed. So once again we potentially witnessed a high level of short covering in Friday’s market. This is why we do not run a hedge fund here at SGK – it is too expensive and risky a structure in our view.  

Helping matters too is the fact that as companies here in the U.S. have released earnings results, the results have been not that bad, in fact many of our core holdings are producing very good results. So traders may have over-compensated during the sell-off earlier this week and last week for weakness in Europe and the negative currency adjustment that would inevitably show up in earnings due to the strong U.S. dollar. We have listed the earnings below for four of our companies that did release results this week and even in the oil and natural gas segment – the results were pretty good. As far as the data on the U.S. economy this week, early week releases were not very encouraging. Retail sales were -0.3% for September and -0.2% excluding autos – both were below expectations. The figures for the producer price index (PPI) and core PPI (excluding food and energy) were -0.1% and 0% respectively, again both below expectations and stoking deflation concerns. Finally on Tuesday, the Empire manufacturing figure came out at 6.2 for October which was well below the forecast for 20.4.  

Thursday and Friday we had more encouraging news on the U.S. economy and U.S. markets responded the way they should, with interest rates coming off the lows and stocks stabilizing then rebounding on Friday. Initial weekly jobless claims ending 10/11/2014 fell to 264,000 compared to the estimate for 290,000. Industrial production and capacity utilization, indicators of factory output in our economy, came out at +1.0% and 79.3% respectively for September, both figures exceeding expectations. The Philadelphia Fed for October beat expectations at 20.7. Finally on Friday we had reports on housing starts and building permits and at 1,017,000 and 1,018,000 for September both indicators showed the housing sector remains robust. Despite all the turmoil in equity markets over the past two weeks, the University of Michigan consumer sentiment survey for October released mid-morning Friday came in at 86.4 which was well above the expectation for 84.0 and the prior month’s 84.6. 

One of the things that does provide us with an advantage over other economies such as those in Europe, is the resiliency of the all-mighty U.S. consumer. Call it America’s $11 trillion advantage: Consumer spending is likely to steer the U.S. economy safely through the shoals of deteriorating global growth and turbulent financial markets. There is no question in our minds the combination of more jobs, falling gasoline prices and low borrowing costs will help lift household purchases. Such tailwinds probably matter more than Europe’s struggles or the slackening in emerging markets that caused the Dow Jones Industrial Average to erase its gains for the year earlier this week. Household purchases make up almost 70 percent of the $16.8 trillion U.S. economy and have climbed an average 2 percent in the recovery that’s now in its sixth year. Spending growth will accelerate to 2.7 percent next year after 2.3 percent in 2014, according to the latest Bloomberg survey of economists. The poll, taken from Oct. 3 to Oct. 8 in the midst of the meltdown in equities, showed little change in the median projections from the prior month. The economy is forecast to expand 3 percent in 2015 after 2.2 percent growth this year, according to the survey. While consumer sentiment can correlate with sharp movements in stock prices, so far economists have not adjusted their forecasts lower.
SGK Blog--Update October 3, 2014: Fed Still on Hold as Market Shakes

With companies just beginning to report third quarter earnings, investors turned all their attention to the release of the minutes of the Federal Open Market Committee’s September meeting. After a depressing 1.5% decline in the S&P 500 just a day earlier, many were expecting further trouble. The International Monetary Fund had released updated estimates for global growth on Tuesday which were even lower than the estimates released just a few months earlier. The world economy was predicted to grow at 3.8% in 2015, down from the 4% rate given in the July forecast. The World Economic Outlook stated: “In advanced economies, the legacies of the precrisis boom and the subsequent crsisi, including high private and public debt, still cast a shadow on the recovery.” In fact, they went so far as to call stocks overvalued: “Downside risks related to an equity price correction in 2014 have also risen, consistent with the notion that some valuations could be frothy.” They did not name specific markets, but considering that the S&P 500 has registered five consecutive years of annual gains, not a lot of guessing was involved. But they did name the U.S. as one of the few bright spots. The IMF expects the U.S. economy to grow at 2.2% for 2014, higher than the 1.7% rise expected back in July. Next year, that growth is expected to expand to 3.1%. This compares to the euro area where growth of 1.3% in 2015 is slower than the 1.5% pace previously estimated. This follows an anemic 0.8% gain this year.

The reaction to the release of the Fed’s minutes on Wednesday afternoon provided a boost of unexpected optimism. The key phrases were, first: “a number of participants noted that economic growth over the medium term might be slower than they expected if foreign economic growth came in weaker than anticipated…” Additionally, “Some participants saw the current forward guidance as appropriate in light of risk-management considerations, which suggested that it would be prudent to err on the side of patience while awaiting further evidence of sustained progress toward the committee’s goals.” In other words, the Fed was in no hurry to change their current outlook. This ran counter the belief in the markets that they might indeed move to raise interest rates sooner than anticipated; that is, before June of 2015. The Fed has not raised rates since 2006 so even the hint of a jump is enough to push equities lower since low rates plus quantitative easing have been the main fuel for adding liquidity to the markets and herding investors to the higher risk, higher return profile of stocks. Plus, with the euro down against the dollar by around 7% this year, the stronger currency is acting a pseudo-tightening because it lowers inflationary pressures by making imports cheaper.

With the unemployment rate at 5.9%, it is getting close to levels where there is pressure to start normalizing policy. In the week ended October 4, initial jobless claims declined by 1,000 to 287,000 according to the Labor Department. That is the lowest level in eight years for that stat. Earlier this week, the Labor Department released their monthly Job Openings and Labor Turnover Survey (JOLTS). It showed the number of available jobs rising by 910,000 in the year ended August, the biggest 12-month gain since records began in December 2000. However, the hiring rate dropped to 3.3%, the lowest since January, from 3.6% in July. Fed chairwoman Yellen said the divergence between openings and hirings could point to economic slack. Nevertheless, it is hard to argue that with the three month average payroll creation hovering around 225,000, the labor market is not strengthening. We have yet to see a real breakthrough in the real wages yet, but it seems only a matter of time at this point. Over time, history has shown that the more jobs are created, the higher wages eventually rise. Since wages comprise about 70% of the average private payroll, that will be the trigger to get the Fed’s attention. Until that happens, investors will just have to keep watching the data, just like the Fed is doing.

SGK Blog--Update October 3, 2014: Signs of Slowing Growth in Europe and China Dampen Enthusiasm for Stocks 

The first trading day of the fourth quarter did not start well for stocks as a number of international issues seemed to rear their ugly heads all at the same time. Data came out Wednesday indicating euro-area factories reduced prices by the most in more than a year and German manufacturing shrank, underlining the mounting challenge policy makers faced before the European Central Bank meeting Thursday. A spokesperson for the German government said Russia risks an escalation of sanctions given the continued turmoil in the Ukraine. This conflict escalated again this week and it threatens to tip Europe back into recession. Italy cut its growth forecast this week. Economists are forecasting growth in Asian countries, including China and Japan, may continue to slow through 2016. Our Treasury yields here in the U.S. have gained versus German bunds for a record nine quarters as the European Central Bank has unveiled a series of stimulus measures to boost credit lending and combat the threat of deflation. The ECB was forecast to announce Thursday details of its plan to buy asset-backed securities. The ECB is on a mission to avert deflation as the euro region’s economic landscape deteriorates. Purchasing Managers’ Indexes from Markit Economics showed manufacturing also contracted in France, Austria and Greece, with a gauge for the 18-nation region pointing to near-stagnation. A separate report showed spillover to the U.K., with factory growth there at a 17-month low. All this negativity and the increase in our yields here in the U.S. relative to other countries has resulted in a steady increase in the value of the U.S. dollar compared to other currencies. The Brazilian real depreciated 1.3 percent and South Korea’s won dropped to a six-month low this week. Pro-democracy protests continued in Hong Kong for a sixth consecutive day this week with markets in the city and China shut for holidays. All this added up to a sell-off in stocks and a rally in high quality bonds, emphasizing the importance of maintaining proper balance in our portfolios.

When the European Central Bank did come out and announced their asset purchase plans, equity markets in Europe did not respond well as traders criticized the program as lacking “the big bazooka” – in other words not being large enough to shake European countries from the slow growth mode and deflationary trend. The ECB announced they will buy assets for at least two years to boost inflation and economic growth in the euro area, ECB President Mario Draghi said. The Frankfurt-based central bank will start buying covered bonds this month and plans to purchase asset-backed securities starting this quarter, Draghi said Thursday at a press conference in Naples, Italy, after the ECB left interest rates unchanged at record lows. “These purchases will have a sizable impact on the balance sheet,” he said. Unlike our program that our Fed Chair Ben Bernanke announced with his quantitative easing measures, Draghi was vague and, when asked, he was not very specific as to whether there would be set target amounts for purchases on a monthly basis. This caused traders to question the enthusiasm behind the program, Germany has been against it from the start, and made them wonder just how big Draghi was willing to expand the ECB’s balance sheet. The ECB’s asset-buying plan is part of a range of stimulus measures it has announced since June to fight the threat of falling prices in the 18-nation currency bloc. Inflation slowed to 0.3 percent last month, the least in almost five years, and the central bank’s preferred measure of medium-term inflation expectations has extended its decline.  

Here in the U.S., compounding the sell-off Wednesday, a report showed U.S. manufacturing cooled in September following the strongest rate of growth in three years, while, according to the report from payroll company ADP, companies accelerated hiring for the first time in three months. The concern here is that although the economy may be showing signs of slowing, with more hiring that could lead to wage inflation and that would be a bad combination. It may prompt the Fed to take action on interest rates sooner than expected. The Fed is set to end later this month its asset purchases under its so-called quantitative easing programs. The Russell 2000 tumbled 7.7 percent in the third quarter, its worst performance in three years, as traders sold speculative stocks. There has also been pressure on riskier assets such as junk bonds as the Fed increases its scrutiny of asset classes such as leveraged loans. We consider these latter two asset classes riskier areas of the market and as such we avoid these types of securities. The Russell 2000 Index is approaching a 10 percent retreat from an all-time closing high on March 4. 

For the most part, the economic data here in the U.S. had a slightly negative tone to it this week. The Institute for Supply Management’s manufacturing index dropped to 56.6 from 59 in August, the gauge’s average over the past three months was the highest since early 2011, figures from the Tempe, Arizona-based group showed Wednesday. Construction spending in the U.S. fell 0.8% in August versus the expectation for a 0.4% gain and the prior month’s 1.2% gain. A measure of consumer confidence for September dropped to 86.0, below the expectation for 92.0 and having dipped from the prior month’s 93.4. Early in the week personal income and personal spending came in at about expected levels at +0.3% and +0.4% respectively. Pending home sales in August declined 1.0% compared to the forecast for a 0.2% drop while home prices for July increased 6.7% relative to the forecast for a 7.4% year-over-year gain. Initial weekly jobless claims figures for the week ending 9/27/2014 were a bright spot as they came in at 287,000 versus the expectation for 297,000. However enthusiasm was dampened that day as August factory orders here in the U.S. declined 10.1% versus the expectation for a 9.3% drop. So overall the data was not bad – just not as good as expected.  

Helping salvage stocks on Friday was the surprisingly strong September jobs report here in the U.S. Employers added 248,000 new jobs versus the expectation for 210,000 and the August figures were revised upwards to 180,000 new jobs created compared to the previous estimate of 142,000. The jobless rate fell to 5.9% from the figure for August of 6.1%. Average hourly earnings were unchanged in the report, which although considered a negative from the standpoint of an economist, a trader would view that as a sign that we are not seeing the wage inflation that would potentially spook stock traders. Stocks rallied and interest rates on the short end of the yield curve rose but overall we did not see a spike higher in the yield on the U.S. 10-year Treasury despite the strength of the report and in fact the yield on the 30-year Treasury actually declined Friday. So we witnessed a relief rally in stocks Friday and potentially some short covering as well as the market remained fairly robust throughout the day, although it did close down for the week.
SGK Blog--Update September 26, 2014: Market Looking for Guidance  

With the earnings conference call season about three weeks away, the market was able to focus on economic data this week.  First up was information about housing.  New home sales surged in August to the highest level in more than six years.  According to the Commerce Department, sales rose 18% to a 504,000 annualized pace last month.  That was higher the highest forecast in a Bloomberg survey of economists and the strongest since May 2008.  The median sales price of a new home rose 8% from August 2013 to $275,600.  The supply of new homes at the current sales rate dropped to 4.8 months from 5.6 months in July.  This is a sign of a healthy market.  New home sales are viewed as more timely than existing home sales because the former is tabulated when contracts are signed.  New home sales, however, only make up about 8% of the residential market.  Speaking of which, on Monday data for previously owned homes was also released.  According to the National Association of Realtors, existing home sales dropped 1.8% to a 5.05 million annual pace in August.  The median forecast in a Bloomberg survey was for a 5.2 million pace.  The median price of an existing property sold rose 4.8% to $219,800 in August from $209,700 a year earlier.  At the current pace, it would take 5.5 months to sell the 2.31 million in inventory.  This is still considered a healthy pace especially considering that the share of properties sold to investors was the lowest in almost five years.  These transactions, which include foreclosures and short sales accounted for only 8% of the market, the fewest since records began in October 2008.  Existing home sales are tabulated when a purchase contract closes making them a little less timely than new home sales by a few weeks to a few months.  Currently, the sales pace is closer to the middle-bottom range of the record 7.08 million sold in 2005 and low of 4.11 transactions in 2008.  Our conclusion is that the residential housing market continues to grow but the recovery has been slow and steady instead of robust.  In general, the economic recovery has had a less steep slope than in past cycles.  This is not unexpected given the severity of the financial crisis in 2008-2009.   

First time jobless claims rose 12,000 to 293,000 in the week ended September 20 according to the Labor Department.  Claims reached a 14-year low of 279,000 in mid-July so we are not that far from that figure.  The figure fell near the middle of estimates that ranged from 275,000 to 320,000.  Demand for durable goods, those meant to last at least three years, fell 18% in August.  Looking inside the numbers, the headline figure is not as bad as feared.  Commercial aircraft orders jumped in July and given that these orders often come in irregular chunks, a fallback was not unexpected.  Civilian aircraft bookings fell by 74% after rising 316% in July.  Excluding aircraft figures, the index actually rose 0.6% for non-defense capital goods according to the Commerce Department.  Similarly, demand for automobiles fell 6% last month, but this was after a 10% surge in July.  Excluding all transportation equipment, durable orders were up 0.7% which reflects a favorable environment for growth.

The final economic data point of the week was released on Friday and involved the latest revision of second quarter GDP.  The U.S. economy expanded in the second quarter at the fastest rate since 2011.  GDP grew at a revised 4.6% rate compared to the previous estimate of 4.2%.  Inventories added 1.42 percentage points to GDP while final sales, which exclude inventories, rose 3.4% compared with a previously reported 3.1%.  Overall, a fairly positive report as the third calendar quarter and government year-end arrives next Tuesday.

SGK Blog--Update September 19, 2014: Federal Reserve Vows To Keep Interest Rates Low While Adjusting Rate Forecasts Higher 

The Federal Reserve maintained a commitment to keep interest rates near zero for a “considerable time” after asset purchases are completed, saying the economy is expanding at a moderate pace and inflation is below its goal. “Labor market conditions improved somewhat further” while “significant underutilization of labor resources” remains, the Federal Open Markets Committee said Wednesday in a statement in Washington, DC. “Inflation has been running below the committee’s longer-run objective.” In July, the Fed said inflation was “somewhat closer” to its goal. Policy makers tapered monthly bond buying to $15 billion in their seventh consecutive $10 billion cut, staying on course to end the program in October. Bond purchases intended to hold down long-term interest rates have swelled the Fed’s balance sheet to $4.42 trillion. Even so, Fed officials raised their median estimate for the federal funds rate at the end of 2015 to 1.375 percent, compared with 1.125 percent in June. The rate will be at 3.75 percent at the end of 2017, the Fed said today for the first time as it included that year in its Summary of Economic Projections. That is the same as Fed officials’ longer-run estimate. The median estimate in June for the long-run fed funds rate was also 3.75 percent.  

Fed Chair Janet Yellen and her Fed colleagues are debating how much longer to keep interest rates near zero as they get closer to their goals for full employment and stable prices. At the same time, they are considering a change in guidance on the outlook for borrowing costs to give them more flexibility to react to the latest economic data. “The likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year,” according to the statement. The personal consumption expenditures index, the central bank’s preferred price gauge, increased 1.6 percent in July from a year earlier and hasn’t exceeded the Fed’s 2 percent objective since March 2012. The Fed repeated that it will consider a wide range of information in deciding when to raise the benchmark federal funds rate, which it has kept near zero since December 2008. Bond purchases will be divided between $10 billion in Treasuries and $5 billion in mortgage-backed securities.  The Fed also said it will maintain its policy of reinvesting maturing debt. Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser dissented. The Fed published new guidelines for its exit strategy, saying that the phaseout of reinvestment “will depend on how economic and financial conditions and the economic outlook evolve.” FOMC participants said the main tool to move the federal funds rate will be changes in the interest rate it pays on excess reserves. Fed officials said reverse repurchase agreements will be used “as needed” to help control the fed funds rate and will phase out later. 

Stocks actually got a lift after the Fed meeting despite the fact that interest rates did move higher, especially on the short end of the yield curve. Perhaps this was due to Yellen’s calming comments during her news conference after their statement was released. They did articulate the procedures and mechanisms for altering policy very clearly even if they were a little vague on the exact criteria. The Fed in our view is doing a very good job of articulating policy and the news conferences are a great way to expand on their views. Janet Yellen is so far doing a fine job. Considering the current Fed Funds rate is between 0-0.25%, we were a little surprised the increase in their forecast to 1.375% by year end 2015 did not have more of an impact on both stock and bond prices. The bond market is predicting that the Fed Funds rate will not be that high. The fact that bond prices did not actually move much after their announcement had a calming effect on the stock market, which had actually turned negative immediately following the release of the statement.  

Also helping matters was the release earlier in the day of the figures for the Consumer Price Index (CPI) for the month of August which showed a decline of 0.2% versus the expectation for a flat figure. The core rate, excluding food and energy, was flat versus the expectation for an increase of 0.2%. Earlier in the week, the producer price index (PPI) came out exactly in-line with expectations as it was also flat for August with the core rate increasing only 0.1%. Contributing to the relative calm markets demonstrated this week, housing starts and building permits came out and were well below expectations at an annualized rate of 956,000 and 998,000 respectively in August. Initial weekly jobless claims for the week ending 9/13/2014 were below expectations (a positive) coming in at 280,000 versus the expectation for a figure of 305,000.  Industrial production for August was -0.1% while capacity utilization slipped to 78.8% from the prior month’s 79.1%. Both figures were also below expectations. The fact that the U.S. economic news was very mixed this week with many figures coming in below expectations helped alleviate concerns the Fed would act to increase rates too quickly. Earlier in the week amidst signs of a slowdown in manufacturing and slipping home prices in China, their central bank provided monetary easing in the form of adding 500 billion yuan to the nation’s largest commercial lenders via its standing lending facility. This helped lend support to Asian markets overseas and that spilled over to U.S. markets this week too.

SGK Blog--Update September 12, 2014: Apple Unveils New Products as U.S. Retail Sales Rise  

During the week that many were focused on the new products from Apple, the Commerce Department reported retail sales for August climbed at the fastest pace in four months.  The 0.6% gain matched the median forecast surveyed by Bloomberg and came after a stronger-than-prior reading of 0.3% in July.  Auto dealers and building materials stores led the advance with auto dealers registering a 1.5% rise, the best since March.  Sales of cars and light trucks rose to 17.5 million annualized in August according to Ward’s Automotive Group, the highest level since January 2006.  Excluding autos, retail sales rose 0.3% which also matched the median forecast.  The auto group AAA reported that regular gasoline sold at an average of $3.42 a gallon as of September 10, the lowest in more than six months.  The U.S. produced 8.59 million barrels a day of crude oil production in the week ended September 5 based on EIA data.  In 2008, that figure was 5 million barrels a day.  Volume may soon eclipse the 1970 high of 9.6 million barrels a day if the trend continues. 

Higher spending by consumers goes hand-in-hand with a better job picture.  Though last week’s job data was below estimates, it did not derail confidence.  This week the Labor Department reported that the number of Americans filing for unemployment benefits rose 11,000 to 315,000 in the week ended September 6.  This was the highest reading since June 28 and exceeded the median of 300,000 forecasted.  The less volatile four-week average rose to 304,000 from 303,250 a week earlier.  This data will be heavily analyzed by the Fed in its regularly scheduled meeting Federal Open Market Committee meeting next week.  It will be an important meeting because it will also include a post-meeting press conference with Fed chair Yellen.  This will be the last time the Fed will have before the media before their latest quantitative easing program is expected to end next month.  So we assume that if there is anything truly market-moving to be revealed, it will be done next week.  That said, we are not expecting any earth-shaking event.  The job market has improved since the Fed started its tapering program late last year but we have yet to see any real, sustainable growth in real wages.  That is, nominal growth minus inflation equals real changes.  With inflation running about 1.8%-2.0% on a yearly basis and wage growth near that range, employees have kept pace but not really made progress in accumulating wealth through wage income.  From a company perspective, that is good because demand is increasing for goods and services, yet employers are not pressured to raise wages quickly because the available pool of labor remains deep.  At some point, that will change but no one, not even the Fed, knows when it will.  In the interim, Yellen & Co. are fixated on making sure that companies are still willing to hire and invest hoping that eventually such wage pressures will develop.  The key is not to create a salary problem for companies but to give employees an incentive to find work—namely, to better their lives on a real basis through employment.  All this liquidity that the Fed has pumped into the economy has lifted the price of financial assets as a result.  How much has contributed to the record-breaking levels of the S&P 500 we will find out when rates start to move up sometime next year.

SGK Blog--Update September 5, 2014: August Employment Data Disappoints 

The week began with the dollar strengthening to a seven-month high against the yen and Treasuries falling as data showed U.S. manufacturing expanded. The Institute for Supply Management’s index of manufacturing unexpectedly climbed to 59, the highest level since March 2011, from July’s 57.1, the Tempe, Arizona-based group reported Monday. Readings greater than 50 indicate growth. The median forecast in a Bloomberg survey of economists was 57. Gauges of factory output in Europe and China released Monday when U.S. markets were closed signaled slower growth overseas, boosting speculation that policy makers will need to boost stimulus measures there. Early in the week, European money markets were pricing in about a 50 percent probability that the European Central Bank would cut interest rates by 10 basis points at their next meeting, according to BNP Paribas SA. Commodities tumbled as oil and gold sank, while energy companies led U.S. stocks lower Tuesday when U.S. markets reopened for trading. The U.S. dollar climbed 0.7 percent to 105.10 yen at mid-day in trading in New York and gained 0.7 percent to $1.6488 per British pound. Yields on 10-year Treasury notes increased seven basis points on Tuesday alone, the most in more than a month, to 2.414 percent. The Standard & Poor’s 500 Index lost 0.3 percent after the biggest monthly rally in August since February, as energy companies tumbled 1.6 percent. Gold slid 1.7 percent and oil retreated 2.7 percent. Commodities are generally priced in U.S. dollars so the decline Monday was not supply or demand related, it was almost exclusively due to the combination of strong U.S. economic data combined with weak data from overseas, including the U.K., and the impact this had on the U.S. dollar. Of course this also bolstered the case for the Federal Reserve to raise interest rates sooner than anticipated. The U.S. dollar has been in a strong upward swing in recent months and the early week data lent support to that trend continuing. 

When the European Central Bank finally did meet this week, they decided to cut interest rates and start buying assets, in a bid to boost the flow of funding for the euro-area economy while stopping short of broad-based quantitative easing. All eyes were on the news conference as ECB President Mario Draghi’s plan to buy asset-backed securities and covered bonds pushed the euro below $1.30 for the first time since July 2013. When he spoke he said the inflation outlook had worsened. Germany’s Jens Weidmann opposed the rate cut and ABS plan, according to two officials. The ECB “will purchase a broad portfolio of simple and transparent securities,” Draghi said at a press conference in Frankfurt Thursday. “Some of our council were in favor of doing more than presented.” Euro-area inflation languished at 0.3 percent last month, far below the ECB’s 2 percent target. The ECB on Thursday also cut its macroeconomic forecasts for 2014 from its previous assessment in June. Gross domestic product is now predicted to expand by 0.9 percent this year and 1.6 percent in 2015, instead of the previous 1 percent and 1.7 percent. Inflation is seen at 0.6 percent this year instead of 0.7 percent previously. The inflation outlook for 2015 is unchanged at 1.1 percent. “We took into account the overall subdued outlook for inflation, the weakening in the growth momentum in the recent past,” Draghi said. “The Governing Council sees the risks around the economic outlook on the downside.” The ECB reduced all three of its main interest rates by 10 basis points. The benchmark rate was lowered to 0.05 percent, the deposit rate is now minus 0.2 percent, and the marginal lending facility is 0.3 percent. The euro fell to as low as $1.2952 and traded at $1.2932 at 5:50 p.m. Frankfurt time on Thursday. The dissent from Bundesbank President Weidmann highlights the resistance in Germany, the region’s largest economy. In July, he called ABS purchases “problematic” and warned against supporting bank profits while socializing the losses. The ECB President finds himself pressed into action for the second time in four monetary-policy meetings. The 18-nation euro area is struggling with a stalling economy and escalating sanctions against Russia due to the situation in the Ukraine that threaten trade flows. In June, the ECB cut rates and announced a three-year targeted loan program for banks, called TLTRO, aimed at boosting lending to households and businesses. Draghi said at the time that interest rates were “for all the practical purposes” at the lower bound. This just shows confirms the disconnect between the U.S. and European economies as their central bank adds stimulus while ours is pulling it. 

As if to confirm this trend, the same day the ECB cut rates here in the U.S. we had information released showing service providers such as retailers and construction firms expanded in August at the fastest pace in nine years, pointing to greater momentum in the economy that’s generating jobs and brightening Americans’ spirits. The Institute for Supply Management’s non-manufacturing index climbed to 59.6, the highest since August 2005, from 58.7 a month earlier, the Tempe, Arizona-based group said today. Bloomberg’s weekly measure of consumer sentiment rose to the second-highest level in a year and filings for were little changed, other figures showed on Thursday. The improvement at service providers was broad-based and, combined with faster manufacturing growth, raises the odds of a self-supporting cycle of more spending and job gains that could further propel the expansion.  Shifting the world’s largest economy into a higher gear depends in part on a pickup in worker pay that has been elusive. With that said, a significant pick-up in wages could also trigger inflation and cause the Fed to raise interest rates sooner than expected, which would be a headwind for both stock and bond markets. The strong ISM services data did help propel U.S. rates higher in Thursday trading as well.  

Throwing a wet blanket over the enthusiasm for U.S. economic data this week was the August jobs report which came out on Friday at 8:30 am. American employers hired fewer workers than forecast in August and the jobless rate dropped because people left the workforce, which bolsters those on the Federal Reserve who want to be more deliberate in removing monetary stimulus. The 142,000 advance in payrolls was smaller than the lowest estimate in a Bloomberg survey and followed a revised 212,000 gain in July, figures from the Labor Department showed. The median estimate was for a 230,000 increase. The unemployment rate fell to 6.1 percent from 6.2 percent in July, reflecting a drop in joblessness among teenagers. Employers who boosted headcounts in the first half of the year may be more restrained in their hiring as they await even faster economic growth. Fed Chair Janet Yellen and her colleagues will use today’s report to help discern the extent of slack in the labor market as they pare back record monetary stimulus, while keeping interest rates low at the same time. So time will tell if this is just a one month blip or if it is the beginning of a trend. Perhaps companies were simply waiting it out in August to gauge September back-to-school demand and if the general pick-up in economic activity we have recently witnessed here in the U.S. is here to stay. Stocks declined and bonds rallied on the report given it was weaker than expected.

SGK Blog--Update August 29, 2014: S&P Reaches 2000  

During the last week of August, Wall Street is usually in full vacation mode.  This year seems to be following that script pretty closely.  Things overseas have heated up in the Ukraine conflict and evidence of a new outbreak of the deadly Ebola virus in West Africa have grabbed the headlines.  The biggest monetary-related issues were related to economic releases.  The U.S. economy expanded at an annualized 4.2% in the second quarter, up from an initial estimate of 4% according to the Commerce Department.  The median Bloomberg economists’ survey called for a 3.9% rise.  The pickup came from bigger gains in corporate spending and a smaller trade deficit.  Business investment increased at a 8.1% annualized rate, the most since the first quarter of 2012.  Household consumption which provides the bulk of GDP, grew at a 2.5% annualized rate which matched the early estimate.  However, consumers’ purchasing power improved.  Disposable income adjusted for inflation rose at a 4.2% rate in the second quarter versus a 3.4% rise in the first quarter.  Excluding inventories and trade, so-called GDP final sales rose 3.1%, up from a previously reported 2.8% rise, the biggest advance in four years.  Cleary, the recovery is becoming more entrenched.  This is also evidenced by initial employment claims remaining below 300,000 in the week ended August 23 according to the Labor Department.  The median forecast called for an increase to 300,000 while the final number came in at 298,000.  U.S. firms added more than 200,000 employees to payrolls in July for a sixth consecutive month, the longest such streak since 1997.  Nevertheless, Janet Yellen said during her speech at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming last week that the “labor market has yet to fully recover.”    She added: “a key challenge is to assess just how far the economy now stands from attainment of its maximum employment goal.”  We believe that Yellen & Co. are taking the right approach by taking into account not only payroll figures but also other indicators like whether jobs are easy to get, how willing employees are to quit and the underemployment rate which includes those who want to work full-time but cannot.  That gives a more complete picture of the labor market.  The big risk in this approach is that it is slow.  All this information does not come out at one time and some is more dated than other tidbits.  The Fed has to see at a minimum nine months in the future because their actions take time to filter through the entire $16 trillion economy.  In reality, they have to predict years in advance because of the global effect of their decisions.  So far, they have been on the right side of caution but the time is coming when they will need to begin to apply a less generous approach to monetary policy.

Other data released this week included new home sales which fell in July for the second month.  According to the Commerce Department, sales fell 2.4% to a 412,000 annualized pace which was weaker than the lowest estimate in a Bloomberg survey.  With the median sales price up 2.9% from July 2013 to 269,000, builders are benefitting but the question of affordability will become an issue if prices continue to rise and consumers become hesitant.  New home sales account for only about 5% of the residential market.  They are tabulated when contracts are signed making them a timelier indicator than existing home sales which are totaled when the deal is actually closed which could be weeks or months later.  Thus, the momentum we have seen in existing home sales suggests that consumers awoke from a difficult winter to conduct deals in late spring but the latest new home sales figures show the follow-through has not really been there.  The bottom line is that the housing market remains mixed.  A stronger job market will benefit but that momentum could be slowed if rates rise which is another reason why Yellen & Co. have been reluctant to take away the proverbial punch bowl.

We did see orders for durable goods rise in July by the most on record thanks to a surge in commercial aircraft orders according to the Commerce Department.  Boeing said it received 324 orders for planes last month, almost three times the 109 total in June.  Excluding transportation equipment, the figure fell 0.8% after a 3% rise the month earlier.  We are seeing a jump in appliance demand which makes sense given the stronger existing home sales data we mentioned earlier.  The ISM reports on manufacturing also are corroborating an increase in the workload of the nation’s factories.  The latest figures have been consistently above a 50.0 reading which suggests overall growth in both goods and services. 

SGK Blog--Update August 22, 2014: Strong Data and Tame Inflation Help Lift Stocks for the Week  

The week started off on a positive note as international tensions eased somewhat.  Ukrainian Foreign Minister Pavlo Klimkin met his Russian counterpart Sergei Lavrov for more than five hours of talks in Berlin last Sunday, as they sought to ease tensions after officials in Kiev said troops had partially destroyed an armed convoy from Russia last week.  Klimkin said the talks had brought “moderate progress,” though he called on Russia to follow words with actions.  Iraqi and Kurdish forces retook control of the Mosul Dam over the weekend, Iraqiya television reported, citing military spokesman Qassem Ata.  The U.S. widened its airstrikes in Iraq over the weekend to help secure the dam near Mosul, Iraq’s largest northern city, after it was seized by Islamist militants.  Iraq is OPEC’s second-biggest oil producer.  This helped ease pressure on oil prices as well.  The S&P 500 had fallen as much as 3.9 percent from a record reached on July 24 amid growing concern over global conflicts from Ukraine to Gaza and Iraq.  The benchmark index jumped in Monday trading also due to signs of a slowing economy that stoked bets central banks will leave interest rates near record lows for longer.  Reports showed the euro area’s recovery stalled in the second quarter, spurring speculation the European Central Bank will boost stimulus measures.  In the U.S., July retail sales registered the worst performance in six months and consumer sentiment slipped in the previous week.

Helping the early week optimism was a report showing the National Association of Home Builders/Wells Fargo sentiment measure climbed to 55 from 53 in July, the Washington-based group reported Monday.  Confidence among U.S. homebuilders rose in August to the highest level in seven months, demonstrating the industry is making more headway after weakness earlier this year.  Readings above 50 mean more respondents said conditions were good.  The median forecast in a Bloomberg survey of economists projected it would hold at 53.  Historically low mortgage rates and increased employment are bringing home purchases within reach of more Americans.  Faster wage gains would help provide an additional push for the industry, which is struggling to lure first-time buyers beset by tougher credit conditions.  “As the employment picture brightens, builders are seeing a noticeable increase in the number of serious buyers entering the market,” NAHB Chairman Kevin Kelly, a homebuilder from Wilmington, Delaware, said in a statement.  “However, builders still face a number of challenges, including tight credit conditions for borrowers and shortages of finished lots and labor.”  

Tuesday’s data showed that home construction rebounded in July and the cost of living rose at a slower pace, showing a strengthening U.S. economy has yet to generate a sustained pickup in inflation.  A 15.7 percent jump took housing starts to a 1.09 million annualized rate, the strongest since November, and halted a two-month slide, the Commerce Department said in Washington.  This was well above the expectation for a 964,000 annualized rate according to economists’ forecasts.  The figures for building permits for July was also better than expected.  The consumer price index (CPI) increased 0.1 percent in July after rising 0.3 percent in June, the Labor Department also reported.  An improving job market and cheaper borrowing costs are helping revive residential real estate, helping boost sales at companies such as Home Depot, which also came out with a strong earnings report Tuesday.  The core rate for CPI, which excludes food and energy, came out in-line with expectations helping boost traders confidence.  As inflation continues to run below the Federal Reserve’s target, it gives the central bank room to keep interest rates low well after the projected end of its bond-buying program in October.

Federal Reserve officials raised the possibility that they might begin removing aggressive stimulus sooner than anticipated, as they neared agreement on an exit strategy, according to minutes of their July meeting.  “Many participants noted that if convergence toward the committee’s objectives occurred more quickly than expected, it might become appropriate to begin removing monetary policy accommodation sooner than they currently anticipated,” the minutes, released Wednesday in Washington, read.  Rates did rise slightly on this news, but most traders were waiting and eagerly anticipating Fed Chair Janet Yellen’s comments at Jackson Hole on Friday.  She has so far committed monetary policy to stronger labor markets, which she measures with an array of indicators, so long as inflation remains in check.  The minutes said “many participants” still see “a larger gap between current labor market conditions and those consistent with their assessments of normal levels of labor utilization.”  Many members noted, however, that the characterization of labor market underutilization might have to change before long, particularly if progress in the labor market continued to be faster than anticipated,” the minutes said.  A factor we believe will be important in their decision making will be if we start to see signs of wage inflation as labor markets tighten, which we have not really seen so far.

On balance the remaining week’s economic news, primarily released on Thursday, was positive.  Initial weekly jobless claims for the week ending 8/16/2014 were 298,000 compared to the expectation for 308,000 and the prior week’s 312,000.  Existing home sales for July were 5.15 million compared to the forecast for 5.00 million and the prior month’s 5.03 million.  The Philadelphia Fed survey, a measurement of the robustness of the manufacturing sector in that region, came in at 28.0 for August compared to the expectation for 15.5 and the previous month’s 23.9.  Finally, the Index of Leading Indicators, often cited as a predictor of future economic growth although it is based on historical data, came in for July at +0.9% which was better than the forecast for +0.7% and the prior month’s figure of +0.6%.  All of these data points were trending in the right direction.

All eyes were on Fed Chair Janet Yellen’s and European Central Bank (ECB) President Mario Draghi’s speeches Friday at the Kansas City Fed’s annual economics conference in Jackson Hole, Wyoming.  The expectation was that Yellen would make dovish comments with respect to the fact in the Fed’s view the labor market here in the U.S. has not reached its full potential therefore more needs to be done, or rather more time is needed to allow it to fully heal.  With respect to Draghi, given the recent data indicated the broader European economy sputtered in the second quarter, it was expected that he may hint at further central bank stimulus to come.  Federal Reserve Chair Janet Yellen began her remarks by saying slack remains in the U.S. labor market even after gains made during the five years of economic recovery.  “The economy has made considerable progress in recovering from the largest and most sustained loss of employment” since the Great Depression, she stated.  Even so, she underscored the Federal Open Market Committee statement last month that “underutilization of labor resources still remains significant.”  Yellen’s remarks appeared in line with the message from minutes of the July FOMC meeting, which showed officials growing more aware that labor markets are approaching full employment.  Still, pinpointing a full recovery in the job market is difficult given the “depth of the damage” from the recession, she said.  Her speech walked through the arguments of how much slack might be related to weak demand as opposed to more permanent trends.  Overall, there were no real surprises in her remarks.  There was some profit taking Friday based on her comments and also an increase in tensions yet again in the Ukraine.

SGK Blog--Update August 15, 2014: Deals Make Headlines  

There were a number of economic releases this week.  Retail sales failed to ignite much excitement with a flat July reading according to the Commerce Department after a 0.2% rise in June.  Declines in electronics and furniture stores offset gains in clothing and groceries.  Excluding autos and gas, the increase was only 0.1% compared to an expectation of a 0.4% rise.  The back-to-school season has begun and next month’s reading will be a key indicator.  The lackluster retail figure coincided with initial unemployment filings which rose more than forecast in the week ended August 9.  Jobless claims climbed by 21,000 to 311,000 which is the highest in six weeks according to the Labor Department.  The median forecasts was for a figure of 295,000.  As we have mentioned previously, summer is a difficult month to forecast due to car companies which often shutdown in July-August to retool their lines for the new car season.  We have not seen much of that so far and there was nothing unusual in the data according to officials.  That said, the four-week average remains below 300,000.  Moreover, the Labor Department reported its monthly Job Openings and Labor Turnover (JOLT) survey this week which showed the number of unfilled positions rising by 94,000 to 4.67 million, the most since February 2001.  This report combines resignations, help-wanted ads and the pace of hiring to give a broader view of the labor market than the usual payroll or unemployment figures.  There are about 2 unemployed people jockeying for each opening compared to 1.8 job seekers per opening in December 2007.  The JOLT report is part of Fed Chair Yellen’s so-called “dashboard” which she monitors for signs of improvement in the economy.  The “quits rate” which measures the willingness of the employed to leave their jobs held at 1.8% versus 2.1% when the recession started in late 2007.  Given that we are not quite back to pre-recessionary levels, the pressure for a Fed move has not increased and the market continues to expect low levels for a “considerable time” if the quantitative easing ends as expected later this fall.

Producer prices also provides evidence that the economy is still in need of extra medicine.  Wholesale prices rose at 0.1% in July according to the Labor Department following at 0.4% gain in June.  Excluding the volatile food and energy sectors, the so-called core rate rose 0.2%.  Year-over-year, the overall rate rose at 1.7%, and the core rate was 1.6% higher.   The latter figure matches the rise in the personal consumption expenditures index which the Fed watches closely.  These numbers show that inflation is under control and remains present but is not a threat.

The pricing situation in Europe is somewhat different.  Eurostat, the European Union’s statistics office in Luxembourg said this week that yearly inflation was 0.4% in July.  That is way below the “around 2%” level that the European Central Bank (ECB) has been looking for.  Eurozone GDP results confirm this stagnation.  For the second quarter the region was flat compared to the first quarter, when it increased 0.2%.  Germany’s economy shrank 0.2% for its first contraction since 2012.  France was flat, and Italy fell into its third recession since 2008 with GDP falling 0.2% in the April to June period.  Positives included growth in Spain, Belgium, Austria and in smaller countries like Latvia and Slovakia.  The euro-area economy grew 0.7% in the year.  In June the ECB predicted a 1% growth for 2014 and 1.7% in 2015.  Those numbers now look doubtful and ECB president Draghi said risks to the outlook are growing because of the recent flare up of the Ukraine crisis.  The sanctions placed on Russia directly led to the lowest level of German investor confidence since 2012.  Sanctions are hurtful but they can change in a hurry so it is not inconceivable that Germany can remain a growth engine going forward.   But that is assuming the crisis subsides and sanctions have a brief life.  The uncertainty is weighing on investors as German bond yields reached record lows are traders sought safety and return of principal over any return on principal.  The yield on German 2-year securities actually turned negative meaning, at maturity, an investor would be locking in a loss by buying at such prices.  Europe still needs to have long-term structural change to accomplish long-term growth.

SGK Blog--Update August 8, 2014: Stocks Volatile as Overseas Tensions Grow 

U.S. stock sentiment was generally negative this week, as the Dow Jones Industrial Average hit its lowest level since April and pushed the average into negative territory for the year, as concern that the escalating conflict in the Ukraine offset better-than-estimated second quarter earnings and generally positive U.S. economic news. Russia has massed troops along its border with Ukraine, prompting the U.S. to say there’s a risk of an invasion. President Putin retaliated Wednesday against European Union and U.S. sanctions by ordering restrictions on food imports from countries that seek to punish Russia. No one likes a trade war and obviously an actual war is worse! Putin appeared to back-off his stance when he indicated he was interested in de-escalating the situation which helped equities on Friday. He declared Friday that exercises on the Ukraine border were over, but we have heard that before from him and actions speak louder than words. European Central Bank President Mario Draghi said the risks to the recovery from conflicts including that in Ukraine are increasing. Headwinds facing the 18-nation euro area’s recovery are intensifying after reports this week showed that Italy slipped back into recession and German industrial output for June was much weaker than expected. The standoff between Russia and the U.S. and its allies has unfortunately escalated into the worst such conflict since the Cold War and it is having an impact on both the Russian economy and the neighboring countries that do business there. Not helping matters was the news that the U.S. had resumed bombing runs in Iraq against the militant group the Islamic State in Iraq.

Traders also pay a great deal of attention to data coming from the world’s second largest economy – China. So when a indicator came out Tuesday showing weakness, stock futures reversed course and turned sharply negative in the pre-market, even though there was no news emanating from U.S. markets to suggest that a reversal was pending. China’s service industries stagnated in July as a private index fell to a record low, suggesting the government’s stimulus measures are failing to gain traction outside of manufacturing. The services Purchasing Managers’ Index declined to 50.0, the dividing line between expansion and contraction, from June’s 53.1, according to HSBC Holdings Plc and Markit Economics. A similar official gauge released Aug. 3 dropped to a six-month low of 54.2. Asian stocks extended losses as the HSBC-Markit index’s lowest reading since it began in 2005 signaled that falling home prices and new construction are dragging on services, which account for almost half of gross domestic product now in China. The International Monetary Fund’s China mission chief warned last week real estate is the biggest near-term risk to the economy. The weakness in the headline number likely reflects the impact of the ongoing property slowdown in many cities. Given the Chinese economy is more of a managed economy than one driven by free markets, the report points to the need for continued policy support to offset the drag from the property correction and consolidate the economic recovery. 

Interestingly, Tuesday’s equity markets were also negatively impacted by strong U.S. data when both factory orders and the ISM Services Index were released. This seems counterintuitive but it raised concerns the Federal Reserve would begin the process of raising interest rates sooner than expected. Factory orders for June rose 1.1%, over twice the +0.5% expected. The report showed bookings for non-military equipment excluding aircraft, a proxy for capital equipment demand, advanced 3.3%. The Institute of Supply Management’s Service Index for July expanded to 58.7, well above the expectation for a 56.5 increase as it reached an almost 9 year high. This survey covers an array of industries including utilities, retailing, healthcare and finance that make up almost 90% of the economy. It also factors in construction and agriculture. Improving conditions were evidenced in virtually every industry surveyed. So it is a case where good news turned out to be bad for stocks because it was almost too good, again stoking fears the Fed will have to make an interest rate move prior to the date economists have forecast. 

On balance, the rest of the news coming out on the U.S. economy this week was quite positive. Jobless claims decreased by 14,000 to 289,000 in the week ended Aug. 2 from 303,000 in the prior period, a Labor Department report showed Thursday in Washington. The median forecast of 47 economists surveyed by Bloomberg called for an increase to 304,000. Companies are holding on to more workers in an effort to keep up with increased orders and stronger consumer demand, contributing to a virtuous cycle of growth as the economy accelerates. Fewer layoffs and more jobs would support further gains in incomes and household spending, which accounts for 70 percent of the economy. A separate report showed consumer borrowing rose in June as American households took out auto and student loans. The $17.3 billion increase in consumer credit followed a $19.6 billion May advance, the Federal Reserve reported Thursday in Washington. Non-revolving loans, including borrowing for cars and college tuition, climbed $16.3 billion. Stronger employment and gains in home values are giving households the confidence to borrow and make big-ticket purchases such as cars and appliances. Banks also are showing greater willingness to lend, which could boost consumer demand, the biggest part of the economy. So enthusiasm for equities this week was really dampened by the news coming from overseas. Markets were helped Friday though by the report that second quarter productivity here in the U.S. increased at a 2.5% rate versus the expected 1.4% gain. The same report showed that unit labor costs in the U.S. grew at a modest +0.6% pace in the second quarter versus the expectation for a 2.0% gain. High productivity combined with low unit labor costs is positive for markets as it relieves concerns that heightened inflation may result given the recent economic strength.  

SGK Blog--Update August 1, 2014: Fed Continues Taper as Employment Picks Up

It was a busy week for both economic data and also company earnings.  On Wednesday, the Federal Reserve concluded their regularly scheduled Open Market Committee (FOMC) meeting with little change to their outlook.  They stated: “Labor market conditions improved, with the unemployment rate declining further.  However, a range of labor market indicators suggests that there remains significant underutilization of labor resources.  Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.”  As such, the Fed governors are comfortable with keeping the target interest rate on federal funds at 0%.  In order to support their dual mandate of “maximum employment and price stability”, they feel the need to continue to purchase fixed income securities but at a reduced pace.  Beginning in August, the FOMC will purchase $10 billion per month of mortgage-backed securities and $15 billion per month of longer-term Treasury securities.  This is a reduction of $10 billion in total from the previous month.  Thus, technically it is still quantitative easing yet, de facto, it is tapering.  The Fed stated that “asset purchases are not on a preset course” which gives them wiggle room in case they need to change the pace of tapering including the unlikely possibility of once again increasing the amount of purchases.  They continue to stress “that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”  The last thing the Fed wants is to spook the market into thinking that rate increases will come prematurely or involve massive spikes.

On Friday, the Labor Department reported that the U.S. added more than 200,000 jobs for the sixth straight month in July, the longest such period since 1997.  The 209,000 advance followed a 298,000 rise in June that was stronger than previously reported and blunted the fact that the expectation for July’s increase was 230,000.  The unemployment rate, taken from a survey of households, increased to 6.2% from 6.1% as the participation rate rose to 62.9% from 62.8% a month earlier.  Private payrolls, which exclude government workers, rose 198,000 last month.  The only negative with today’s report was that average hourly earnings were unchanged at $24.45.  Though it is up 2% over the past 12 months, it is not growing much faster than inflation which suggests that workers are merely running in place rather than building future wealth.  With the average work week holding steady at 34.5 hours, this indicates, as the Fed hinted earlier, slack in the labor force.  Fed Chair Janet Yellen told lawmakers last month that she remained concerned about the low participation rate and sluggish wage growth.  After the latest report, her fears are not likely to be go away but might be helped by the fact that the more timely weekly initial unemployment report for the week ended July 26 showed 302,000 filers.  Though that number climbed from the week earlier, the four-week average of 297,250 was the lowest since April 2006 and remains consistent with a strengthening labor market.

These solid labor market figures are showing up in other government data released this week.  The first reading of second quarter GDP was released on Wednesday which showed an annualized gain of 4% according to the Commerce Department.  That was a nice rebound from the 2.1% contraction for the first quarter of the year, which itself was revised up from a previously reported 2.9% decline.  The rise was led by gains in consumer spending and business investment.  There was a surge in inventories which added 1.7 percentage points to the second quarter as stockpiles were rebuilt at a $93.4 billion annualized pace versus the $35.2 billion rate in the first quarter.  That could mean that future quarters will not be as strong as consumers and businesses labor to work off that build-up.  But, if demand is indeed strong enough, it will lead to a virtuous cycle of needing to replace liquidating inventory regularly.  Nevertheless, consumer spending rose at a 2.5% pace which was more than twice the 1.2% advance during the first three months of the year.  A separate report released on Friday by the Commerce Department showed that for the month of June, household purchases rose 0.4%.  Incomes also advanced 0.4%.  A key pricing measure showed that excluding food and fuel, prices rose 0.1% in June from the prior month and was up 1.5% from a year ago.  Total prices rose 1.6% in the year ended June, after advancing 1.7% in May. That is still below the 2% range expected by the Fed but not so far below the target to become a worry…yet.  On the manufacturing side, the Institute of Supply Management’s index was 57.1 in July.  An indicator above 50 is defined as expansionary and this was the highest since April 2011, up from 55.3 a month earlier.

With so many positive indicators, there is little doubt that after a winter-ravaged first quarter, the economy has indeed rebounded in the second quarter as many had anticipated.  The question is can the pace continue to improve?  Also, how fast will the Fed let it happen before they decided that higher interest rates are needed?  We are not economists but expect that the Fed will do as it says and stop the quantitative easing program in October and look to raise rates next year.  Most indicators are pointing towards spring of next year for the first hike.  Yet, as we have seen over the past few years, there are lot of domestic and international events which could conspire to either accelerate or delay this timetable.  Stay tuned.

SGK Blog--Update July 25, 2014: Earnings Season Continues

Before we get to our long list of earnings reports, we’ll take a look at a good week of economic releases.  The consumer price index (CPI) rose 0.3% in June according to the Labor Department.  That matched the median Bloomberg figure and was down slightly from the 0.4% figure from May.  The core measure, which excludes food and fuel, rose just 0.1%.  For the 12 months ended in June, the core measure rose 1.9% and overall measure was 2.1% higher.  That is very close to the “target” level that the Fed is looking for in terms of inflation.  The Fed’s preferred gauge, the personal consumption expenditure price index, rose 1.8% in May from a year earlier.  So, both of these measures are quite close to that “around 2%” goal that Fed chairwoman Yellen has spoken of in the past.  The biggest boost to the CPI came from gasoline costs which rose 3.3%.  A decline in the cost of new cars and hotel rates helped curb the overall gain. 

Sales of previously owned U.S. homes rose to an eight-month high in June.  All four U.S. regions showed gains and resulted in a 5.04 million annual sales rate last month according to the National Association of Realtors.  Prices rose at the slowest pace since March 2012 and inventories rose to an almost two-year high.  Even with the higher stock, at the current sales pace, it would take 5.5 months to sell all those houses in inventory, the same time period as in May.  The median time a home was on the market fell to 44 days from 47 days in May with 42% of homes on the market for less than one month.  First-time buyers accounted for 28% of all purchases, and there are a far lower percentage of distressed deals taking place when compared to two years ago.  Sales of new homes painted a different picture when the Commerce Department reported its data later in the week.  New home sales are tallied when purchase contracts are signed and are considered more timely than existing home sales which are counted when a sale is final.  Sales of newly built homes fell 8.1% to a 406,000 annualized pace, lower than the any economist surveyed by Bloomberg.  One of the biggest issues that remain for both new and existing home buyers is access to mortgage credit.  Thus, the overall outlook for housing is more “measured” than “enthusiastic”.  Confidence among homebuilders rose in July with the National Association of Home Builders/Wells Fargo sentiment measure climbing to a six-month high of 53 from 49 in June.  With the average rate for a 30-year fixed mortgage at 4.13% in the week ended July 17 according to Freddie Mac, that is higher than the 3.35% figure from May 2013. 

What can overcome this uneven data is the fact that more people are employed.  Higher employment has historically led to higher spending and higher home sales.  The number of people filing for first time unemployment benefits dropped in the week ended July 19th to 284,000 according to the Labor Department.  That is the fewest since February 2006.  As we noted before, applications can be quite volatile during the summer because auto makers schedule plant shutdowns in order to change over lines for the production of new models.  Fewer claims suggest employers are reluctant to let staff go and may indicate better sales figures overall headed into the fall.  Michigan, New Jersey and Ohio reported the biggest decrease in claims and those states are known for auto plant employment which might indicate that improving demand for autos at least is here to stay.  The number of people continuing to achieve jobless benefits fell by 8,000 to 2.5 million in the week ended July 12.  With employers adding 288,000 non-farm jobs in June, the hope is that the momentum continues as we enter August, the month of back-to-school shopping which the second most important time of the year for retailers.    We continue to feel that the economy has already achieved a measure of sustainable growth which will take time to present itself in more data.  We have already seen better sales figures from a number of the firms we follow which is a direct result of a healthier economy.  Outside of geopolitical events, there are not a lot of hurdles ahead for the economy as a whole to overcome as we enter a traditionally quiet time of the year in terms of trading.  Of course, events often conspire to lay waste to expectations… 

SGK Blog--Update July 18, 2014: Janet Yellen Testifies Before Senate Banking Committee; Tensions Rise in the Ukraine


The central bank must press on with monetary stimulus as ‘‘significant slack’’ remains in labor markets and inflation is still below the Fed’s goal, Fed Chair Janet Yellen said in semi-annual testimony prepared for delivery to the Senate Banking Committee. Yellen cited labor-market weaknesses even after an unexpectedly fast decline in unemployment put pressure on Fed officials to consider accelerating their timetable for an interest-rate increase. Yellen said today that rates are likely to stay low for a ‘‘considerable period’’ after bond purchases end, which she said could happen following the Fed’s October meeting. Minutes from the Fed’s June meeting, released last week, showed some policy makers were concerned investors may be growing too complacent about the economic outlook and the central bank should be on the lookout for excessive risk-taking. Fed Chair Yellen warned she sees signs of asset price bubbles forming in some markets such as those for leveraged loans and lower-rated corporate debt, while indicating stocks aren’t overvalued. “We’re seeing a deterioration in lending standards, and we are attentive to risks that can develop in this environment” of low interest rates. We would add these are areas of the market we avoid.

Tensions rose sharply in Europe this week centered once again on the Ukraine, causing stock indices to decline sharply in Thursday trading. A Malaysian Airlines jet appeared to have been shot down over eastern Ukraine by a Russian-made mobile air-defense missile, according to U.S. military and intelligence officials. While the matter is still being reviewed, evidence so far indicates that the plane was struck by a weapon known as the SA-11 Gadfly, a widely used system in Eastern Europe. It’s not clear who fired the weapon at the airliner, killing all 295 people on board today, or whether those responsible knew they were shooting at a commercial flight. The government in Kiev blamed pro-Russian rebels and the separatists denied the accusation. Ukraine’s state security service said it intercepted phone conversations among militants discussing the missile strike, which knocked Flight 17 from the sky near the eastern town of Torez, about 30 kilometers (18 miles) from the Russian border. The Boeing 777 was en route to Kuala Lumpur from Amsterdam.   There is a growing belief that Russian-backed separatists in eastern Ukraine or Russia may have mistaken the airliner for a Ukrainian military cargo aircraft. Some of the separatists are veterans of the Russian or Ukrainian militaries who may have been trained on the Gadfly system, a U.S. intelligence official said. This came just as the U.S. and European allies stepped up economic sanctions on Russia for their ongoing involvement in the conflict. The stepped up sanctions and the airplane strike sent Russian stocks tumbling this week and the Russian economy is now threatened with the likelihood of a severe recession taking hold. 

In U.S. economic news, retail sales showed a broad-based gain in June, which probably helped the U.S. economy rebound in the second quarter. Overall sales increased 0.2% after a 0.5% advance in May that was larger than previously reported, Commerce Department figures showed today in Washington. The reading fell short of the 0.6% increase projected by the median estimate of 83 economists surveyed by Bloomberg, restrained by a drop among auto dealers. Demand climbed in nine of 13 major categories last month. Consumers are more comfortable opening their wallets as a strengthening labor market lifts earnings. Higher wages give American households the wherewithal to withstand recent increases in food and gasoline costs that had chipped away at buying power.  

In other economic news, we received relatively good reports on the U.S. manufacturing sector. An early look at July through the Empire Manufacturing gauge suggests that we are definitely witnessing a pick-up in activity as it rose to 25.6 from the prior month’s 19.3 and the expectation of 13.2. Industrial production and capacity utilization for June were not quite so robust coming in just shy of expectations at +0.2% and 79.1% respectively. The National Association of Home Builders index for July was 53 relative to the 50 expected and the prior month’s figure of 49. The closely watched Producer Price Index or PPI, a measure of inflation at the wholesale level, was +0.4% for June which was above the expectation for +0.2%. This is concerning given we need to be wary of any signs that inflation may be building at any level in the economy. When the more volatile food and energy portion was stripped out however, a measurement known as core PPI, the figure came in exactly as expected at +0.2%. Like we don’t have to eat and fill our gas tanks! 

Weekly jobless claims for the week ending 7/12/2014 fell to 302,000 which was below expectations. Adding to stock market declines Thursday was the fact we had a much weaker than expected figures for housing starts and building permits for June as they fell to 893,000 and 963,000 respectively. Economists had been forecasting a pick-up in activity in these areas so this was disappointing. On Friday, the University of Michigan consumer sentiment survey for July was 81.3 versus the expectation for 84 while the index of leading indicators for June rose just 0.3% versus the expectation for an increase of 0.5%. We will have to keep a close eye on the trends in the economic data going forward as many economists were forecasting a very strong rebound in activity in the second quarter here in the U.S. after the sharp slowdown in the first quarter due to the severity of the winter across the country.

SGK Blog--Update July 11, 2014: Markets Trend Lower as Earnings Season Begins  

The minutes of the Federal Reserve’s June policy meeting were released this week.  They agreed to end the monthly bond-buying program by later this year stating: “If the economy progresses about as the Fed expects, warranting reductions in the pace of purchases at each upcoming meeting, this final reduction would occur following the October meeting.”  At its peak, the latest round of quantitative easing amounted to $85 billion per month in U.S. Treasury and mortgage-backed securities.  Starting late last year, the Fed began to “taper” this program generally reducing the amount by $10 billion with the current level set at $35 billion.  This has led to a massive expansion of its balance sheet which currently stands around $4.4 trillion in bonds, loans and other assets.  This was the first time the Fed was explicit about an end date, but simple math revealed that it was going to come to an end within the next six months assuming the current tapering pace continued.

The minutes showed that there remained some difference of opinion.  In terms of employment: “Most participants projected the improvement in labor market conditions to continue, with the unemployment rate moving down gradually over the medium term.”  With the latest monthly reporting showing national unemployment at 6.1% for the month of June, the trend there has been quite positive.  This week jobless claims declined by 11,000 to 304,000 in the week ended July 5 according to the Labor Department.  The median forecast was for 315,000 which suggest that the labor market is gaining momentum as the second half of the year begins.  Upcoming weeks are likely to be volatile as auto plants begin their usual summer shutdowns to retool equipment for new model year cars and trucks.  That is why the four-week average is important to note.  That number dropped to 311,500 last week from 315,000 the week before.

Where Fed officials did not agree was on the subject of financial conditions.  The minutes stated “Favorable financial conditions appeared be supporting economic activity.  However, participants also discussed whether some recent trends in financial markets might suggest that investors were not appropriately taking account of risks in their investment decisions.”  In other words, there may be pockets of excessive risk-taking which is another way of saying that bubbles are forming.  Obviously, the concern is not sharp enough or widespread enough to state specifically or appoint the appropriate agency to take a closer look at.  However, it shows that the policy of quantitative easing does have unintended consequences which we saw a lot of during the heart of the financial crisis back in 2008-2009.  With the Fed still maintaining a zero interest rate policy, the market is fine with the tapering pace.  The real question will arise when the tapering is done and some signs of inflation begin emerging in the economy.  How will the Fed begin to apply the brakes facing a $4 trillion plus balance sheet?  Stay tuned.

SGK Blog--Update July 3, 2014: Economy Adds 288,000 New Jobs in June 

July began on a positive note as a report Tuesday showed manufacturing in China expanded in June by the fastest pace this year. Their purchasing managers’ index rose to 51.0 for June from 50.8 in May, according to the National Bureau of Statistics and China Federation of Logistics and Purchasing. The reading matched economists’ median estimate. A similar gauge from HSBC Holdings Plc and Markit Economics, which some feel is more reliable than statistics provided by the Chinese government, advanced to 50.7 from the prior month’s 49.4. This is a critical gauge because it demonstrates the Chinese government is back on track in their attempts to revive growth in that country back up to the 7.5% annual level. A figure less than 50 signals contraction and earlier in the year that is where the manufacturing measures in China had been coming in. By the time our markets opened Tuesday, European equity bourses were already sharply in the green on the news. 

On the home front, we continued to receive positive data on the economy. Chicago PMI, a measure of the manufacturing sector in that industrial region, came out at 62.6 for June compared to the expectation for 61.0 while pending home sales for May rose at a relatively robust rate of 6.1% compared to the expectation for +1.5%. The Institute of Supply Management’s ISM Index, a gauge of manufacturing across the nation, was 55.3 for June, just shy of expectations. Construction spending in May was also shy of forecasts at +0.1% compared to the expectation for +0.4%. Factory orders for May fell 0.5% compared to the forecast for a decline of 0.4%. We will see if the June numbers pick up as sometimes construction spending and factory orders take a while to kick into gear after a winter like the one we had. The ISM Services Index came out at 56 for June, just shy of the 56.5 expected. 

Thursday’s employment figures were impressive to say the least. The report came out a day earlier than normal because of the Holiday Friday. Employers added more workers than projected in June and the unemployment rate fell to an almost six-year low of 6.1 percent, underscoring a brighter U.S. labor market that will help spur the economy. The addition of 288,000 jobs followed a 224,000 gain the prior month that was bigger than previously estimated, Labor Department figures showed today in Washington.  The median forecast in a Bloomberg survey of economists called for a 215,000 advance.  The number of long-term unemployed Americans fell to 3.1 million, showing they’re having greater success finding work. Factories took on the most workers in four months, while payrolls at private service providers climbed by the most since October 2012. The number of people out of work for 27 weeks or longer -- the so-called long-term unemployed -- decreased as a percentage of all jobless to 32.8 percent, the lowest since June 2009. Payroll estimates of 94 economists in the Bloomberg survey ranged from gains of 145,000 to 290,000 after a previously reported 217,000 advance.  The unemployment rate, which is derived from a separate Labor Department survey of households, fell to the lowest since September 2008.  It was projected to hold at 6.3 percent, according to the survey median. Revisions to prior reports added a total of 29,000 jobs to overall payrolls in the previous two months.  

A separate report from the Labor Department today showed little change in the number of Americans filing applications for unemployment benefits last week, a sign that employers are limiting dismissals. Jobless claims rose by 2,000 to 315,000 in the week ended June 28.  The median forecast of economists surveyed by Bloomberg called for 313,000 claims. Today’s payrolls report showed that private employment, which excludes government agencies, rose by 262,000 in June after a 224,000 gain the prior month. The so-called participation rate, which indicates the share of the working-age people in the labor force, held at 62.8 percent.  Recent strides in the labor market underscore the economy’s snapback from a first-quarter contraction.  The economy shrank at a 2.9 percent annualized rate from January through March, the biggest drop-off since the first quarter of 2009, the Commerce Department reported last month. Consumer purchases grew at the weakest pace in five years. Gross domestic product probably bounced back in the second quarter and will expand at an average 3.1 percent rate in the remaining two quarters of 2014, according to the median forecast in a Bloomberg survey conducted June 6 to June 11. Household purchases are also expected to improve, it showed. Based on the positive news on the labor market, interest rates rose across the yield curve Thursday and gains in stock futures were muted because of the increase in the rate on the U.S. 10-year Treasury.   

SGK Blog--Update June 27, 2014: Economic Data Mixed as We Approach Earnings Season 

The week started out well as we received generally positive news on housing, demonstrating that the market for homes was recovering from our snowy winter. Purchases of new homes in May rose by the most in 22 years. Sales increased 18.6%, the biggest one-month gain since January 1992. The figure came in at an annualized pace of 504,000, according to the Commerce Department, and this far exceeded the average forecast of the 74 economists surveyed by Bloomberg. That information followed the release of data Monday indicated existing home sales in May also exceeded forecasts coming in at 4.89 million relative to the forecast for 4.80 million. The Case-Shiller 20-city Index of housing prices for April rose 10.8%, which is relatively robust even though it came out just shy of estimates. The housing data coincided with a release Tuesday on consumer confidence which also exceeded expectations as it rose for June to 85.2 from the previous month’s 82.2.

Stocks started to trade lower and bonds higher though as the week progressed when we received other important data on the U.S. economy. Durable goods orders for May dropped 1.0% compared to the expectation for a 0.4% rise. Even excluding the more volatile transportation component, the figure dropped 0.1% while that forecast had also been for a 0.4% rise. The same day we had the third revision to 1st quarter gross domestic product (GDP) down to a level of -2.9% compared to the previous estimate of -1.0% and the forecast for it to drop to -1.8%. Although this appears to be a pretty ugly number at first glance, and it was, the market shook it off a bit in the sense that it is viewed as somewhat old news. We know the economy did poorly in the first quarter for a variety of reasons. We are not in a recession though (defined as two consecutive quarters of negative GDP) because of the strength of the economic numbers we have seen since we received the data from the peak of the winter doldrums.  

On balance, there were no real surprises the rest of the week from the standpoint of the economy. Initial weekly jobless claims ending 6/21/2014 were 312,000 compared to the estimate for 310,000. Personal income and personal spending for the month of May came in at +0.4% and +0.2% respectively compared to forecasts of +0.4% on incomes and +0.4% on spending. The closely watched personal consumption expenditures index – a key inflation measurement the Fed observes – came out for May exactly as expected at +0.2%. Not too weak and not too strong is a definite positive! Finally, the University of Michigan consumer sentiment measure for June came in at 82.5 which was up from the prior month’s 81.2 and the expectation for 81.7. It was clearly evident at times this week that traders were paying more attention to World Cup soccer, especially when the U.S. was playing mid-day Thursday, as volumes were low throughout the week and volatility was very limited. It will get interesting as second quarter corporate earnings are released during the month of July and early August. World Cup ends just in time for earnings to really kick into gear!
SGK Blog--Update June 20, 2014: Fed Says U.S. Economy is Rebounding; Raises Interest Rate Forecast for Next Two Years

The Federal Reserve said growth is bouncing back and the job market is improving as ti continued to reduce the monthly pace of its asset purchases. “Economic activity is rebounding in the current quarter and will continue to expand at a moderate pace thereafter,” Federal Reserve Chair Janet Yellen said at a press conference in Washington Wednesday following a meeting of the Federal Open Market Committee. Even with declines in unemployment, “a broader assessment of indicators suggests that underutilization in the labor market remains significant,” she went on to add. The FOMC trimmed bond buying by $10 billion for a fifth straight meeting to $35 billion, keeping it on pace to end the program late this year. Now Yellen and her fellow policy makers are debating how long to keep interest rates near zero as the U.S. labor market improves and inflation moves closer to the Fed’s 2% goal. They did repeat in their statement they expect rates to stay low for a “considerable time” after the bond buying ends.  

What was probably more important than their actual statement, which did not change a whole lot, is the update Fed officials made to their economic forecasts. They predicted their target interest rate will be 1.13% at the end of 2015 and 2.5% by the end of 2016. These rates are higher than they had previously forecast. Also significant, they lowered their long term estimated rate to 3.75% from 4%. By doing this they are acknowledging they expect growth in the U.S. economy to be slower than has been the historic norm. Fed participants estimated long term growth at 2.1% to 2.3% compared with 2.2% to 2.3%. One of the chief concerns we have cited in our weekly is the risk of inflation due to their easy money policies. On this subject Yellen stated, “Inflation has continued to run below the committee’s 2% objective. Low inflation could pose risks to economic performance. At the same time, longer term expectations are still well-anchored.” The personal consumption expenditures index, the Fed’s preferred inflation gauge, rose 1.6% from a year earlier in April, the most since November 2012. The consumer price index, a separate inflation measure, rose 2.1% in May on an annualized basis.  

Lastly, Yellen indicated policy makers are discussing a new set of principles to guide an eventual exit from record easing and expects to announce them later this year, so that should be very interesting. She stated, “The committee is confident it has the tools it needs to raise short-term interest rates when necessary. The Fed will continue to have a very large balance sheet for some time.” That last one is stating the obvious! 

In economic related news this week, capacity utilization and industrial production, both measures of factory utilization which can be indicators of the health of the U.S. manufacturing sector, came out at 79.1% and +0.6% for the month of May respectively. These numbers were basically in-line with expectations. The same can be said for housing starts which came in at 1,001,000 for the month of May, basically in-line with forecasts. Initial weekly jobless claims were as expected at 312,000 for the week ending 6/14/2014 and the index of leading indicators for May was right in-line with expectations as it increased +0.5%. In general, when economic indicators come in so close to expectations, it is considered a positive for stock and bond markets as generally traders dislike surprises, The only worrisome figure that came out this week was the consumer price index (CPI) which rose +0.4% in the month of May alone, which was greater than the forecast for +0.2%. Obviously the Fed would prefer not see to a sharp rise in inflation so this bears watching
SGK Blog--Update June 13, 2014: Equities Retreat on the Escalating Conflict in Iraq 

Islamist fighters extended their advance in Iraq Friday, entering two northeastern towns as government forces failed to halt an offensive that triggered concern over a civil war and prompted the U.S. not to rule out airstrikes. Prime Minister Nouri al-Maliki’s security forces left Jalulah and Saaiydiyah after militants called on them to give up their weapons and leave their posts, according to news reports. The Interior Ministry started to prepare a new plan to defend Baghdad against an attack by members of the Islamic State of Iraq and the Levant, or ISIL. In a sign that the Sunni militants are pushing the country toward another round of sectarian conflict, a representative of Iraq’s top Shiite religious leader called on citizens to carry arms and fight terrorism. He said in the town of Karbala that those killed in a “holy” war would be considered martyrs. The Iraqi insurgency highlights the risks to oil supply from a nation forecast to provide about 60 percent of OPEC’s output growth for the rest of this decade, according to the International Energy Agency. 

The gains made by the Islamic State of Iraq and the Levant, or ISIL, which split from an al-Qaeda affiliate last year, pose the biggest risk to Prime Minister Nouri al-Maliki’s government since the U.S. withdrawal from Iraq three years ago. They also threaten the stability of oil production in the north of the country. The extremists may “eventually” pose a direct threat to U.S. interests, President Obama said in a news conference. “What we’re going to have to do is combine selective actions by our military to make sure that we’re going after terrorists who could harm our personnel overseas or eventually hit the homeland.” Maliki last month asked the U.S. to mount air attacks against militant training camps in western Iraq, according to U.S. officials. Obama yesterday said he wouldn’t rule out that option. He emphasized there are no plans to put U.S. troops on the ground in Iraq. The Pentagon will announce today increased surveillance over Iraq, U.S. defense officials said. This heightened conflict put upward pressure on oil prices which can lead to a drag on economic output as eventually that will translate into higher prices at the pump – especially just as many kids are coming out of school and parents are about to head out on summer vacations. 

Investors are also watching data to determine the strength of the world’s largest economy here in the U.S. Reports yesterday on jobless claims and retail sales fell short of estimates. Retail sales rose 0.3% in May as many American consumers took a respite following a three-month surge in shopping. The expectation was for a 0.7% rise in the May overall figure. Applications for unemployment benefits in the U.S. rose to 317,000 last week. The median forecast amongst 52 economists surveyed by Bloomberg called for 310,000 claims. Wholesale prices in the U.S. unexpectedly fell in May, suggesting demand isn’t robust enough to push inflation closer to the Federal Reserve’s target. The figure came in at -0.2% versus the expectation for +0.2%. The Thomson Reuters/University of Michigan index of consumer sentiment unexpectedly fell to 81.2 this month from 81.9 in May and relative to the expectation for an increase to 82.9. Overall this created a gloomy mood for stock traders this week and the major averages reflected that.

SGK Blog--Update June 6, 2014: Employment Report Highlights Week

The Labor Department reported that nonfarm payrolls grew by 217,000 in May, and the unemployment rate stayed at 6.3%.  The median estimate from a survey of Bloomberg economists was for 215,000 new jobs so the actual number was quite close.  It was the fourth consecutive monthly report above 200,000, the first time that’s happened since early 2000.  Average hourly wage growth was 2.1% for the past 12 months, but the average workweek remained unchanged at 34.5 hours.  On a positive note, the number of discouraged workers—those who are no longer looking for a job because they think they cannot get one—fell to 697,000 last month compared to 780,000 in May 2013.  Also encouraging is the fact that the number of people unemployed for 27 weeks or longer as a percentage of total unemployed fell to 34.6%, the lowest level since August 2008.  Also the underemployment rate—those who are part-time workers who would prefer full-time positions plus those who want to work but have given up—declined to 12.2%, the lowest level since October 2008.  With the current report, all of the jobs lost during the recession have been recovered.  With the 217,000 gain, the nation has surpassed the payroll peak of 138.4 million reached in January 2008, a time right before the country faced the brunt of the worst recession since World War II. 

We also got positive news in the more current weekly employment data.  The number of initial unemployment claims climbed to 312,000 in figures reported on Thursday.  The four-week average for jobless claims fell to 310,250 in the period ended May 31, the lowest since June 2007 according to the Labor Department.  The number of people continuing to receive jobless benefits dropped by 20,000 to 2.6 million in the week ended May 24, the fewest since October 2007. 

Outside of employment, this week’s data continued to point to a strengthening economy.  The Institute for Supply Management’s factor index rose to 55.4 in May from the prior month’s 54.9.  The non-manufacturing index climbed to 56.3 last month from 55.2 in April.  Readings above 50 in either survey signal expansion.  Vehicle sales rose to a 16.7 million annual pace in may, the strongest since February 2007. 

Overseas, the mood is a bit different.  The European Central Bank (ECB) made some well-anticipated moves at their interest rate meeting yesterday.  The main lending rate was reduced to 0.15% from 0.25% and the ECB dropped the rate on bank deposits to -0.1%.  In other words, the central bank is going to be charging commercial banks for keeping their money at the ECB, an unprecedented move for an entity the size of the Europe’s central bank.  Speaking at a news conference, ECB President Mario Draghi said, “We think it is a significant package.  Are we finished?  The answer is no.  If need be, within our mandate, we aren’t finished here.”  Thus, Draghi and his colleagues were prepared to take further “unconventional” measures if Thursday’s measures ultimately prove to be inadequate.  He added: “A broad-based asset-purchase program is certainly one of those instruments.”  The ECB did not hang the banks out to dry, however.  A new series of targeted long-term refinancing operations will give banks access to low-interest rate loans.  The amount they can borrow will be linked to the scale of their new lending.  ECB economists also published new forecasts for inflation and growth which prompted the actions taken by the central bank.  They now expect the annual rate of inflation in 2014 to be 0.7%, down from the 1.0% forecast back in March.  The euro-zone economy is now expected to grow by just 1.0% this year, lower than the 1.2% forecasted at the end of the first quarter.

What do we make of the plan?  It was necessary.  Draghi’s “whatever it takes” rhetoric in past sessions was enough to halt the bleeding at that time but the threat of deflation was becoming too great.  According to him, “We don’t see deflation…we don’t see households postponing their spending plans.”  In our opinion, it’s not a question of postponing, it has become more a question of whether they had any to begin with.  Euro zone inflation weakened to 0.5% in May, the lowest level in more than four years and well below the ECB’s target of around 2%.  That is not a sign of a well-functioning, demand-driven economy.  Japan has grappled with deflation for two decades, so Europe is right to be fearful.  European bourses loved the news with the Germany DAX index briefly topping 10,000 for the first time ever.  In the last five years, it has nearly doubled.  But what’s good for the market may not be good for main street.  The price of the euro has been a key roadblock for the central bankers.  It is slightly weaker versus the dollar year-to-date, but, in the interim, it has shown spikes higher even in the face of a declining economic picture.

Will this plan work?  Time will tell but it’s clear that Europe must do more.  The exports of goods and services comprised 27% of the entire European Union’s (including countries that do not use the euro as currency) GDP.  That compares to 13% for the U.S.  So a slowdown in major markets like China and Japan hurts them much more than the U.S. which derives a much higher percentage of GDP from the output of its citizens buying things from other U.S. citizens.  A higher push to lend via a negative interest rate offers some incentive but, at the margin, there is not much difference between the current 0.1% “fee” and the previous 0% rate.  It is more a nuisance than a real catalyst.  Draghi & Co. have kept the “nuclear option” under wraps; namely, quantitative easing through the purchase of sovereign bonds with no strings, consequences or sterilization attached.  The ECB is now likely to give time for these new policies to take effect then reconvene to see the results.  In fact, the first of the new long-term refinancing operations will not take place until the September, still nearly three months away.  With government bond yields from France to Portugal at low levels, they do not feel pressure to do more as these economies continue to get their fiscal houses in order.  But the combination of still-in-place austerity measures at various locales plus falling commodity prices shows that, unlike what Draghi says, they may not see deflationary pressures but the populous is certainly starting to feel it.

SGK Blog--Update May 30, 2014: GDP Falls During First Quarter

Gross Domestic Product in the first quarter fell at a 1.0% annualized rate as reported by the Commerce Department this week.  This figure was a revision to an earlier 0.1% gain that the government reported last month.  The last decline in GDP was the first quarter of 2011.  The median forecast of economists surveyed by Bloomberg was for a 0.5% contraction.  Companies increased inventories by $49 billion in the three months ended March, less than the $111.7 billion in the final three months of 2013.  This subtracted 1.62 percentage points from GDP, the most since the fourth quarter of 2012.  Ironically, because inventories rose, but not as much as in the fourth quarter, it is deemed as a liquidation and subtracts from GDP growth.  Non-residential investment fell at a 1.6% annualized rate.  Spending for equipment fell 3.1%, the most since the third quarter of 2012.  Consumer spending, which accounts for over two-thirds of GDP, increased at a 3.1% annualized rate and added 2.1 percentage points to GDP.  Many pundits were not concerned with the overall decline because consumers did continue to spend even in the face of harsh winter weather.  Retail sales picked up near the end of the quarter and construction spending also showed signs of improvement as the quarter came to a close.  The median projection for growth in the second quarter is a 3.5% rise.  For all of 2013, the expectation is for a 1.9% gain after a 2.8% rise in 2013.

Recent trends in employment also point towards more improvement.  Initial jobless claims fell by 27,000 to 300,000 in the week ended May 24 according to the Labor Department.  A Bloomberg survey of economists estimated a range from 300,000 to 330,000 after an initial reading of 326,000 in the prior week.  The less volatile four-week average declined to 311,500 from 322,750 the week prior.  The number of people continuing to receive jobless benefits fell by 17,000 to 2.63 million in the week ended May 17.  Durable goods which are items meant to last at least three years, rose 0.8% in April according to Commerce Department figures released Tuesday.  The median forecast was for a 0.7% decline so this was an unexpected surprise higher.  Orders for military hardware rose for the most since December 2012.  There was also a 7% gain in the demand for computers and a 3.4% rise in orders for fabricated metals.  If the housing market continues to improve, albeit slowly, it will create more demand for goods such as electrical equipment and appliances.  Bucking this trend was data released today which shows that consumer spending unexpectedly fell in April.  The Commerce Department said household spending fell 0.1%, the first decrease in a year, after a revised 1.0% rise the prior month that was the strongest reading since April 2009.  Though a bit disappointing, it makes sense that pent up demand that was released in March once all the snow melted and winter storms passed took a breather the following month.  Disposable income rose 0.2% in April after climbing 0.3% in the prior three months.  The risk is that the consumer will fall into a pattern of unimpressive spending during the summer months.  We continue to believe that the economy will show further signs of strength as we conclude the second quarter next month.

SGK Blog--Update May 23, 2014: Earnings Growth Lackluster in First Quarter 

As first quarter earnings season comes to a close, the results can best be described as lackluster. We have written it the past that stock prices tend to be driven over time by two main factors, future projected earnings (or better yet free cash flow) and interest rates. While the backdrop for interest rates remains subdued, earnings are perhaps a little more worrisome. More than 90% of S&P 500 companies have reported their first quarter results to date and profit gains were just 2.1% overall compared with a year earlier and this was well below the prior quarter’s year-over-year gain of 8.5%. Now we are seeing softer reports on industrial production, housing starts, consumer sentiment and European economic growth and overall this is concerning. We can no longer chock up soft data to weather related issues. Analysts are forecasting a 6% gain in year-over-year profits for the second quarter and in our view this is ambitious. Of the companies so far offering guidance, 72% of them have warned that second quarter profits will be below expectations. Thus, earnings expectations for the second quarter need to come down. Particularly given the weakness we have seen in growth in both Europe and China in recent weeks. We never underestimate the predictive power of the yield curve either, and the recent direction has been troubling. If the economy were strengthening, market interest rates should be rising. We are not complaining, lower rates helps stimulate activity and the less the Federal Reserve is involved in terms of manipulating rates the better. At least the yield curve remains upwards sloping, so we can interpret the curve as suggesting that expectations for both U.S. economic growth and inflation remain subdued. If the yield curve were to flatten or become inverted, than that becomes a worrisome event. 

In other important news this week, the Federal Open Markets Committee (FOMC) released the minutes from their April meeting. Policy makers discussed the need to improve guidance on the likely path of interest rates and tools to raise short term borrowing costs. Although they did not see much change in the economic outlook from the meeting prior, the release of the minutes and in particular the discussion surrounding how to communicate future interest rate increases better caused an immediate reaction in the bond market. Treasuries sold off and interest rates rose and in addition the yield curve steepened as the spread between 5 and 30 year Treasuries widened to the most in more than a month. The extent of the interest rate move was muted however as they also discussed the fact that the continued stimulus to push the unemployment rate lower does not appear to be causing a corresponding spike in the inflation rate or an increase in inflationary expectations. This hints that they are comfortable remaining accommodative for now and continuing on their path of gradually reducing accommodation while the economy gains traction. 

The economic news this week was generally positive. The Markit Economics preliminary index of U.S. manufacturing rose to 56.2 in May from 55.4 a month earlier as output accelerated. Readings above 50 for the purchasing managers’ measure indicate expansion and the May figure was the highest in three months. Helping matters in terms of global markets as well was a preliminary reading of a purchasing managers index in China from HSBC Holdings PLC and Markit Economics came in at 49.7, exceeding the 48.3 median estimate of analysts surveyed by Bloomberg and a final reading of 48.1 in April. Although below the magic number of 50, the number is trending in the right direction. Previously owned U.S. home purchases increased in April as a bigger supply of properties lured buyers and raised prospects for a stronger spring buying season. We have also witnessed interest rates decline from where they stood at the end of last year, and this helps home borrowers. The 1.3% gain, the first this year, pushed sales to a 4.65 million annualized rate, National Association of Realtors data showed. The number of available properties climbed to almost a two year high helping slow the pace of price appreciation. New home sales for April, released Friday, rose by the most in six months on the backs of falling interest rates. The 6.4% increase to a 433,000 annualized rate followed a revised 407,000 in March that was larger than initially estimated, according to the Commerce Department in Washington. Economists had forecast a rise to 425,000 in the month of April. Surprisingly, more Americans filed applications for unemployment benefits last week, showing progress in the labor market remains choppy. Jobless claims increased by 28,000 to 326,000 in the week ended May 17 after 298,000 filing the prior week. The forecast of 50 economists surveyed by Bloomberg called for rise to 310,000. With the exception of the labor data however, this was a pretty good week all-in-all.

SGK Blog--Update May 16, 2014: Markets Pause and Bonds Move Higher  

In economic news this week, initial jobless claims fell below 300,000 for the first time since 2007.  In the week ended May 10, jobless claims fell by 24,000 to 297,000 according to the Labor Department.  The forecast was for 320,000 claims.  The four-week average fell to 323,250 from 325, 250 the week before.  The number of people continuing to collect benefits fell by 9,000 to 2.67 million in the week ended May 3, also the fewest since 2007.  Following last month’s 288,000 payroll increase, the economy is showing some strength.  Given that initial claims are a more timely indicator than the jobs report, expectations will be high for the May payroll data to be released on June 6.

On the pricing front, there was more of push upward last month than in previous periods.  The consumer price index rose 0.3% in April, the biggest advance since June, after rising 0.2% the prior month.  Over the past 12 months, prices were up 2% after a 1.5% year-over-year rise in March.  Stripping out volatile food and energy costs, the so-called core measure rose 0.2% which was a little above the median forecast of a 0.1% rise.  The core measure was up 1.8% year-over-year, the biggest yearly change since August.  Producer prices which measure whole goods and services rose 0.6% in April, the largest gain since September 2012.  Over the past 12 months, producer prices rose 2.1% with food prices surging by the most in three years.  An 8.4% rise in the cost of meats helped push up that category.  The producer price core measure, which also strips out food and fuel, rose 0.5% after increasing 0.6% in March.  Good prices rose 0.6% last month while service costs such as airline fares were up a similar amount.  Both the consumer and producer price measures showed that long-term inflation expectations remain stable.  The Federal Reserve has targeted 2% as the preferred target and consumer prices have not reached that level since March 2012.

The story in Europe is different.  The euro area grew just 0.8% at a seasonally adjusted annualized rate in the first quarter as France stalled and Italy shrank.  Germany grew 3.3% but that was not enough to offset weaker territories like Portugal that was down 0.7%.  European Central Bank (ECB) President Draghi said last week that further stimulus was coming in June.  This week word spread that Germany’s Bundesbank was also comfortable with more accommodative measures.  That was a key pivot because German reluctance to any loosening has always been a major roadblock against more forceful action.  Granted, outright bond purchases and unrestrained quantitative easing is not up for discussion, but at least Europe is coming to grips with the fact that the euro area’s recovery from a record-long recession is still quite fragile with the inflation rate at less than half the ECB’s target.  Unemployment was 11.8% in March, near the all-time high of 12% last year.  With the Bundesbank warning that the German economy will slow “noticeably” in the second quarter, the pressure to act is building.

SGK Blog--Update May 9, 2014: Stocks Trade in a Range as Earnings Season Comes to a Close 

Traders shook off the early week doldrums Monday as equity indices began the day on a sour note based on heightened tensions in the Ukraine and weak Chinese manufacturing data, but reversed course at 10 am when the Institute of Supply Management’s (ISM) Services Index was released. This latter figure rose to 55.2 in April from the prior month’s 53.1. A reading over 50 signals expansion and a survey of economists had predicted the figure would come in at 54. Services account for approximately 90% of the U.S. economy so this is an important figure. It shows that the economy continues to shake off the winter blues and weather related issues that occurred during the first quarter. On the flip side, futures had been pointing to a negative open Monday based on the fact that China’s manufacturing industries contacted for a fourth month in April. HSBC Holdings Plc and Markit Economics said Monday their purchasing managers’ index for China came in at 48.1. That missed the median estimate of 48.4 and numbers below 50 signal a contraction. JP Morgan also hit markets Monday with a warning that fixed-income and equities trading revenue would be down about 20% from a year earlier amid “a continued challenging environment and lower client activity levels.” Violence in the Ukraine made headlines over the weekend amid the tragic situation there and that made traders jittery as well at the week’s outset.

American workers were less productive in the first quarter as harsh winter weather prevented some from getting to their jobs, causing the economy to stall. The measure of employee output per hour (productivity) dropped at a 1.7 percent annualized rate, the weakest reading in a year, after rising at a 2.3 percent pace in the last three months of 2013, a Labor Department report showed. The median forecast in a Bloomberg survey of 59 economists called for a 1.2 percent drop. Unit labor costs climbed at a 4.2 percent rate, more than estimated. The pullback in productivity came as snow and unusually cold weather covered much of the U.S., depressing economic activity as consumers stayed indoors and companies put off investment plans. As growth recovers in the months ahead, some companies may be induced to either take on more workers or invest in equipment to keep up with demand. Productivity is important because it helps determine the pace at which an economy can grow without stoking inflation, which economists term its speed limit. That reflects the rate of growth of the labor force plus how much each worker can produce. Smaller gains in productivity therefore mean advances in gross domestic product will also be restrained. Last quarter’s increase in expenses per worker, which are adjusted for efficiency gains, was the biggest since the last three months of 2012. Costs were forecast to rise 2.8 percent last quarter, according to the Bloomberg survey median. This spike in unit labor costs is concerning because high labor costs can squeeze corporate profit margins and also because labor costs are a key metric in the calculation of inflation measures. Lower margins and higher inflation are a major headwind to advancing stock prices so this bears close watching in the months ahead. 

The Treasury market’s yield curve steepened this week by the most in almost eight months after Federal Reserve Chair Janet Yellen eased investor concern that policy makers would accelerate interest-rate increases. Five-year notes, more susceptible to changes in Fed rate policy expectations, outperformed 30-year bonds after Yellen told Congress in testimony Thursday rates are unlikely to rise unless the recovery is stronger.  U.S. job openings fell in March, a report on Friday showed.  Demand for Treasuries at this week’s note and bond auctions fell to the weakest level in seven months on bets a rally may have gone too far, too fast. Basically shorter term rates stayed relatively flat this week while longer term rates rose. In our view, Janet Yellen definitely moved the needle for when rates rise to the back half of 2015 as she confirmed her dovish bias with her discussion this week. We had been concerned as rates had flattened out and the yield curve is one of the best predictors of a slowing economy.

SGK Blog--Update May 2, 2014: GDP Figures Reflect Harsh Winter  

The Labor Department released non-farm payroll numbers for the month of March and the numbers at first blush were impressive. The 288,000 gain in employment was the biggest since January 2012 and followed a revised 203,000 increase the prior month that was stronger than first estimated, Labor Department figures showed.   This handily surpassed the expectation for a 210,000 increase and showed that the economy rebounded from the bad weather months of December-February. Unemployment dropped from 6.7 percent to the lowest level since September 2008 as fewer people entered the labor force.  The jobless rate plunged to 6.3 percent from the previous month’s 6.7% figure as companies grew confident the U.S. economy is emerging from a first-quarter slowdown. Gains in equities on the strong report was tempered by increased violence in the Ukraine during the Friday trading session, and that made traders reluctant to be long stocks heading into the weekend.

Gross domestic product grew at a 0.1% annualized rate during the first quarter, compared with a 2.6% gain in the fourth quarter according to figures released by the Commerce Department on Wednesday.  The median forecast of 83 economists surveyed by Bloomberg called for a 1.2% increase.  This is an “advance” reading which means this figure will be revised twice more.  The second estimate will be based on more complete data and is scheduled for release on May 29.  Many pundits attributed the shortfall to the severe winter weather than blanketed much of the middle and eastern U.S.  Average snow cover in the contiguous U.S. from December through February was the 10th largest for the period since 1966 according to the National Oceanic and Atmospheric Administration.  New York, Philadelphia, Boston and Chicago each had one of their 10 snowiest winters ever.  Real exports fell 7.6% in contrast to a 9.5% increase in the fourth quarter.  Real nonresidential fixed investment fell 2.1% in contrast to a 5.7% rise in the previous quarter.  Real personal consumption expenditures, which comprises the lion’s share of GDP, rose 3.0% compared to a 3.3% in the fourth quarter even with the pressure on retailers from the harsh weather.  Services, which is a subsector of this area, accelerated to a 4.4% increase versus the 3.5% increase in the final quarter of last year.  Thus, the headline number may be weak, but looking at the details shows that the economy continues to chug along at a nice pace.  Moreover, all of this data is “backward” looking.  We are already in May and the most recent data we see—from weekly initial unemployment claims, monthly consumer and wholesale pricing data and monthly purchasing managers’ surveys show that the Federal Reserve’s outlook for a slowly strengthening economy remains on track.  A separate Bloomberg survey of economists shows that growth will pick up to 2.7% pace for all of 2014 which means that a lot will be expected of the last three quarters of the year if this advance GDP number sticks through future revisions.  The latest consumer spending data shows that March was a bumper crop month for individuals to hit the auto-dealer lots and malls.  It rose 0.9% according to the Commerce Department, the most since August 2009, after a 0.5% gain in February that was larger than previously estimated.     

Speaking of the Federal Reserve, they conducted a regularly scheduled meeting of the Federal Open Market Committee this week.  The result was as expected which meant it was largely overlooked by the market.  While acknowledging that growth has picked up recently, the Fed said that labor conditions remain “mixed” and the unemployment rate “remains elevated.”  In fact, the weekly initial unemployment claims were a bit elevated this week compared to consensus.  In the week ended April 26, jobless claims rose by 14,000 to 344,000 while the median forecast was for a rise of 320,000.  Springtime data is often overly influenced by the Easter holiday and spring break items, so too much stock cannot be put into this uptick.  The trend remains for lower firings.  Therefore, beginning in May, they will taper their purchases of mortgage-backed securities and U.S. Treasuries to a total of $45 billion per month from the current pace of $55 billion per month.  They will likely continue scaling back purchases in steady steps unless the economy or broader geo-political climate throws them for an unexpected loop somehow.  Since that appears to be a remote possibility, the market is working under the belief that by mid-term elections, the Fed could be all tapered out.  Then the real guessing begins:  When will they start to raise rates explicitly?  Chairwoman Janet Yellen, after some unscripted remarks at the March post-Fed meeting press conference, has been more direct in her main message.  That is, a “wide range” of economic indicators will be used including labor, financial and market indicators rather than one figure or a given time frame.  Her desire to build consensus among the Fed governors is evident in this meeting’s result being voted upon unanimously.  Granted, there are three empty seats on the policy voting committee as those vacancies have not been filled yet.  Regardless, the Fed is showing a unified, calming presence to the market as the summer months approach. 

Meanwhile, the European Union’s statistical agency reported that consumer prices rose by 0.7% in April from a year ago, a slight pickup from the 0.5% March figure, but still way below the target of closer to 2%.  April was the seventh straight month in which inflation was less than half the target rate.  European Central Bank (ECB) officials thought that last month would see a pickup thanks to Easter travel and shopping and the introduction of warmer temperatures spurring seasonal merchandise and service sales.  Admittedly, ECB President Mario Draghi thought April would “pick up somewhat” and then remain low in subsequent months before rising to the target rate by late 2016.  That might very well occur, but that is over two years away, and businesses are not likely to thrive in an environment of such “lowflation.”  The ECB cut its benchmark rate last October when inflation first dropped below 1%, but in the interim it has done nothing of consequence.  We did see a rise in the service inflation to 1.6% and net demand for corporate loans turned positive for the first time since the second quarter of 2011.  Those are positive data points but remain more anecdotal than sustainable.  The ECB is reluctant to implement more quantitative efforts like we see here in the U.S., but eventually they may be forced to do so.

SGK Blog--Update April 25, 2014: Economic Data Mixed Amongst Earnings Deluge 

This was a mixed week in terms of the economic data we received on the U.S. economy. On the one hand, figures for manufacturing showed a rebound from the effects of the winter doldrums, but the housing data seemed to indicate deeper issues than just a weather related slowdown. Durable goods orders for March came in much stronger than expected. These are goods designed to last longer than one year so it would include appliances, airplanes, etc. The overall number showed an increase of 2.6% compared to the 2% forecast while excluding the more volatile transportation sector the figure was +2.0% compared to the estimate for +0.5%.  The big gains were driven by the highest increase in computers and electronics orders since November 2010. This may have been helped by Microsoft’s decision to end support for Windows XP at the end of March.  Initial weekly jobless claims for the week ending 4/19/2014 were higher than expected at 329,000, but this does tend to fluctuate week-to-week and the basic trend over the past few weeks has been heading in the right direction, which is lower. 

Housing data released this week was more concerning. Although existing home sales at 4.59 million for March was basically in-line with expectations, new homes sales at 384,000 for the same month was well below the expected 455,000 figure. New home sales are counted when contracts are signed so it is a more current measure of the health of the housing market. Home builders from NVR to Toll Brothers have also noted that they have seen a recent sharp slowdown in activity. The Wall Street Journal noted in a front page article Friday that overall mortgage lending (both home purchases and refinancing) declined to the lowest level in 14 years in the first quarter of the year. They attributed this to a combination of higher interest rates but also higher housing prices, particularly in certain parts of the country. They noted that the average 30-year fixed rate mortgage stood at 4.5% last week compared to 3.6% just last May. That may still seem low by historical standards but consumers have been used to low rates for quite some time, and combined with tougher lending requirements, it clearly has had a negative impact on overall lending activity. 

Tension remain high in Europe as the situation in the Ukraine remains highly unstable and very unpredictable. Five rebels were killed by Ukrainian forces at a checkpoint on Thursday, causing Vladimir Putin to warn the Ukraine against continuing their offensive against pro-Russian forces. More troubling is the fact that he has 40,000 Russian troops amassed along the border with the Ukraine and they stepped up exercises in the area as a result of the conflict. The situation creates heightened uncertainty across European economies. In response, European Central Bank President Mario Draghi indicated the bank may start broad-based asset purchases in a radical shift similar to our central bank’s stimulus efforts if the inflation outlook in Europe worsens. He gave a speech in Amsterdam where he stated, “the objective here would not be to defend the current stance, but rather to increase meaningfully the degree of monetary accommodation.” He went on to say, “the Governing Council is committed – unanimously – to using both unconventional and conventional instruments to deal effectively with the risks of a too-prolonged period of low inflation.” That sounds eerily familiar to our central banks stance over the past several years. Clearly they have been monitoring our progress with unconventional forms of stimulus carefully. In other European news, German business confidence unexpectedly rose in April, signaling optimism that Europe’s largest economy may withstand risks from the tension in the Ukraine and price weakness in the area. If a major conflict breaks out in the Ukraine however, then all bets are off!
SGK Blog--Update April 17, 2014: Earnings Season Begins 
The consumer price index climbed 0.2% in March as food and rents rose according to the Labor Department.  Excluding the volatile and fuel and food categories, the so-called core figure rose the same 0.2% after rising 0.1% the previous month.  Over the past year, the overall increase has been 1.1% with the core up 1.7%.  These figures remain below but still close to the sweet spot the Federal Reserve is looking for around the 2% range.  The Fed stopped short of including a “quantitative element” as part of its outlook.  They tried using such static figures on the employment front but found that wanting as well once the guidepost came into range without the economy responding the way they had hoped.  Instead, they will consider a multitude of factors according to the minutes of the Federal Open Market Committee’s latest meeting last month.  At the least the U.S. is not alone in terms of below-expected inflation.  According to data covering 121 economies tracked by Bloomberg, nearly two-thirds are experiencing smaller gains in consumer prices than a year ago.  This is a big topic especially in Europe where their latest price figure was nearly flat and fears of deflation are becoming more pronounced.

Even if prices are not rising, American consumers have released some of their cold weather-suppressed pent-up demand when it comes to retail sales.  The Commerce Department reported that sales rose 1.1% in March, the biggest gain since September 2012.  Plus, February’s figure was revised upwards more than twice as large as previously reported.  Ten of 13 categories showed an increase.  Sales excluding gas stations rose 1.4%, the most since March 2010.  One of the biggest contributors was the jump in auto purchases.  Sales at auto dealers rose 3.1% in March after rising 2.5% in February.  Not surprisingly, as the weather warmed somewhat in March, dealerships become busier.  Cars and light trucks sold in March at a 16.3 million annualized pace, the fastest since May 2007 according to data released by Ward’s Automotive Group.  But buying was not limited to cars, consumers spent more at department stores, sporting-goods outlets and building-supply shops.  Internet sales also rose.  With jobless claims this week hovering near their lowest level since 2007, companies may not be robustly hiring but dismissals are certainly on the decline.  The last time the four-week average of claims was this low was October 2007 which was the month and year that marked the previous market peak.  That marked a high point for employment before the financial crisis began in earnest the following year.  Currently, we are seeing employment begin to pick up after being stagnant for years.    

Meanwhile, housing starts climbed 2.8% to a 946,000 annualized rate in March according to the Commerce Department.  Permits for future projects declined 2.4%.  Work on single-family properties rose 6% while construction of multifamily projects such as condominiums and apartment buildings fell 3.1%.  The National Association of Home Builders/Wells Fargo builder sentiment rose to 47 in April from 46 in March.  Readings above 50 mean more respondents report good market conditions.  Thus, we have seen both severe winter weather as well as less affordability via a higher interest rate affect the market.  The average 30-year, fixed rate mortgage was 4.34% for the week ended April 10 according to Freddie Mac.  This compares to 3.43% a year ago.  In general, the U.S. requires between 1.6-1.9 million new units a year to accommodate population growth and household formation according to the Harvard Joint Center for Housing.  So while the market is returning to health, builders have yet to supply the needed capacity.  That bodes well for future demand, but presently it remains a data point in the not too hot, not too cold economy. 

SGK Blog--Update April 11, 2014: Global Equity Indices Are Choppy Ahead of First Quarter Earnings Season  

Before earnings season officially got underway this week, analysts’ forecasts for profits for companies in the S&P 500 index indicate a decline of 0.4% compared to the comparable quarter last year, according to FactSet.  This would mark the first drop in operating profit since the third quarter of 2012 and represents a downward revision of the estimates 3 months ago at year end when analysts’ had forecast an increase of 4.4%.  Can we put all the blame on the “polar vortex” (sorry to bring up that term again!) that settled over the Midwest and Northeast and swept in snowstorms that shuttered businesses and government offices, snarled highway traffic and grounded thousands of flights?  Or is this just a classic case of analysts’ revising down their forecasts as we get closer to the timing of corporate releases.  It seems a familiar pattern, although this quarter companies have issued negative guidance at a near record pace with 93 members of the S&P warning that first quarter profit could miss forecasts.  The reality though is bad weather did in fact halt construction projects, disrupted rail lines and hurt auto sales.  Even if people could get to a dealership, who wanted to take a test drive in six inches of snow!

Stocks continued their retreat in early week trading, especially the high flying momentum stocks in the biotech and social media space that had been so strong last year.  Valuations were skewed and a number of these high profile names such as Facebook, Biogen and Vertex Pharmaceuticals fell sharply during the period when the NASDAQ declined so abruptly.  It seemed almost all stocks in the NASDAQ were subject to the move away from the momentum players, but we tend to hold names such as Amgen and Check Point Software Technologies that trade at much more reasonable valuations, and those securities held up better during the downdraft.  A big part of this pullback is based on the notion that it will be challenging for many companies to deliver on earnings expectations and therefore, how does one actually justify the price relative to earnings of a company such as Amazon or Netflix?  Many stocks simply got way ahead of themselves and were overdue for a correction.

U.S. equities got a bit of a lift in Wednesday trading when the minutes of the Federal Reserve Open Markets Committee (FOMC) were released.  Several Fed policy makers said a rise in their median projection for the main interest rate exaggerated the likely speed of tightening, according to minutes of their March 18-19 meeting.  Even after rates rise, officials said last month, they might have to be kept at levels considered below normal for longer because of tighter credit, higher savings and slower growth in potential output. Treasury yields rose last month after policy makers predicted that the benchmark interest rate would rise faster than previously forecast.  Janet Yellen, presiding over her first meeting as chair, later downplayed the importance of the forecasts, even as she said that rates might start to rise “around six months” after the Fed ends its bond-purchase program.  Again, this helped calm traders fears and we witnessed “short covering” particularly in names that had sold off hard recently. 

In other economic news, the fewest number of Americans since before the last recession filed applications for unemployment benefits last week, pointing to more progress in the labor market.  Jobless claims decreased by 32,000 to 300,000 in the week ended April 5, the lowest since May 2007, a Labor Department report showed Thursday.  The figure was lower than the most optimistic forecast in a Bloomberg survey of 52 economists.  A report also released Thursday showed China’s exports and imports unexpectedly fell in March, adding to concern that expansion in the world’s second-largest economy will deteriorate further.  Premier Li Keqiang said the nation will roll out more policies to support growth while avoiding stronger stimulus.  Attention was squarely focused on the economic data being released worldwide this week while that attention will likely shift to the health of corporations as we get into the thick of earnings releases over the next 3-4 weeks.

SGK Blog--Update April 4, 2014: Payrolls rise by 192,000; Unemployment Rate Steady  

The Labor Department reported that March saw an increase of 192,000 in non-farm payrolls.  February’s totals were revised higher to 197,000, up from the 175,000 gain announced in early March.  The median forecast in a Bloomberg survey of economists projected a rise of 200,000 so the final number was a little shy but not by too much especially in light of the previous month’s revision.  In fact, both January and February were revised higher—by a total of 37,000—which means that poor winter weather did not have as much of a detrimental effect as originally thought.  Private payrolls, which do not include government agencies, rose by 192,000, the most in four months.  With March’s increase, total private payrolls reached 116.1 million, surpassing the pre-recession peak.  When government agencies are included, the U.S. has recovered all but 437,000 of the 8.7 million jobs lost during the last recession.  The report also showed an increase in hours worked which is taken by many to be a precursor of continued job gains in the future as current workers become less productive and employers turn to new hires to maintain output.  A jump in temporary workers by 28,500 is another sign of future hiring.

The unemployment rate, derived from a survey of households, held steady at 6.7%.  The labor force participation rate rose to 63.2% from 63.0% last month which was a good sign because it showed that more workers are trying to enter the workforce, yet overall that had no effect on the number of those employed.  We still remain far removed from the 65.7% rate that existed when the recession was deemed over at the end of June 2009.  Regardless, there were many positives in this month’s report.  Janet Yellen’s Federal Reserve said it would stop using the unemployment rate alone as a determining factor when the central bank might start raising short-term rates.  As such, traders and investors will be looking at every detail of the employment situation.  More workers and higher participation might be viewed as a sign that things were heating up quickly.  However, average hourly earnings month-over-month was flat and year-over-year it was up only 2.1%, below the market’s expectation of a 2.3% rise.  We will get another dose of data next Tuesday when the Labor Department will release their JOLT report which gives a view of job openings.  It will track how willing people are to quit their current job and how hard, in their estimation, it is to find a new one.  Our conclusion is that the winter weather did indeed mask some of the economic growth that we saw building during the last months of 2013.  There still remains slack in the labor market which is what we saw with a rise in the initial unemployment claims data this week.  The global pool of labor continues to grow rapidly, so the firming of prices is unlikely until sometime later this year.  We continue to believe that the economy continues headed in the right direction.

Overseas, the European Central Bank (ECB) is dealing with conflicting signals.  The euro zone is expected to emerge with a GDP growth of 1.2% this year after last year’s contraction, but unemployment remains near a record high.  Euro zone inflation slowed to 0.5% in March, the lowest level since November 2009, which is pressuring companies who are having a hard time raising prices.  ECB Vice President Vitor Constancio said on April 1 that he expects “the low figure in March will be corrected to a high figure in April”.  ECB staff projections show the rate climbing to 1.5% in 2016.  According to the International Monetary Fund’s Christine Lagarde, the euro zone needs more monetary easing.  ECB president Mario Draghi has pledged since September 2012 to buy bonds of stressed countries if their governments commit to reforms.  German Bundesbank leader Jens Weidmann has in the past criticized such pledges and other quantitative easing measures. 

International investors are returning to the region with buyers emerging for Spanish and Italian bonds and Greece contemplating the first public offering of debt since it was frozen out of the markets years ago.  We think the market is telling the ECB that the common currency bloc needs a lift—whether that is through QE or new long-term loans to banks or posting a negative deposit rate virtually forcing money centers to lend out excess cash rather than lose it via “negative interest” while sitting at the ECB.  It is wise to listen to what the market is saying—politicians usually don’t lose their jobs giving the people what they want.  A far more difficult question is dealing with what the markets actually need.  The key to that answer is determining correctly whether the current trend of low prices is cyclical or secular.  If it is the former, then a sit tight approach is correct.  If it is the latter, then much more is needed from the ECB to fend off even the hint of deflation.  Stay tuned. 

SGK Blog--Update March 28, 2014: Global Stocks Hold Steady in the Face of Rising Tensions in the Ukraine 

As the quarter comes to a close, traders were focused on events going on globally and the data coming out on the economy. Stocks were weaker during the week when Obama spoke out against the actions taken by Russia in annexing Crimea, formerly part of the Ukraine. When rhetoric rises, tensions mount and traders get nervous. It is hard to imagine Russia stepping up their occupation of other portions of the Ukraine, but Putin is notoriously unpredictable. The actions he has taken to date have been enormously popular at home, even if not good for the broader economy or stock market in Russia, not to mention the decline in the relative value of the ruble – their currency. With all that said, Russian military exercises continue near the Ukrainian border as Putin is clearly sending a signal that he will not be swayed by western sanctions or talk. Countering tensions in Eastern Europe, there was speculation amongst traders this week that the recent data coming out of China in terms of their exports and industrial production would prompt the government to take measures to stimulate their economy. So the weaker than expected Chinese manufacturing data for March that came out on Monday actually helped stock indices firm up and even rise this week in anticipation of possible stimulus measures being taken at some point. 

Helping equity indices remain resilient this week was the important data that came out giving us insights into the health of the U.S. economy. We are just now getting over the measurement period that was heavily impacted by weather related issues that hit the country in January and February. Housing data tends to come out with the most significant lag, as it takes time to pull together. The Case-Shiller 20-city Index showed that housing prices rose in January 13.2% year-over-year continuing the trend towards a recovery in that sector. New home sales for February were 440,000, slightly below expectations, while pending home sales for the same month decline 0.8% which was worse than expected. Part of this we can attribute to weather, but other factors include the aforementioned rising house prices, which brings affordability into question, and also rising mortgage rates. Personal incomes for February rose 0.3%, slightly better than expected, while personal spending for the same month also rose 0.3%, which was in-line with expectations. The personal consumption expenditures index, or PCE for short, is a measure the Fed uses to gauge inflationary pressures in the economy and it came in exactly as expected at +0.1%, which is good. 

Orders for durable goods for February were much higher than expected at +2.2%, but excluding the more volatile transportation segment, the increase was only 0.2% which was actually slightly below expectations. As far as March is concerned, initial weekly jobless claims for the week ending 3/22/2014 were better than expected at 311,000 compared to the forecast for 330,000. We also had two measures of consumer confidence for March released this week with the Conference Board’s measure rising to 82.3 from 78.3 in February and compared to forecasts for a figure of 78.2, while the University of Michigan consumer sentiment survey came in right in-line with forecasts at 80.0. Thus, we can conclude the American consumer and U.S. businesses have remained resilient in the face of snowy and cold conditions!
SGK Blog--Update March 21, 2014: Fed's Message Gives Markets Pause 

In her first press conference at the helm of the Federal Reserve, Janet Yellen left the markets with something to remember. The Federal Open Market Committee met as scheduled and offered no bombshells when it released its conclusions in the usual post-meeting press release. It stated: “Labor markets were mixed but on balance showed further improvement.” They also said: “Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.” Beginning next month, the Committee will reduce its monthly purchases of agency mortgage-backed securities and longer-term Treasury securities from $65 billion per month to $55 billion per month. The hope is that the “sizable and still-increasing holdings” will continue downward pressure on longer term rates, help the housing markets and provide further fuel for a still recovering economy. As expected, they also stated that they expect to further taper such purchases in the coming months assuming “ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.”

Here is where things got tricky. Everyone who invests or lends money is wondering how long the Fed will keep being accommodative. It’s one thing to taper purchases down to zero, and quick math says at the current $10 billion reduction per month, that should be done by the fall of this year. It is another thing to actually raise rates. That is important distinction is what former chair Bernanke spent the second half of last year trying to get the markets to understand. It is not that Yellen undid those efforts, but her responses during the press conference created more doubt about when that would happen. The Fed Committee’s statement merely said that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends.” Not exactly a “save the date” type statement. Yellen, when asked to clarify the timing more exactly, said it is “hard to define” but that it could mean “something on the order of around six months or that type of thing.” Another quick math exercise results in the Fed raising rates by April 2015. The market did not expect that although the Fed also released quarterly updates to its central tendencies and ranges of economic projections that saw 13 members expecting policy firming in 2015. The exact date of that firming was not stated in the projections, however. But thanks to Yellen, we now know the answer.

What is our take? Much ado about nothing. The Fed statement said their “assessment will take into account a wide range of information” and went on to lists four indicators including labor market conditions and “readings on financial developments” (whatever that means). In her press conference, Yellen herself mentioned 10 different labor-market indicators she is tracking including the rate at which people are quitting their jobs and portion of workers in part-time positions. Thus it would be naïve to assume that come April 2015, the Fed will flip a switch and the fed funds rate will rise on cue. Were the markets expecting a rate increase? Yes, someday, but clearly the sharper path for a potential hike was not in the cards which led to the Dow Jones Industrial Average selling off around 210 points on Wednesday afternoon before rebounding into the close. This confusion was bound to happen because the Fed has shifted from giving timelines via their quarterly central tendencies to using more quantitative measures like the 6.5% unemployment rate threshold. Yellen made a point to state that the Fed was going to drop such direct measures in favor of a broader array of indicators within no set timeline. The real message to take from all of this is that after all-time highs in some equity indices and a long-term 10-year Treasury bond that remains lower than what some might expect, there are a lot of nervous investors out there.

Recently released data shows that the economy continues on the pace of slow but steady improvement. Initial jobless claims rose by 5,000 to 320,000 in the week ended March 15th according to the Labor Department. The less volatile four-week average fell to the lowest level since late November. The number of people continuing to receive jobless benefits remains near a three-month low. Inflation was little changed in February with the consumer price index increasing only 0.1% from January in the latest Labor Department report. The twelve month gain was only 1.1%, the smallest since October and considerably below the preferred guideline of about 2% the Fed looks for. Excluding food and fuel, the so-called core measure was up 1.6% year-over-year, the same as in January. The housing market presented a bit of a downer this week as sales of existing homes fell in February to a 4.6 million annual rate according to the National Association of Realtors. Prices rose 9.1% with the median price up to $189,000. The slowdown can be traced to a number of factors: higher borrowing costs, declining affordability, tepid job growth and, very importantly, bad weather. Not surprisingly, the endless winter has dampened the desire to drive around unfamiliar neighborhoods in search of a new abode, and it has hampered closings for deals which do get done. According to data provider Planaytics Inc., February ended with its cold final week since 2003 with the second week being the snowiest such period since 2007. At the current sales pace, it would take 5.2 months to sell the approximately 2 million previously owned homes currently on the market. That compares to the 4.9 months supply in January. Below 5 months is considered a tight or sellers market so we are not that far removed from healthy conditions even with the slight setback last month. Housing starts reported by the Commerce Department were little changed in February from January’s numbers. The 907,000 annualized pace was not far from the 910,000 median figure reported in a Bloomberg survey. On a positive note, permits filed for future construction surged 7.7%, the most since October. Nevertheless, it really will not be until April when a true picture of health can be determined and, hopefully, the disruptions of winter are put behind us.

SGK Blog--Update March 14, 2014: Global Stocks are Weaker on China Data and Heightened Ukraine Tensions 

Global stock indices were generally negative this week on concerns over weakness in export data coming out of China and on concerns the situation in the Ukraine would escalate. China experienced that country’s first bond default as China’s Chaori Solar failed to make an interest payment. As the world’s second largest economy, China draws a great deal of attention when it comes to headlines. China’s exports unexpectedly tumbled 18% in February, even though a good portion of that slide was attributed to the timing of their Lunar New Year holidays during which, as far as we can tell, hardly anybody seems to do productive work in that country! However, given we here in the U.S. are also significant importers of Chinese goods, it also raises questions about how big an impact our lousy weather in February has had on the global economy. Certainly, our expectation is that we will see a weather related impact on first quarter earnings as companies begin to report in about a month’s time. We do not own the stock, but a major American company DuPont warned that their first quarter earnings would be negatively impacted by “the cold and the Ukraine.” As China is such a large manufacturer of goods globally, commodity prices sharply declined on the export news and this put pressure on the currencies of commodity driven countries such as Australia and Canada. Later in the week we received additional data indicating that Chinese industrial output, investment and retail sales growth cooled more than estimated in January and February and this contributed to a sharp decline in stock prices in Thursday trading and particularly overnight in Asian markets. 

Not helping matters, tensions between Russia and the Ukraine added to investor unease. In Crimea, unidentified armed men fired in the air as they moved into a Ukrainian naval post in the latest confrontation since Russian military groups seized control of the Black Sea peninsula. There does not appear to be a quick resolution to this conflict in site and tensions between the U.S. and Russia continue to mount. If the situation is not resolved peacefully then this would have a ripple effect across European economies, which have just recently turned the corner as a number of countries rely on Russian exports of commodities such as natural gas to drive their production. We can certainly hope for a peaceful resolution, but a quick end to the matter does not appear to be in sight. 

In U.S. economic news this week, the story was somewhat mixed. Thursday’s data releases were strong, which in a strange way may have contributed to stock market declines here as it reinforces the notion that the Fed does not need to keep buying Treasuries and mortgage-backed securities each month. Their stimulus program is expected to continue to be reduced by $10 billion in purchases after each FOMC meeting with the target end date prior to year end. The strong data on retail sales and initial unemployment claims supported this view. Retail sales rose 0.3% in February, excluding autos it rose the same amount, versus expectations for both figures to rise 0.2%. This was welcome news as clearly retailers in many parts of the country were impacted by the weather. Initial weekly unemployment claims fell to 315,000 for the week ending 3/8/2014 which was well below the expectation for 329,000 and the prior week’s figure of 323,000. 

A significant risk to markets for 2014/2015 would be if we saw indications of inflation accelerating in the economy. Friday’s release of the producer price figures was welcome from that standpoint. PPI actually declined 0.1% for February and excluding the more volatile food and energy segment, referred to as core PPI, this decline was actually 0.2%. The expectation was for an increase of 0.2% for PPI and 0.1% for core PPI. One factor though that is worth noting, Janet Yellen has indicated that the Fed needs to look at broader indicators to gauge the health of the labor market other than just the unemployment rate. In the last employment release, the rate for those that have been out of work less than 27 weeks (short term unemployed) was just 4.2%. This is an indicator that some parts of the labor market are actually tightening. Two points to make here, labor is a key cost component for any company. As labor costs rise, margins get squeezed and that is a clear negative for the stock market. Second, tighter labor markets and rising wages can lead to inflation, as this is key metric in many of the measures the Fed uses to gauge inflationary pressure in the economy. Inflation leads to higher interest rates which in turn would present a major headwind for the stock market. So this bears watching closely. Finally, the University of Michigan released their consumer sentiment survey for March and this came in at 79.9, which was below the expectation for 82.0. This may be an indication that consumers are paying attention to events as they transpire in the Ukraine and are worried. It may also be a by-product of the fact that for many high income tax payers, especially those that spend and help drive the U.S. economy, they saw sharp increases in their tax bills this year thanks to the new higher rate for the top bracket and the new tax – the Medicare surcharge on unearned income as part of President Obama’s Affordable Care Act. This latter tax was new for 2013.

SGK Blog--Update March 7, 2014: Employment Rises Above Expectations  

According to the Labor Department, employers added 175,000 non-farm jobs in February.  This followed a revised 129,000 increase the prior month.  The median forecast for February was for a gain of 149,000 with a range of +100,000 to +220,000 according to a Bloomberg survey.  The unemployment rate climbed up slightly from 6.6% to 6.7%.  Private employment, which excludes government agencies, saw payrolls rise by 162,000 after a gain of 145,000 in January.  The now closely watched participation rate, which measures the percentage of people eligible for jobs actually working, held steady at 63.0%. The payroll data is constructed from a survey of businesses while the unemployment rate is comprised of household responses. 

The labor market improvement is one of the reasons why the Fed has begun dialing back its bond buying by $10 billion per month as part of its quantitative easing program.  A big question facing today’s data release was how much weather would affect the results.  The week ended February 15 was the coldest second week of February since 2011.  The South Atlantic region, according to weather-data provider Planalystics Inc., saw the most snowfall since 1983.  February’s conditions followed the chilliest January in three years.  The government data shows that 601,000 people were not at work because of the weather during the survey week, the most since 2010.  Hours worked declined as well with the average workweek falling to 34.2 hours last month, the lowest since January 2011.  Thus, we have our answer: it is clear that weather has had an effect on the data for the first few months of the year.  We have seen payrolls steadily climb each month: from +84,000 in December, to +129,000 in January to the current 175,000 addition.  It would be presumptuous to assume that the numbers keep going up from here because this data is often revised and the economy is not growing strongly at this point.  But the newest and, from an investors point-of-view more important, more important question to ask is how will earnings and outlooks change based upon the weather interruptions.  The bond market viewed today’s report as a sign that weather has muted a strengthening economy.  Traders pushed the price of a 10-year Treasury note down and, as a result, yields went higher.  We are still not back to the 3.00% yield level that the bond was trading at near the beginning of the year, but the trend since the beginning of the month has been toward higher rates.

The European Central Bank (ECB) left its main interest rate at 0.25% and offered no hints at other measures to bolster euro zone growth.  Inflation, the other mandate the ECB has to worry about, has been below 1% for five consecutive months.  A level closer to 2% is considered just right to spur growth and allow some pricing by firms but not high enough to stoke negative results.   The non-move is important because ECB president Draghi had said that by March, the ECB would have enough information to judge the need for fresh stimulus.  One option would be to halt so-called sterilization operations which soaks up money spent on Greek and other troubled countries bonds.  That would have freed up nearly $240 billion in excess liquidity in the financial system and brought down interbank lending rates.  Draghi said there was no need to act because there was no sign of crisis in money-market rates adding “…the injection of the liquidity would really last only a relatively short time, less than a year for sure.”  The issue that Draghi and his colleagues face is whether to turn to more U.S.-style easing through the removal of sterilization tools, for example, or hope that inflation returns (the expectation is for 1.5% by 2016).  If it does not, the euro zone could be faced with what Japan is now dealing with—entrenched deflation causing economic stagnation.  Events in the Ukraine may yet stoke inflation if the prices of energy rise in a protracted conflict and a lower euro would make imports more expensive.  But these are two items mostly out of the ECB’s control.  Central bankers worldwide hope that the patient approach does not turn into a situation they cannot get themselves out of down the road.

SGK Blog--Update February 28, 2014: Yellen Mentions Weather, Provides Lift to Equity Markets  

Federal Reserve Chair Janet Yellen said the central bank is likely to keep trimming asset purchases, even as policy makers monitor data to determine if recent weakness in the economy is temporary.  “Unseasonably cold weather has played some role,” she said in response to a question Thursday from the Senate Banking Committee.  “What we need to do, and will be doing in the weeks ahead, is to try to get a firmer handle on exactly how much of that set of soft data can be explained by weather and what portion, if any, is due to softer outlook.”  Yellen repeated the Fed’s statements that the central bank intends to reduce asset purchases at a measured pace, and she said in response to a separate question that the bond-buying program was likely to end in the fall.  At the same time, “if there’s a significant change in the outlook, certainly we would be open to reconsidering, but I wouldn’t want to jump to conclusions here.”  Yellen’s testimony to the Senate panel, originally scheduled for Feb. 13, was postponed because of a snowstorm, creating an unusual two-week gap between her appearances before the two committees that oversee the central bank.  Since her House testimony, weaker-than-forecast data on retailing, manufacturing and home construction have suggested the economy is slowing, in part because of harsh winter weather.  Yellen, in the second day of her semi-annual testimony on the economy and monetary policy, also repeated the Fed’s pledge to keep the benchmark interest low at least as long as unemployment stays above 6.5 percent and the outlook for inflation doesn’t exceed 2.5 percent.

Federal Reserve policy makers, at their Jan. 28-29 meeting, said they would soon have to modify the year-old commitment, according to minutes released last week.  This caused concern amongst equity traders after the minutes were released.  Yellen’s words Thursday were “soothing” to market participants in that there were no surprises.  So far so good!  Yellen, 67, declined to say whether the Fed would scrap the unemployment threshold, while also indicating that policy makers can’t rely on the jobless rate alone to assess the condition of the labor market.  Responding to a question, she said that “the unemployment rate is not a sufficient statistic for the state of the labor market.  There is no hard and fast rule about what unemployment rate constitutes full employment, and we will need to consider a broad range of indicators.”  Yellen, in her prepared comments, said the recovery in the labor market is “far from complete.”  At the same time, “My colleagues on the FOMC and I anticipate that economic activity and employment will expand at a moderate pace this year and next, the unemployment rate will continue to decline toward its longer-run sustainable level, and inflation will move back toward 2 percent over coming years.”

A February 13 report showed that sales at U.S. retailers declined in January by the most since June 2012 amid slower employment and wage growth, along with colder-than-normal temperatures.  Cold weather also weighed on factory production, which unexpectedly declined in January by the most since May 2009.  The jobless rate fell to 6.6 percent in January, prompting San Francisco Fed President John Williams to say Feb. 19 that the central bank should abandon its unemployment threshold for the federal funds rate and switch to qualitative descriptions about progress toward the central bank’s mandate for full employment and stable prices.  Boston Fed President Eric Rosengren said Wednesday that there remains “significant slack” in labor markets and called for “a very patient approach” in removing stimulus.  Neither Rosengren nor Williams is a voting member of the FOMC this year, though they participate in meetings.  Yellen wrapped up her testimony by saying, “I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that it does not run persistently above or below that level.”  The 12-month rate of inflation, measured by the personal consumption expenditures price index, has been below the Fed’s 2 percent target every month since May 2012 and rose at a 1.1 percent rate for the 12 months ending December.  Again, her words provided reassurance to market participants that Janet Yellen is providing a steady hand at the helm of the Fed. 

In economic news this week, the Case-Shiller 20-city Index of home prices rose 13.4% in December, about as expected.  This was welcome news in view of the fact that sales had been slowing due to poor weather across the country.  Economists had forecast slow sales in January so the figure for new home sales at 468,000 compared to the expectation for 400,000 was welcome news indeed.  Initial weekly jobless claims rose to 348,000 compared to the expectation for 335,000 for the week ending 2/22/14 (blame the weather!)  Durable goods orders for January slumped 1.0% about in-line with expectations but excluding transportation the figure actually rose 1.1% which was considerably higher than expected.  The fourth quarter estimate for GDP came in slightly below the previous estimate at 2.4%, but was still better than expected at this time last year when forecasts were dismal.  The Chicago Purchasing Managers Index for February rose to 59.8, considerably higher than expected and possibly pointing to a manufacturing recovery after that sector had slowed in December & January on rough weather in that region.  Finally, both the University of Michigan consumer sentiment survey for February at 81.6 and pending home sales for January at +0.1% were both in-line with expectations.  With no major surprises this week on the economic front and Janet Yellen’s soothing testimony, markets responded favorably.  The economy continues to chug along but at a pace moderate enough to comfort traders concerned over the potential for the Federal Reserve to begin the process of raising short term interest rates.  Typically, when that process begins, that is when stocks come under significant pressure.

SGK Blog--Update February 21, 2014: Economic Data Makes Headlines  

With corporate earnings season winding down, economic data took more center stage this week.  Events overseas like the situation in the Ukraine means that investors will be focused on the top-down view until the next period of earnings “confessions” take place in the spring.  The Labor Department revamped wholesale prices which now means the monthly producer price index (PPI) will encompass 75% of the economy, up from only a third for the old index.  The old data also only reflected the cost of goods alone, while the new methodology includes services.  Services such as financial advice, wholesalers and transportation providers will account for about 63% of the new index, goods will count towards approximately 24%, prices received from government purchases and exported good will represent about 11% and construction will fill in the last 2%.  The top-line category is now known as “final demand” while the old measure will be called “finished goods”.  The final demand PPI rose by 0.2% in January from the prior month.  That was just above expectations of a 0.1% increase and follows a 0.1% rise in December.  The new “core” measure was also adjusted.  One without food, energy and trade services which is defined as changes in margins received by wholesalers and retailers and is the most volatile services category.  It rose 0.1% last month.  Excluding just food and energy, final demand rose 0.2%.  Year-over-year, PPI final demand rose 1.1% while excluding food and energy, the index rose 1.3%.  The major benefit of the revision in methodology will be for investors to see how various slices of the larger economy are rising or falling in terms of prices.  For example, the cost of pharmaceutical preparations rose a record 2.7%.  And, we are all now well aware that last month’s rise in the price of finfish and shellfish was the largest since 1984!  Good things to know.

Consumer prices rose 0.1% in January after a 0.2% gain in the prior month according to the Labor Department.  Year-over-year the measure rose 1.6%, the smallest 12-month gain since June of last year.  A rise in the price of hotel rooms and medical care was offset by lower costs for new and used cars and airline fares.  The CPI did not have a major overhaul but yet is still considered one of the broadest price measures the government tracks with about 60% of its index covering services. 

Meanwhile, the housing market seemed to be very affected by the winter weather which should come as no surprise considering its harshness.  Housing starts fell 16% to an 888,000 annualized rate according to the Commerce Department.  It was the biggest decrease since February 2011.  Existing home sales fell 5.1% to a 4.62 million annual rate in January according to the National Association of Realtors.  Harsh weather in addition to low supply slowed demand. First time homebuyers accounted for 26% of purchases, the lowest since record keeping of that stat began in October 2008 suggesting that affordability and the sluggish job market also played a role.  The National Association of Home Builders/Wells Fargo sentiment gauge fell to a surprising 46 in February from 56 in January.  Readings less than 50 indicate more respondents reported poor market conditions than good.  According to the NAHB Chairman, “Significant weather conditions across most the country led to a decline in buyer traffic last month.  Builders also have additional concerns about meeting ongoing and future demand due to a shortage of lots and labor.”  The last statement is head scratching because unemployment has been stubbornly high and participation of those eligible for jobs has been near record lows.  This week initial unemployment claims declined by 3,000 to 336,000 but still remain above the psychologically important 300,000 level.  So what’s happening?  The people with the skills are not always matching up with the openings.  That is a sign of cyclical unemployment issues, not structural.  That is, the jobs are out there but with consumers still getting credit-healthy and the housing market just starting to function closer to normal, it will take time for those matches to be made.

SGK Blog--Update February 14, 2014: Stocks Steady on Acquisitions and Yellen Testimony  

Equity indices continued to recover from the January jitters despite the impact of frigid weather on the economy here in the U.S.  Markets were buoyed Thursday by the announcement of a proposed mega-merger between Comcast and Time Warner Cable – the two largest providers of cable services in the U.S.  Comcast would actually be acquiring Time Warner for $45.2 billion.  Wall Street loves acquisitions of this size as it means a large payday for the investment bankers involved.  Estimates put the fees associated with this one at well over $100 million.  It looks like jobs on Wall Street will become popular again!  Janet Yellen, the new Chairman of the Federal Reserve, helped soothe traders’ anxieties as she pledged to maintain the policies of her predecessor, Ben S. Bernanke, scaling back bond-buying under the quantitative-easing stimulus strategy in “measured steps.”  She testified before the House Financial Services Committee, delivering the first semi-annual report on monetary policy since she was sworn in last week.  She was supposed to appear before the Senate Banking Committee Thursday but was snowed in like the rest of us.  The central bank has cut its purchases of Treasuries and mortgage debt to $65 billion a month from $85 billion last year, citing economic improvement.  The buying is designed to hold down long-term borrowing costs and fuel growth.  Traders are also relieved that the spike in interest rates we witnessed late last year and early this year has settled back down into a normal trading pattern with the Ten-year Treasury rate below 3%. 

The economic data here in the U.S. continues to show signs of a weather related impact.  Retail sales were weaker than expected as they fell in January the most since June 2012.  The Commerce Department reported that sales for January decreased 0.4% as winter weather kept consumers away from auto showrooms and stores.  This followed a revised decline of 0.1% for December.  Excluding autos, retail sales for January were flat.  Jobless claims increased by 8,000 to 339,000 in the week ended Feb. 8, from 331,000 the prior period, a Labor Department report showed.  Economists surveyed by Bloomberg called for a decrease to 330,000.  This weaker than expected data helped improve the bid for Treasuries as interest rates declined on the news.  Rates on Treasury one-month bills declined for a fourth day, helped after Congress approved a suspension of the nation’s debt ceiling Wednesday until March 2015.  The only real benefit to slightly weaker than expected data on the economy is that it does help keep interest rates in check.  This can offset the impact on rates of the Federal Reserve’s gradual reduction in stimulus.  Lower interest rates tend to support stocks, but in the absence of good news now that earnings season is coming to a close, we will see how long that lasts.

SGK Blog--Update February 7, 2014: Market Volatility Increases  

According to the Labor Department, nonfarm payrolls rose by 113,000 in January continuing a disappointing trend begun last month. December’s revised 75,000 was also below expectations when it was released early in the New Year. The median forecast of economists in a Bloomberg survey called for a 180,000 advance. The unemployment rate, taken from a survey of households not businesses, fell to 6.6% from 6.7% last month. These figures are disappointing but far from disastrous.  In fact, the now closely watched participation rate actually rose to 63.0% from 62.8% meaning there was a higher percentage of people actively looking for jobs. The Labor Department also issued its annual benchmark update which aligns employment data with corporate tax records and provides a further check on the data released. The revision showed payrolls grew by an additional 347,000 workers from April 2012 through March 2013.

More than half the gain in employment came from construction and manufacturing which seems a bit odd given all the talk about weather-related issues affecting industries from coast to coast. Retailers, affected by a below-average holiday shopping season, reduced payrolls by about 13,000, the most since June 2012. In a positive sign, average hourly earnings rose by 0.2% in January and increased 1.9% over the past 12 months. The report also showed an 8,100 increase in hiring by temporary-help services. These signs suggest that companies may not be in a robust hiring mode, but they continue to muddle along with enough employees to get the job done.

Will these figures affect the Fed’s tapering program? We anticipate that they will not. Seasonally adjusted or not, it is apparent that the harsh winter that has struck over December and January is having some type of an effect on production and, thus, investing in human capital. A year ago, the employment numbers seemed too high for the winter months and too low for the spring months and data smoothing was blamed for such gyrations. The Fed is going to take this information and couple it with data it receives from bank lending officers, housing surveys and reports from other central banks to see how it will proceed. The Federal Open Market Committee meeting scheduled for March 18-19 will have extra focus. We will have one more monthly jobs report by then in addition to numerous weekly initial unemployment claims updates. Plus, it will be new chairman Janet Yellen’s first meeting she presides over as the new chief, and the press and public will be eagerly awaiting the post-meeting press conference.   

Meanwhile in Europe, European Central Bank (ECB) president Mario Draghi said stimulus measures could come as early as March for the euro zone. The ECB kept its main lending rate at 0.25% and next month the ECB will publish inflation forecasts into 2016, the first time it will release estimates that far into the future. Its current projections are for inflation of 1.1% in 2014 and 1.3% in 2015, well below the medium-term target of just below 2%. If the inflationary expectations into 2016 stay well below target, it is likely the ECB will act with the most likely move being a rate cut. Other options include more loans to banks through Long-term Refinancing Operations which would complement loans due in early 2015. However, banks remain reluctant to lend this cash to consumers. With retail sales falling 1.6% in December, the consumer is not picking up the slack. Another option is to stop “sterilizing” money injected into markets. Currently, under the Securities Market Program, the ECB withdraws funds from the banking system in amounts equal to what they have purchased in government bonds from Greece, Ireland, Portugal, Spain and Italy. Such a program allow the central bank to say they are not involved in the markets because no funds have theoretically been created. Ending the equal withdrawal of funds would be one way to boost monetary easing.

SGK Blog--Update January 31, 2014: Stocks Continue Retreat on Global Currency Concerns and Mixed Earnings 

Global stock indices were roiled Wednesday ahead of the Fed meeting outcome as events in Turkey made headlines, continuing the theme so far in 2014 of high levels of volatility in emerging market currencies. Why do we care about Turkey? It plays to the broader theme of the uncertain global economic picture, particularly in the world’s second largest economy – China – amidst a scenario where the U.S. Federal Reserve will likely continue on its path of reducing monetary stimulus. The Turkish currency – the lira - dramatically reversed course in early trading Wednesday after early gains when the Turkish central bank doubled interest rates to assuage concerns that the Turkish economy will be left exposed by a slowdown in China and a reduction in U.S. monetary stimulus. The Turkish currency had initially gained more than 4% on the central bank’s midnight decision, then rapidly depreciated 2.4% compared to the previous day’s close to trade at 2.2690 per dollar at 4:30 pm Istanbul time, which was early morning here. Yields on their two-year benchmark notes were at 10.88% and the Borsa Istanbul 100 Index of stock prices slumped 2.6%. Bank Governor Erdem Basci is fighting to restore credibility eroded by a currency run that gained speed amid domestic upheaval and a global rout of emerging markets. Prime Minister Recep Tayyip Erdogan, who said yesterday he’s always opposed higher rates, is caught in a graft scandal that has ensnared several ministers and the chief executive officer of a state-owned bank. Wow – and we thought our politics were bad! This spooked investors just as the reduction of U.S. monetary stimulus began sucking money out of riskier assets. The dilemma for Turkey is that foreign investors may not be enticed by the significantly higher yields given the downside potential of the currency. 

Wednesday also saw the release of the Federal Open Market Committee’s (FOMC) statement on interest rate policy. There really were no surprises here as the Fed decided to stick with its plan to continue to reduce its monthly bond purchases from the current pace of $75 billion per month to $65 billion per month. In our view, their decision to continue with tapering, despite the unfolding turmoil in emerging markets, suggests the Fed has a domestic policy compass firmly in hand. They are sending a clear message that unless a much larger scale crisis emerges, do not expect them to deviate from their current policy path. In a clear message in terms of the direction they are headed, their statement included the following: “if incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.” This implies by year-end at the latest, the Fed will be no longer purchases bonds on a monthly basis. Given their balance sheet is in the neighborhood of $4 trillion, this makes sense in our view. In order to calm market concerns, they gave further clues about policy saying the unemployment rate probably would have to decline “well past” the original benchmark of 6.5% before the FOMC would consider hiking its zero-bound target interest rate – the Fed Funds rate. What is interesting is that although stocks sold off on the day, the bond market was relatively calm. In fact, given the flight to quality with the tumult in emerging markets, the interest rate on the U.S. Ten-year Treasury actually declined to close that day with a yield under 2.7%, which we have not seen in a while. We should also point out that for the first time in a long time the vote from committee members was unanimous. 

Economic data was a mixed bag this week. In the U.S., the housing data for December for both new home sales at 414,000 and pending home sales showing a decline of 8.7% came in much worse than expected on weather related issues. Initial weekly jobless claims for the week ending 1/25/2014 at 348,000 were also considerably higher than expected, which is also concerning particularly given December’s lousy employment report. On a positive note, 4th quarter gross domestic product (GDP) came in at +3.2% which was above consensus estimates. This was largely driven by consumer spending as household purchases grew at a 3.3% pace, the best since the end of 2010, and this helped overcome cutbacks in government spending. The pickup in demand was broad based as business investments and exports also accelerated, helping offset the damage from the 16-day partial government shutdown. Reports late in the week on personal income and personal spending showed that while incomes were flat coming in at 0% for December, spending at +0.4% was higher than expected for that same month. Overseas, German unemployment declined more than forecast in January – helping their stock index in Thursday trading – while a report from China indicated that manufacturing had shrunk for the first time in six months. China continues to bear close attention as we read a report this week that 65% of China’s consumer wealth is tied up in real estate. A bubble bursting in that country’s real estate market would have serious negative global repercussions. In Friday trading, global equity indices were roiled by a report from the European Union’s statistics office in Luxembourg showing that consumer prices rose at an annual rate of just 0.7%, below the expectation for +0.9%, and this fueled deflationary concerns in Europe amongst traders. The European Central Bank’s target inflation rate is 2% so this puts pressure on the bank to lower interest rates when they meet next week.

SGK Blog--Update January 24, 2014: Earnings Season Begins

With snow storms pummeling the East Coast, the Federal government was shut for one day this week.  It turns out that this week was light for economic releases, so the winter weather did not cause many unintended disruptions in that aspect.  We did get the usual weekly initial unemployment claims which remained near a six-week low.  For the week ended January 18, the number of jobless claims rose to 1,000 to 326,000 from the week prior.  That was a little below the median forecast of 330,000 in a survey of economists conducted by Bloomberg.  The Labor Department said there were no unusual circumstances surrounding the data.  Given the surprisingly tepid December jobs report, seeing these figures makes that number seem more and more like an aberration rather than the start of a trend.  The next monthly payroll figure will be released on February 7.

Though the trend remains positive, there still remain millions out of work.  The number of people continuing to receive jobless benefits rose by 34,000 to 3.06 million in data from the Labor Department for the week ended January 11.  The report also showed that 1.35 million unemployed people lost emergency extended benefits after Congress allowed the program to expire at the end of 2013.  The program began in 2008 and at one point provided a total of 99 weeks of benefits, including 26 weeks of standard state-funded benefits.  By the end of 2013, the maximum was down to 73 weeks covered.  The weekly initial jobless claims shows that companies are slowing their pace of firings, but those continuing to remain jobless remain numerous.  Job growth averaged 182,170 per month in 2013 compared to 182,750 in 2012 but even these figures have not been strong enough to absorb these long-term unemployed.  The Fed continues to struggle with this issue because the longer someone remains unemployed, the more his or her skills deteriorate.  Frustration often leads to curtailing job search efforts completely.  That, in turn, affects the nation’s collective productivity level and its standard of living.  Granted, these changes take time to fully be felt, but we are now nearly six years beyond the collapse of Lehman Brothers which is widely viewed as one of the low points of the financial crisis and jobs are still not abundant.    

There was good news on the housing front.  Existing homes sales rose 1% to a 4.87 million annual pace according to the National Association of Realtors.  December’s figures capped the strongest year for the industry since 2006.  The supply of homes fell 9.3% in December from November.  At the current pace of sales, it would take 4.6 months to clear out the inventory compared to 5.1 months at the end of November.  A number between 5-6 months is considered a healthy market.  Another piece of good news is that distressed property transactions accounted for only 14% of the total.  This is a far cry for the nearly 40%+ we saw back in 2009 and 2010.  Given the poor weather and cold conditions in December, the numbers look even better since it proves there are determined buyers in the market even in the face of mortgage rates which are higher.  The average 30-year fixed rate was 4.41% for the week ended January 16, compared to 3.38% a year ago according to Freddie Mac.  The spring selling season is coming up which could further provide a tailwind to the industry.

SGK Blog--Update January 17, 2014: Stocks Drift Sideways as Earnings Season Approaches  

Concerns on the part of traders over corporate earnings and stock valuations helped push equity indices sharply lower in Monday trading.  As the week progressed, the major averages did recover ground but concerns remain.  In 2013, the 500 companies in the Standard & Poor’s 500 Index delivered average revenue and earnings growth of 2.7% and 3.9% respectively.  Forecasts by analysts put those figures at 5.1% and 9.5% respectively.  That seems lofty to us at this point and it is likely these estimates will come in as we progress throughout the year.  Goldman Sachs warned this week in a research piece they consider valuations on stocks to be somewhat lofty at 15.6 those estimated 2014 earnings compared to an average of 14.1 over the past 5 years.  According to Goldman, further price-to-earnings multiple expansion will be difficult to achieve.  Fed Bank of Atlanta President Dennis Lockhart said Monday the U.S. economy is on “solid footing” and he would support continued cuts to stimulus.  The Fed, which next meets January 28-29, last month announced a reduction in its monthly bond-buying program, citing a recovery in the labor market.

After a couple of slow weeks, we had plenty of data out on the U.S. economy this week.  Helping lift equity markets higher in Tuesday trading, the retail sales report for December came out better than expected despite all the bad weather.  More and more people are shopping on-line which tends to immunize sales from snowy conditions, even though many did not get their deliveries in time for Christmas.  The retail sales figure for December was +0.2% compared to the expectation for flat sales although the figure for November was revised downwards to +0.4% from the previously reported +0.7%.  Excluding autos, retail sales rose a relatively robust +0.7% compared to the estimate for a +0.4% increase while again the figure from November was revised lower to +0.1% from the previously reported +0.4%. 

In other economic news, inflation measures came out roughly in-line with expectations this week as the producer price index for December came out at +0.4% and +0.3% excluding food and energy, the so-called core rate.  The consumer price index for December was +0.3% and +0.1% for the core rate.  Initial weekly unemployment claims were slightly better than expected for the week ending 1/11/2014 with 326,000 claims compared to the expectation for 335,000.  Measures for manufacturing for January were better than forecast as Empire Manufacturing (a gauge of the New York area) was 12.5 vs. the forecast for 3.5 and the Philly Fed survey was 9.4 vs. the expected 8.0.  Industrial production and capacity utilization for December came out basically in-line with forecasts at +0.3% and 79.2% respectively.  Finally, we received important information on the all-important housing sector as housing starts for December were 999,000 while 986,000 were expected while building permits were 986,000 versus the 1,000,000 expected.  Overall it was a relatively robust week for economic data at this early stage of the new year and this bodes well in terms of the potential for the U.S. economy in the year ahead.

SGK Blog--Update January 10, 2014: Payrolls Less Than Expected  

Given the feel-good vibe recent economic data have thrown off, it was a bit of surprise when payrolls in December increased at the slowest pace in three years.  The 74,000 gain was less than the median projection in a Bloomberg survey of 197,000.  In fact, the gain was lower than the most pessimistic forecast of a 100,000 gain.  What happened?  Weather was one issue.  Last month was the coldest December since 2009 and snowfall was 21% above normal.  In a country as wide and diverse as the U.S., that should not play so much of a role but given that the majority of the population still lives east of the Mississippi river, weather issues will play a role in housing construction, on-site motion picture/television personnel or the need for higher staff in restaurants or retail stores.  Industry reporter ShopperTrak said that U.S. holiday sales for the November-December period were up only 2.7% year-over-year, the smallest gain since 2009 as foot traffic fell 15%.  Less customers means less need for checkout clerks, mall security and cleanup crews.  The Labor Department said that 273,000 Americans were not at work last month because of weather.

On a positive note, revisions to prior reports added a total of 38,000 jobs to overall payrolls the prior two months.  The unemployment rate, which is derived from a household survey in comparison to payrolls which come from business surveys, fell to 6.7%, the lowest since October 2008.  But even that piece of good news had a drawback:  the labor participation force rate fell to 62.8% in December from 63.0% the month prior.  Less people actively looking for a job can artificially lower the employment rate and mask weakness in hiring.  We have discussed this trend previously.  Though it is an important indicator, it is one of many.  The weekly initial jobless claim figure reported by the Labor Department fell by 15,000 to 330,000 in the week ended January 4.  The four-week average dropped to 349,000 from 358,750.  This data is more timely than the monthly payroll figures which themselves are often subject to multiple revisions.  Our take is that the labor market is improving but it will not be in a straight line.  If this one data point becomes two or three months of below-market expectations, then there is likely to be some concern.

Will these results change the Fed’s attitude toward tapering?  This Wednesday, the Federal Reserve released minutes from its December policy committee meeting.  They concluded: “A majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue.”  Thus, at the margin, it was decided that it was time to curtail some of the buying.  And it is only a curtailing as the members explained: “While deciding to modestly reduce its pace of purchases, the Committee emphasized that its holdings of longer-term securities were sizable and would still be increasing, which would promote a stronger economic recovery…”  If the Fed governors saw a 74,000 gain in jobs reports one month after a 200,000+ figure, it might lead some to reconsider, but rather than resort to a knee-jerk reaction, our guess is that the tapering announcement would still have been made—though Bernanke would have had a little more explaining to do in the post-meeting press conference.

SGK Blog--Update January 3, 2014: Happy New Year! 

We would like to take this opportunity to wish our clients a happy, healthy and prosperous 2014!

After posting the strongest annual gains in over 15 years, equity markets got off to a rocky start in 2014 on the first day of trading as the major averages lost close to 1% on January 2nd. This can be attributed to a variety of factors, including portfolio rebalancing and investors waiting until the new year to realize gains in taxable accounts. Warnings on China from high profile hedge fund manager George Soros also helped spook traders. Not helping matters was weak economic data coming out of that country on the first day of trading in the new year here in the U.S. A China services index fell to a four month low in December, following on declines in key manufacturing gauges in that country. The non-manufacturing Purchasing Managers’ Index slid to 54.6 in December from 56 in November, the Beijing based National Bureau of Statistics and China Federation of Logistics and Purchasing indicated. The key issue in China to watch, and risks cited by Soros, is the fact that the ruling Communist Party is trying to restructure the economy for more sustainable long-term growth, while maintaining a sufficient pace of expansion to protect jobs. A jump in money-market rates, surging property prices in some cities and swelling local-government debt threaten to undermine the government’s efforts. China is a key country to keep an eye on in 2014.

In domestic economic news, the initial weekly jobless claims for the week ending 12/28/2013 rose to 339,000, which was above the expectation for 333,000 but below the previous week’s figure of 341,000. It is expected approximately 1.3 million will lose their long-term unemployment benefits here in January although Congress is working on a fix for that. If that happens it would have a negative impact on the economy in terms of consumer spending. Construction spending rose 1.0% in November, above expectations, while the Institute of Supply Management’s ISM Index came in at 57.0 in December, a slight decline from November’s very strong 57.3. A figure above 50 indicates expansion in the manufacturing sector. Richmond Fed President Jeffrey Lacker also helped fuel stock declines when he stated policy makers will continue to weigh reductions in bond-buying at upcoming meetings. While news the Fed will continue their efforts at “tapering” their bond buying here in 2014 should not come as new news to market participants, traders still don’t like to hear it coming from a Fed policy maker’s lips. Next week will be an exciting week for market participants as we have plenty of important economic data to evaluate including factory orders, the ISM Services Index, the FOMC minutes from their last meeting and, of course, the all-important employment report for December. We will be evaluating these closely for our clients and monitoring your portfolios daily here in 2014 and we thank you for the trust you have placed in us. We value your business highly!

SGK Blog--Update December 27, 2013: Happy Holidays!

We would like to take this opportunity to thank our clients for a great year, and continued health and prosperity in 2014 for all! 

Holiday sales in the U.S. rose 3.5% helped by steep discounts at malls and purchases of children’s apparel and jewelry, according to SpendingPulse. Sales of holiday related categories such as clothing, electronics and luxury goods rose 2.3% from Nov. 1 to Dec. 24 compared to a year earlier, according to Purchase, the New York based research firm. Sales were propped up as retailers such as The Gap, concerned about slow traffic this season, offered deals as much as 75% off, especially on apparel. Don’t be surprised to see these deals continue as retailers try to work down inventory early in the New Year. It was definitely a mixed season for retailers as store visits actually declined 21% for the week ending Dec. 21st, according to ShopperTalk. Some of that can be attributed to more online shopping by consumers. A heavyweight battle in terms of the “blame game” erupted between Amazon and UPS as numerous packages were not delivered on-time before Christmas despite promises from Amazon. UPS blamed the weather and an unexpectedly high volume this year.  

U.S. consumer confidence rose to a four month high as an improving job market and holiday discounts put Americans in the mood to shop. The Bloomberg Consumer Comfort Index rose to minus 27.4 in the period ending December 24, the fifth straight gain, from minus 29.4. Applications for unemployment also declined to 338,000 for the week ending Dec. 21 compared to the estimate for 350,000 and the prior week’s figure of 380,000. We actually had plenty of data out on the economy despite Christmas falling in the middle of the week. Durable goods orders for Nov. rose 3.5%, 1.2% ex-transportation, compared to estimates for a 2.2% and 0.6% increase respectively. Personal income rose 0.2% and personal spending rose 0.5% for November compared to estimates for increases of 0.5% and 0.5% respectively. New homes sales climbed to 464,000 for November relative to the estimate for 433,000 and the University of Michigan consumer sentiment survey for December came in at 82.5 compared to the estimate for 83.3 and the prior month’s figure of 82.5. Overall, this was a pretty good week for economic data here in the U.S. and stock indices continued their Santa Claus rally for the week.

SGK Blog--Update December 20, 2013: Fed Tapers, Markets Soar  

The Federal Reserve delivered an early Christmas present to the markets this week.  In outgoing Federal Reserve Chairman Ben Bernanke’s last post-meeting conference call, he detailed the Federal Open Market Committee’s (FOMC) plan with comments that were viewed as dovish for equity securities.  According to the press release distributed by the Fed, the governors stated: “In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the committee decided to modestly reduce the pace of its asset purchases.”  So instead of $85 billion per month of bond buying, the FOMC will reduce that to “only” $75 billion per month split between $40 billion in long-dated Treasuries and $35 billion in mortgage bonds starting in January.  The policy has been vetted and supported by current Vice-Chair and likely new chairperson Janet Yellen—once she is officially confirmed by the Senate.  The Committee will “closely monitor incoming information on economic and financial developments in coming months” in case the tapering needs to be adjusted emphasizing that “asset purchases are not on a preset course.”

The FOMC clearly had gained more confidence from last summer when talk of tapering first emerged.  First, the fiscal overhang from Congressional issues was alleviated recently when a bipartisan agreement was reached to keep the government funded for two more years thus preventing another partial or full shutdown in January similar to the one that occurred this past fall.  Second, more employment information was released.  The last two monthly employment reports showed payrolls swelling 200,000 in October and 203,000 in November with the unemployment rate falling to 7.0%.  Data related to jobs such as average hourly earnings and initial unemployment claims were also trending in the positive direction.

A big push that has contributed to the overall more positive outlook has been the housing market.  Auto sales are on pace for their best year since 2007, but the housing market’s effect on so many industries makes it a crucial contributor to the wealth effect and better consumer confidence overall.  Housing starts jumped 22.7% to a 1.09 million annualized rate, the most since February 2008 according to the Commerce Department.  Three of four regions showed an increase in activity led by a 41.7% increase in the Midwest and a 38.5% jump in the South.  Confidence among U.S. homebuilders increased more than forecast in December according to the National Association of Home Builders/Wells Fargo builder sentiment gauge.  It rose to 58, exceeding the highest estimate projected in a Bloomberg survey, and surpassing the previous month’s 54 reading.  An index above 50 means more respondents report good market conditions.  The one negative has been existing home sales which decline for the third consecutive month in November according to the National Association of Realtors.  Purchases dropped to a 4.9 million annual rate compared to a survey consensus of 5.02 according to Bloomberg.  Nevertheless, the association projects 2013 will be the best year for the industry in seven years.  Compared to a 13-year low of 4.11 million in 2008, the figures are not too bad though not the record 7.08 level reached in 2005.

Today, the markets received another boost when the Commerce Department revised their estimate of annualized third quarter GDP growth from the previous level of +3.6% to +4.1%.  It is the second-largest quarterly result since the recovery began in 2009.  The revision was driven by a larger increase in consumer spending which now grew at a 2% annual rate rather than the previously estimated 1.4%.  Inventories accounted for a third of the gain, but with the revision higher in consumer spending—which comprises nearly 70% of GDP—the hope is that consumers will absorb some of these added goods.  Various economists predict the current fourth quarter will see GDP growth of around 2.0%-2.2% which is not all that bad against the backdrop in higher inventories and a somewhat lackluster holiday shopping period so far.

SGK Blog--Update December 13, 2013: Traders Brace for Fed Meeting Next Week

While healthy economic data and relative calm in Washington political circles would normally provide a lift to equity trading, this week it has had the opposite effect as concerns have risen that the Fed may surprise markets by announcing a tapering of their bond purchases as soon as next week. The next meeting of the Federal Reserve’s Open Markets Committee (FOMC) is scheduled for December 17-18. All signs are pointing to the Federal Reserve beginning to “taper” their bond purchases at some point, but we feel it is more likely they will begin the process at their January 24-25, 2014 meeting. Or they may provide a timetable at that time for these reductions in purchases. Both meetings are accompanied by press conferences from the Chairman. As we have mentioned, the “taper” refers to the process whereby the Fed begins to gradually reduce the pace of their monthly bond purchases from the current $85 billion level. It is possible they do announce a timeline at their upcoming meeting next week for when the reduction in purchases will begin. It is this very real possibility that accounted for the sell-off in stocks this week. The issue is that it is unpredictable right now and stock traders dislike uncertainty. Irrespective of when the process begins, accompanying an announcement of a timeline, there will very likely be language hinting that the Fed reserves the right to vary the pace of purchases depending on market conditions. That caveat would provide them the opportunity to accelerate or decelerate purchases based on the strength of the economic data they see throughout 2014. Again, they will emphasize that the reduction in bond purchases is separate and distinct from the decision as to when to begin the process of actually raising interest rates in the form of the Federal Funds rate and the discount rate. Of course, working in their favor has been the relatively benign inflationary environment we have been operating in since the financial crisis. There is a lot of uncertainty associated with the issue and it is a real focal point amongst traders as we approach year end. Communicating a clear path forward would be very helpful and we do hope the Fed will provide some clarity around this. 

Speaking of relative calm in Washington, politicians on both sides seem to be in a Merry mood as we approach the Holidays. At least on the surface it appears that way and in some of their public comments. We suspect they are saving their best salvos for when we get closer to election time. The modest budget agreement arrived at between House Budget Committee Chairman Paul Ryan (R. Wis.) and Senate Budget Committee Chairman Patty Murray (D-Wash.), while not very meaty, was refreshing in the sense it was not hashed out in the media in a contentious fashion and was an example of how Washington should actually work – in the spirit of bipartisan compromise. The agreement basically restores about $63 billion in federal sequester cuts, there was no extension of long-term benefits for the unemployed, deficits are cut by $22 billion over the next decade and pensions are trimmed for military retirees younger than 62 and for new federal workers. One of the key points is that it avoids the threat of another government shutdown through October 2015. While no one would call the agreement completely satisfactory and nobody on either side loves it, it is likely to pass in Congress and it represents a foundation from which to build off of. A significant grand bargain appears to have been a fantasy all along under the current leadership structure of both parties therefore small steps and narrower accomplishments appear to be the way forward. There is a lot of work to be done! 

On the economic front, we had generally positive news for the week here in the U.S. Wholesale inflation remained tame for November as the Producer Price Index came in exactly as expected at +0.1% and -0.1% on the core rate, which excludes food and energy. Retail sales in November exceeded forecasts as the 0.7% rise, 0.4% increase excluding autos, was the fastest increase in five months. Consumers flocked to stores and auto dealerships, a sign the consumer is shaking off the third quarter doldrums. Sales were also boosted by the release of new products such as Apple’s new iPads and Microsoft’s new Xbox One product as those flew off the shelves. Another report showed consumer confidence rose for the third straight week. The Bloomberg Consumer Comfort Index advanced to minus 30.9 in the period ending December 8, the best reading since the first week of October, from minus 31.3. The gauge is making progress after sinking to a one-year low in early November in the aftermath of the partial federal shutdown the prior month. The one negative bit of news this week was the unexpected rise in weekly jobless claims as that came in at 368,000 for the week ending December 7 compared to the expectation for 315,000 and the prior week’s revised figure of 300,000. At this time of year, seasonal adjustments to these figures tend to skew them which is why we always put more emphasis on the four week trend. With that said, employment being such a focal point of the Fed, this bears close watching. 

SGK Blog--Update December 6, 2013: The Economy is on a Roll        

The unemployment rate dropped to a five year low of 7% as employers added more workers than forecast last month.  According to the Labor Department, 203,000 non-farm payrolls were added in November following a revised 200,000 in October marking the first strong back-to-back months in a long time.  Estimates in a Bloomberg survey called for an increase in the range of 115,000 to 230,000 with the median forecast at +185,000.  The unemployment rate, derived from a separate Labor Department survey of households rather than employers, was forecast to fall to 7.2%.  Another key positive was the participation rate, which measures the share of working-age people in the labor force, rose to 63% after falling to 62.8% in October, the lowest level since March 1978.

Private employment, which excludes government agencies, rose 196,000 last month after a revised 214,000 advance in October.  The median rise for private payrolls called for a figure of 180,000 so that number was easily exceeded.  Moreover, average hourly earnings rose by 0.2% and has climbed 2% over the past 12 months.  The average work week rose six minutes to 34.5 hours last month.  Hourly earnings and average work week are forward-looking gauges.  A rise in these numbers generally indicates a tightening labor market.  This week’s initial unemployment claims is also a leading indicator.  Payroll and employment data collection often stops near the middle of the month so that the figures can be tabulated by the first Friday of the following month.  Initial unemployment claims are more timely because they are done weekly.  In the week ended November 30, jobless claims fell 23,000 to 298,000 compared to the median Bloomberg forecast of 320,000.  If these trends continue through the first half of this month, it is quite likely the employment figures for December released in early January will show a sub-7% unemployment rate and further 200,000+ job gains.

More people with jobs usually indicates more money to spend.  That is exactly what we saw in data from the Commerce Department today.  Consumer spending rose 0.3% in October after a 0.2% rise in September.  These numbers might be tempered a bit once the final details from the Black Friday shopping season are tallied.  According to various reports, Black Friday sales were lackluster across the country and with a winter storm about to hit the East Coast this weekend, the number of shopping days will be further reduced.  However, according to cloud-based analytics from IBM, Cyber Monday—the first Monday after Black Friday—was the biggest online shopping day in history, growing 20.6% over 2012.  Mobile traffic grew to 31.7% of all online traffic, increasing by 45% over 2012.  (As a footnote, on average, Apple’s iOS users spent $120.29 per order versus $106.70 per order for Google’s Android users).

Gross domestic product grew at a 3.6% annualized rate in the third quarter, up from an initial estimate of 2.8%.  This was primarily due to the biggest increase in inventories since 1998.  Stockpiles added 1.68 percentage points to GDP last quarter, double the initial estimate.  Why are businesses producing so much?  It can be due to various reasons but likely linked to more confidence by management that consumer and business demand will soak up the extra inventory.  Final GDP sales, which excludes the effect of inventories, rose 1.9% in the third quarter after a 2.1% gain in the second quarter.  Consumer spending, which is nearly 70% of the economy, rose 1.4%, the smallest gain since the fourth quarter of 2009.  Though we have seen GDP rise from 1.1% in the first quarter to 2.5% in the second to the latest figure over 3%, continued growth will be heavily dependent on the consumer.  A better job market and healing residential real estate market—new home sales rose 25.4% in October—will  help this trend but it is still a bit concerning to see so much inventory accumulation in one quarter.

SGK Blog--Update November 27, 2013: House Prices Rise Most Since 2006       

House prices in 20 major U.S. cities rose 13.3% over the course of the year ending in September. The median forecast in a Bloomberg survey of 31 economists called for a 13.0% increase. Sellers are standing firm on asking prices as buyers compete for a limited number of available properties. Higher home values are helping propel gains in Americans’ net worth, boosting confidence amongst homeowners and creating momentum for consumer spending. Housing demand has clearly improved this year as prices have benefited from fewer foreclosures with distressed housing transactions back to pre-crisis levels. More applications for home construction were issued in October than at any other time in the past five years. Building permits increased 6.2% last month to a 1.03 million annualized rate, the most since 2008, according to the Commerce Department. Housing starts data will be delayed until December 18 due to the government shutdown in October. The strength of the housing recovery has helped with our post crisis recovery as it is such an important and influential sector here in the U.S. The only negative on housing this week was the fact that pending home sales fell in October 0.6% versus the expectation for a 1.3% increase. The concern here is that higher mortgage rates and a tighter supply of houses are keeping some prospective buyers out of the real-estate arena. We will have to keep a close eye on this, especially with the likelihood rates will rise with the Fed beginning to ease up on their quantitative easing programs in 2014.  

In other economic news this week, initial weekly jobless claims for the week ending 11/23/2013 were 316,000 which was better than the forecast for 330,000. The balance of the data on the week was mixed. Durable goods orders for October were weaker than expected at -2.0% and when transportation goods were factored out it was -0.1%. The Chicago purchasing managers index for November was 63.0 which was better than the expectation of 58.0. The University of Michigan’s consumer sentiment index for November was a better than expected 75.1 as was the index of leading indicators for the month of October which rose 0.2% compared to the expectation for a 0.1% decline. Overall we would say that the impact of the government shutdown on the broader economy was less than expected.     

Third quarter earnings from U.S. companies finished better than most analysts had predicted. Of the 500 companies in the S&P 500, 489 had reported at the time of this draft and the average results were impressive. Year-over-year growth in earnings was a relatively robust 5.6%, which was 3% higher than analysts had expected, although this was lower than the 8% average growth over the past 13 years. Top-line growth (the increase in revenues) was 4%, which was the best since the second quarter of 2012. 67% of companies beat analysts’ average forecasts with the strongest sectors being information technology, healthcare and consumer discretionary stocks. Right now large company stocks on average are trading at approximately 17 times trailing earnings, which is above the long term average of 15. Small capitalization stocks in particular are more expensive given this has been the strongest segment of the market this year. We have been pleased in general with the results from our core list of equity holdings. Given the strength of the stock market this year, we are not inclined to be particularly overweight stocks at this point in client portfolios. Given we avoid what we refer to as high risk sectors such as junk bonds, leveraged loans and the stocks of lesser quality, more highly leveraged companies, we feel we are well positioned heading into a more uncertain environment in 2014 with the high caliber of our holdings – both on the stock and the bond side.

November 22, 2013: New Records for Stocks as Taper Questions Continue Minutes from the Federal Reserve?s October 29-30 meeting did not provide any further clues pertaining to the beginning of the end of the quantitative easing program. According to the release, the governors ?generally expected that the data would prove consistent with the Committee?s outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in the coming months.? Those ?coming months? can be anything from December to June of next year. A recent interview with a Fed district president revealed that ?taper talk? would be on the agenda for December?s meeting. However, given that current chairman Ben Bernanke is stepping down in January and nominee and current vice-chairperson Janet Yellen is likely to take charge, that change may play into the committee?s thinking. Moreover, as we have previously pointed out in our weekly musings, the same government shutdown and debt ceiling issues the markets had to face in October will be revisited in the first two months of next year. If the Fed previously pointed to such fiscal items as a reason not to cut back on their monthly $85 billion of bond buying, there is little reason to believe that upcoming potentially contentious debates won?t also play a major role in their decision making. Leadership change and Congressional dysfunction aside, the Federal Open Market Committee is most concerned about how tapering asset purchases will be seen by the markets given the sharp spike in interest rates that happened this past summer after such talk emerged. The meeting minutes showed extensive discussion on how to increase the clarity of their message. This week, chairman Bernanke in a speech wanted to clearly state that quantitative easing was separate and distinct from actually raising interest rates. Though asset purchases may decline in the ?coming months?, the near 0% policy for fed funds is likely to continue into 2015. By tying moves to the unemployment rate, the Fed is attempting to provide clear signals of their intentions to market participants. St. Louis Fed President James Bullard even proposed an inflation floor, below which the Fed would not raise rates. The rest of the committee found the benefits of such a proposal ?likely to be rather modest.? Bottom line, the Fed is unlikely to act until the labor market has improved ?substantially.? Bond yields moved higher when government data did point to a better economic outlook. Applications for unemployment benefits fell by 21,000 to 323,000 in the week ended November 16. That was the fewest since September 28 and was below a survey of Bloomberg economists of 335,000. Yields on the benchmark 10-year Treasury finished the week at 2.76% after last week?s close at 2.71%. The next employment report does not come out for two weeks, but given the strong report for October (a gain of 204,000 non-farm payrolls), if November also is solid, there will be more signs of bond weakness (yields move in the opposite direction of prices). Inflation remains tame. Wholesale prices, as measured by the producer price index, fell 0.2% according to the Labor Department during the month of October. Excluding food and energy, prices rose 0.2% after a 0.1% gain in September. The consumer price index (CPI) fell 0.1% last month according to a separate Labor Department report released this week. Over the course of the last 12 months ended in October, the CPI rose 1%. Excluding food and fuel, the so-called core rate rose 1.7%. Energy costs decreased 1.7% last month, the most in six months. The price of a barrel of oil traded at $95 today and has fallen 17% since it peaked at $110 per barrel in early September. The average cost of a gallon of regular gasoline so far this month is $3.21, down $0.58 from this year?s peak of $3.79 in February according to AAA motor group. The price of food, new autos and medical care services also all fell last month. This week many retailers have publicly stated that they are willing to sacrifice margins this upcoming holiday season in order to match price discounting from competitors with popular toys serving as a main loss leader. Many kids will get their G.I. Joe with the kung fu grip on sale this year!
SGK Blog--Update November 15, 2013: Yellen Speaks; Market Reacts       

In testimony before Congress, Janet Yellen, the nominee to be the next chairman of the Federal Reserve, signaled she will continue the Federal Reserve’s stimulus efforts. While we perhaps anticipated she might take a slightly more hawkish tone given her dovish reputation, she dispelled all sense of doubt by indicating the central bank should take care not to withdraw stimulus too early from an economy that is operating well below potential. “It’s important not to remove support, especially when the recovery is fragile and the tools available to monetary policy, should the economy falter, are limited given that short-term interest rates are at zero,” she said in testimony to the Senate Banking Committee in Washington Thursday. Stock traders responded favorably to these comments by pushing indices higher. According to a Bloomberg survey of economists done on Nov. 8th, the median forecast of 32 estimates suggested that central bank policy makers will probably pare the $85 billion monthly pace of bond buying to $70 billion at their March 18-19 meeting. We have been receiving mixed signals from other members of the Federal Open Markets Committee on how much longer this quantitative easing will continue at current levels. The reality is we are in a recovery and it has to end sometime. Markets usually move ahead of actual actions so that is why this particular issue has so much influence on trading activity. 

This week we did not have a ton of economic data as the government is now back to being on schedule after the shutdown. Third quarter unit labor costs fell 0.6% versus the expectation for a gain of 0.8%. This is important because labor is a key component of the inflation measurement. If the Fed is not seeing sign of inflation then there is not a huge impetus to reduce stimulus and they can focus on growing the economy. Third quarter productivity came in slightly below expectations rising 1.9%. Initial weekly jobless claims for the week ending 11/02/13 came in at 339,000, which was 9,000 higher than expected. Capacity utilization and industrial production for the month of October were both weaker than expected at 78.1% and -0.1% respectively. Our trade balance for the month of September was also worse than expected at -$41.8 billion. This was another example of a week where bad economic data sent equity indices higher, which may seem counterintuitive but demonstrates how focused traders are on the question of when the Fed will start to reduce their support for the economy.

SGK Blog--Update November 8, 2013: Payrolls Break 200,000 Barrier    
According to the Labor Department, employers added 204,000 non-farm payrolls during the month of October. In addition, September’s number was revised from +148,000 to +163,000. October’s actual number blew away the Bloomberg survey estimate of +120,000. The unemployment rate, which is derived from a survey of households and not businesses, rose to 7.3% last month compared to 7.2% in September. The strong figures led to a sell-off in the bond market as traders believe that a stronger economy will prompt the Fed to move closer to tapering their monthly purchases during the latest phase of quantitative easing. The benchmark 10-year Treasury note finished the week yielding 2.XXX% versus a Thursday close of 2.60%.

The health in the payroll number was broad-based. Retailers added about twice as many workers as the month before, and leisure and hospitality employment was the strongest in six months. Some employers are adding to seasonal jobs in preparation for holiday shopping. Amazon.com Inc. is expected to convert many of their full-time seasonal positions to permanent roles after the season ends as it did in 2012. Amazon relies on fourth quarter sales for about 35% of its annual revenues. In addition to Amazon’s 85,000 seasonal hires (including the U.S. and the U.K.), Wal-Mart will add 55,000, Target is targeting 70,000 more and Kohl’s will add approximately 50,000. Private employment, which excludes government agencies, added 212,000 jobs in October, after a revised increase of 150,000 last month.

The labor participation rate, which indicates the share of working-age persons in the labor force, fell to 62.8% last month from 63.2% in September. That is the lowest level since March 1978. We have argued before that there are a number of reasons why this number is falling including a return to school or further training or a desire to settle for part-time employment rather than remain full-time unemployed. The worst reason is, of course, searchers become more discouraged and dropping out of the labor force altogether. The longer an individual remains unemployed, the further that worker’s skills erode and eventually becomes unemployable no matter what the economic environment. That is the key concern for the Federal Reserve and why they are so keen on reducing the unemployment rate and less worried about a rise in the general level of prices. Though it is a worry, the bottom line for now is that the economy is productive enough to continue to grow even with lower participation.

Gross domestic product, GDP, grew at an annual rate of 2.8% in the third quarter according to the Commerce Department. That followed a 2.5% gain in the second quarter and was above the 2.0% expectation from a Dow Jones survey of economists. The main factor contributing to the surprise was an increase in inventory which added 0.8 percentage points of growth to the quarter. That translates into a $86 billion annualized pace in the expansion of firm stockpiles. Final sales, which excludes inventories, rose 2.0% following a 2.1% gain in the second quarter. Consumer spending, which comprises nearly 70% of GDP, rose 1.5% on an annualized basis. The question to ask is if this increase in inventories will be absorbed by demand during the current quarter which includes a holiday shopping season which is shorter than last year. Moreover, the partial government shutdown, which began on October 1st just as the fourth quarter began and lasted 16 days, is likely to be somewhat of a drag on final figures. If sales do not pickup, many economists now predict a modest 1.5%-2.0% fourth quarter which would leave overall 2013 growth around 2.0%. That is below 2012’s 2.8% growth rate and below the long-run growth rate of approximately 2.5%. A poor holiday season would put on hold the hopes of all those seasonal workers who are hoping for more permanent positions. 

Other data released this week leaned towards the positive. The Institute for Supply Management’s (ISM) non-manufacturing index rose to 55.4 in October from 54.4 in September reflecting that the largest section of the economy made it through the federal government partial-shutdown. A figure above 50.0 indicates expansion. A gauge of employment in service industries rose to 56.2 from 52.7 and business activity increased to 59.7 from 55.1. Last week, the ISM manufacturing index rose to 56.4, the highest level since April 2011. 

The European Commission (EC) on Tuesday trimmed its forecast for growth in the euro zone for 2014 to 1.1% from the previous expectation of 1.2%. The unemployment forecast was nudged slightly up to 12.2% from 12.1%. For this year, the EC expects a contraction of 0.4% which is unchanged from its May forecast. In their press release, they stated: “In recent months, the composition of global economic growth has shifted, and the external environment for the EU economy has become more challenging.” That fear has not manifested itself in higher sovereign bond rates which is a testament to the European Central Bank’s (ECB) efforts to stand as lender of last resort against such challenges. On Wednesday, the central bank lowered its benchmark interests rate to 0.25%.  ECB President Draghi said the euro area was facing a “prolonged period” of low inflation and pledged to keep borrowing costs low for an “extended period.” In language eerily familiar to central bankers on this side of the Atlantic, Draghi said “We are ready to consider all available instruments.” The euro has climbed almost 5% against its major peers this year which creates a big obstacle for exporters—especially its strongest country, Germany. With euro zone inflation at only 0.7% the threat of deflation became too great to ignore and the ECB was forced to act. The Achilles heel of the region seems to be its banking system which could now be facing negative deposit rates as the benchmark rates tumbles toward zero. There still remains far too little capital on the balance sheet of most European banks and the fact that 80% of sovereign and private sector public debt is held by the banks. This concentration of risk means that not having an adequate capital base continues to put the monies of the European public at risk. So far, they have avoided disaster, but it doesn’t mean they are not tempting it. 

SGK Blog--Update November 1, 2013: No Scare in the Markets for October   
With the federal government running again, investors and the Federal Reserve could look forward to some overdue economic data.  This last week in October we received news concerning retail sales in September.  According to the Commerce Department, excluding auto sales, retail sales gained 0.4% following a 0.1% for the month of August.  Overall sales fell 0.1% which was a bit below 0.0% median estimate in a Bloomberg survey.  Nine of 13 major categories advanced in October led by a 0.7% rise at electronic dealers and a 0.9% increase at both grocery stores and restaurants.  Electronic stores got a boost with the release of Apple Inc.’s two new iPhone models while game stores fueled the latest Take-Two Interactive release: Grand Theft Auto V.  With stocks hitting record highs, the so-called “wealth effect” cannot be overly discounted.

The Fed ended a regularly scheduled two-day meeting on Wednesday with little fanfare.  In their press release they highlighted that “Fiscal policy is restraining economic growth.”  As a result it will “await more evidence that progress will be sustained before adjusting the pace of its purchases.”  Therefore, the tapering of the $85 billion per month bond-buying program known as QE3 is unlikely to end soon.  There is one more Fed meeting this year but it would be surprising if Bernanke and co. would begin to de facto tighten monetary policy smack in the middle of the holiday shopping season.  Could it happen?  Yes, it could and we and many others were surprised when they didn’t taper purchases at the September meeting.  But last week’s delayed payroll figure was not impressive, and this week’s ADP private payroll survey was also underwhelming.  According to the median estimate of an October 17-18 Bloomberg News survey, the Fed will not reduce the pace of purchases until its March 18-19, 2014 meeting.  By then, current Vice-chairperson and White House-nominated candidate Janet Yellen will likely be confirmed by the Senate to take over for Bernanke, and she would have had time to disperse her thoughts to not only her colleagues but also the investment community at large.  Could make for an interesting first few months of the new year.     

Wholesale and consumer price data for September was also released this week.  The Labor Department reported a 0.1% fall in producer prices which was below a 0.2% advance estimated in a Bloomberg survey.  Excluding food and energy, this “core” reading was higher by 0.1% from the month earlier after being unchanged in August.  Consumer price data rose as projected as fuel charges climbed.  The index was up 0.2% from August while its so-called core reading was higher by 0.1%.  For the twelve months ending September, overall consumer prices were up 1.2%, the smallest year-over-year gain since April.  The core year-over-year rate was an increase of 1.7% which is barely in the range that the Fed is looking for in terms of price increases. 

In housing, the S&P/Case-Shiller index of property prices in 20 cities rose 12.8% in August compared to year-ago levels.  Tight inventories continue to boost prices even in the face of mortgage rates which have crept higher since spring.  Incidentally, rates are lower as of the week ended October 24th versus the week ended August 22nd according to Freddie Mac.  As of  August, average home prices were back to mid-2004 levels.  The August figure is influenced by transactions in June and July making it really a three-month average.  Values rose in all 20 metro areas.  Earlier this month, the index’s co-creator Robert Shiller was one of three economists awarded the 2013 Nobel Prize in Economic Sciences for research on how financial markets worked and assets are priced.

SGK Blog--Update October 25, 2013: September Payrolls Rise Less Than Expected   

We finally received data on the U.S. economy that had been delayed due to the government closure with the September payroll figures dominating headlines this week. 148,000 new jobs were added in the month of September and this was well below the median forecast of the 93 economists surveyed by Bloomberg who called for a 180,000 advance. On the positive side, the figure for August was revised up to 193,000 from the previous figure of 169,000. The unemployment rate dropped to 7.2% from the previous month’s 7.3% level. Although this latter figure is the lowest rate we have seen since November 2008, we have to note that the labor participation rate is stuck at 63.2%, which matches the lowest level since August of 1978. Ugh! Interestingly, the bad news lifted stocks in early trading Tuesday as traders anticipate that this labor report, combined with the uncertainty created by the dysfunction in Washington and its impact on the real economy, reduces the likelihood of the Fed beginning to taper their bond purchases this calendar year.  

In other economic news, on the housing front, existing home sales for September came in about as expected at 5.29 million while construction spending for August climbed 0.6%, higher than the 0.4% anticipated. Housing and construction have been key drivers here in the U.S. economic recovery after the recession ended in 2009. Initial weekly jobless claims for the week ending 10/19/2013 came in at 350,000 versus the expectation for 341,000. Orders for durable goods here in the U.S. in September rose the most in three months as strong demand for commercial and military aircraft outweighed a drop in business equipment. Bookings for goods meant to last at least three years rose 3.7% after a revised 0.2% gain in August. The median forecast by 67 economists surveyed by Bloomberg called for a 2.3% advance. A gauge of demand for capital equipment slumped 1.1 percent, a sign companies pulled back ahead of the federal government shutdown. Orders excluding transportation equipment, where demand is often volatile month to month, fell 0.1 percent after a 0.4 percent decrease in August. 

On the manufacturing front the news globally was somewhat mixed for the month of October. The Markit/HSBC Purchasing Managers Index for China rose to 50.9 this month from 50.2 in September, which was the fastest expansion in 7 months. But here in the U.S.. factory output was negatively impacted by the government shutdown as U.S. factory output contracted here in October for the first time since late 2009, according to financial data firm Markit. Markit’s “flash” Composite Purchasing Managers Index for the euro zone remained above the all-important 50 level but it retreated to 51.5 in October after hitting a two-year high of 52.2 in September. German factory activity grew, although their service industry saw a surprising fall in the pace of growth. It was a much bleaker picture in France, where manufacturing activity declined at a much faster pace and services expansion all but ground to a halt. Hmmm – maybe taxing business owners at 75% was not such a great idea after all! Certainly not according to French soccer clubs as they announced this week they will not play a round of league matches in the entire month of November to protest President Francois Hollande’s tax on the highest salaries kicking in next year. C’est la vie! 

In terms of third quarter earnings, so far results on average have been pretty good. As of Thursday afternoon, of the 212 companies in the S&P 500 Index that had released earnings to that point, 76% exceeded analysts’ predictions for profits while 53% beat sales estimates according to Bloomberg. Earnings for members of the gauge increased 2.5% while sales growth is on track to increase 2.2% overall, again according to analysts’ estimates compiled by Bloomberg. Of course we are always interested in looking under the hood and understanding the quality of these earnings. We want to understand whether they are based on actual revenue growth and cost controls or if they are manufactured through financial engineering. So far so good with our core holdings, with just a couple of exceptions.

SGK Blog--Update October 18, 2013: We Have a Deal  
Who wouldn’t want a 16-day paid vacation?  Congressional leaders finally came to a deal about re-opening the government and raising the debt ceiling after many weeks of acrimonious debate.  The markets responded favorably, but the question remains: “Was it all worth it?”  In our view, the current debate and ideological divide is unlikely to be bridged between now and early 2014 when, once again, the government will face a shutdown and the debt ceiling limit is reached.  Markets never really panicked even though many were calling a potential default another “Lehman event” in regards to the meltdown that struck the markets after Lehman Brothers declared bankruptcy in 2008.  Instead, the S&P 500 dipped about 1.5% below its September 30th close by October 9th only to see it rebound and close at new record levels.  The potential political fallout is best debated in another forum.  As far as we are concerned, we are glad it is over and the market can refocus on the fundamentals…for now.

Government economic data will begin to resurface with fits and starts over the next few weeks including the missed payroll data and information from the Energy Information Administration which tracks the nation’s use and inventory of commodities such as gasoline and natural gas—important indicators given that the U.S. consumes the most amount of energy of any country on the planet.  Specifically, the Labor Department said that the Employment Situation report will be released next Tuesday and October’s payroll data will be delayed a week from the normal first Friday of the month until the following Friday, November 8.  Meanwhile, the National Association of Homebuilders/Wells Fargo index of builder sentiment was released this week for the month of October.  It showed a decline to 55 this month from a revised 57 in September.   The median forecast in a Bloomberg survey was for a 57 reading.  Readings above 50 mean more builders view conditions as good than poor.  The outlook for sales in the next six months also fell to a four-month low reflecting the gridlock situation in Washington.  Overall, we still believe the environment in the residential real estate market is positive.

The government data which was released can best be characterized as “noisy”.  Weekly initial unemployment claims were 358,000 in the week ended October 12 from a revised 373,000 in the prior period according to the Labor Department.  Applications in California were still elevated due to a computer issue, and the total also included some non-federal workers dismissed due to the shutdown but did not include furloughed Federal employees.  To further muddy matters, about 70,000 claims were filed by Federal workers but that data is two weeks old.  In other words, there is no discernible trend that can be seen from data released the last few weeks.  As the agencies get back up to speed, we will get a clearer picture in the days to come.

SGK Blog--Update October 11, 2013: Equity Markets Shift Course on Deal Prospects in Washington  

After stock markets sold off in Monday and Tuesday trading on light volumes, professional traders got what they were looking for Thursday on signs that the impasse in Washington was headed for some type of resolution. Equity indices shot higher based on a thawing of the tensions in DC that had been lingering between the President and the Speaker of the House. The chief concern amongst market participants was the possibility that politicians would push the timetable to resolve the debt ceiling increase right to the limit. The consequences of a stalemate in DC were so uncertain it was hard for traders to even fathom that our political leaders could be so stupid as to let some type of default event take place. On Thursday, Republicans announced they were seeking a debt ceiling increase until November 22 and President Obama hinted that he was receptive to a short term delay in order to continue the dialogue. While an imperfect solution, and some would argue no real solution at all, this at least released some of the tension that had been building up as professional traders stepped in and acquired stock sending the major averages up over 2% in trading Thursday. Call it a relief rally!    

It has been challenging to interpret the economic data that has been coming out from the various departments in Washington because half of the reports are missing due to the government closure. So after last week’s non event when the September employment report was to be released, missing in action this week were reports on the trade balance, retail sales, the producer price index and export/import prices. While not as high profile as the monthly employment report, these are still very important data points in gauging economic health in our domestic economy. The data that did come out too was subject to some distortion as evidenced by the weekly jobless claims report released Thursday. At first glance the report was terrible as claims for the week ending 10/5/2013 came in at 374,000 versus the expectation for 318,000. However upon further review, it could be explained by two factors: first, furloughed federal workers applying for unemployment benefits given there is no clear end is sight to the shutdown; and second, California was playing catching up on claims after changing over their computer systems over the past two weeks which resulted in that state underreporting claims during that time frame. We did have an indicator on consumer confidence issued by a non-government entity – the University of Michigan’s consumer sentiment survey for the month of October came in at 75.2 versus the expectation for 74.5. We like these surveys because they are some of the most up-to-date data that we get and this figure was a welcome relief when issued given all the turmoil taking place in Washington. 

Normally the nomination of the next Central Bank chief here in the U.S. would have captured front page headlines but, given all that is going on in Washington, the announcement that President Obama’s nominee for the next chairman of the Federal Reserve was to be Janet Yellen was simply noted by market participants, although it did help take the edge off of nervous traders the day the announcement was made. President Obama has made it clear in numerous speeches that he is generally hawkish on rates in the sense that he is very concerned about the potential instability associated with future financial bubbles. Hence originally his first choice was to be Summers until he took himself out of the running. Yellen is considered to be somewhat dovish and expected to follow the path that Ben Bernanke laid out in terms of balancing the focus between full employment and the risks of inflation. Thus, market participants would interpret her nomination as being beneficial for markets in keeping rates low and stimulus applied for as long as it is warranted. Of course, she may come in and attempt to prove to critics that she is in fact tough we believe that risk to be minimal and that may simply be over-thinking the issue. Stability and predictability are always welcome by traders and her views on monetary policy are well known, hence the positive market response to the announcement of her nomination during an otherwise uncertain week. 

SGK Blog--Update October 4, 2013: Government Shutdown Greets End of Quarter 
The federal government shutdown on Tuesday after Congress failed to agree on a continuing resolution that would keep it running.  Most of the government’s 3.3 million workers are deemed “essential” and are still working.  However, over 800,000 individuals were asked not to show up for work anymore which will have far reaching effects in many industries if the work stoppage is prolonged.  If the shutdown continues for three-to-four weeks, an analyst at Moody’s Analytics estimates it would cost the economy $55 billion.  The last time the government shutdown it was late 1995 which stretched into 1996 for a total of 21 days.  Then President Clinton was at odds with House Representative Newt Gingrich.  Today’s major players are President Obama, House Speaker John Boehner and Senate majority leader Harry Reid.  Many politicians such as Senator Cruz from Texas, Representative Meadows from North Carolina and George Representative Graves have raised the stakes, and possibly risked their careers, by standing in the way of a “clean bill” that funds the government.  In their minds, the risk is worth it if spending is strictly controlled even if that means the government has to shut down in order for that to happen.

We have no idea when this might be over.  The key point is that it does come to an end.  What makes the situation trickier is that the government is also running out of money to stay afloat at all.  The debt ceiling debate is due to take over the headlines.  Treasury secretary Lew sent a letter to Congressional leaders stating that “extraordinary measures will be exhausted no later than October 17”.  There’s probably some wiggle room in those days since the Treasury will still have $30 billion left at that point to spend but a so-called technical default would likely occur soon after that.  On November 1, a $67 billion outlay including Social Security and Medicare benefit payments and military pay is due which would certainly not be made given the current status.

A government shutdown, though unwelcome, is manageable.  These individuals are not fired but furloughed.  The country survived 21 days of shutdowns in 1995.  In fact, there have been 17 shutdowns since 1976 according to Bloomberg data.  Not paying sovereign obligations is a totally different ballgame.  The U.S. dollar is the world’s de facto global currency.  Obligations denominated in that currency also carry that status.  When Standard & Poor’s downgraded the U.S. of its AAA credit rating in August 2011, prices for bonds actually rose not because of the rating change but because investors flocked to the securities as a symbol of strength and security given the overseas fiscal turmoil in Europe.  In the ultimate act of faith, buyers of short-term paper have accepted a negative real return (nominal rate minus the inflation rate) meaning they are willing to lose purchasing power simply as a way to get a return of principal rather than a return on principal.  All of that would change if the borrower, in this case the U.S. government, didn’t payback its lenders.  Calling it a catastrophe would be putting it lightly. 

The equity and bond markets have taken this political wrangling in stride. And why not?  Since 1976, the S&P 500 has risen 11% on average in the 12 months following a government shutdown.  The S&P remains within 3% of its all-time high set last month.  The common refrain from traders has been: “I’m a buyer on weakness” meaning that dips in the indices will be met with buy orders.  After the S&P fell 11% in three days in response to the stalemate between President Obama and Congress in August 2011 surrounding that debt ceiling debate, the following 12 months, the S&P gained 25%.  Some investors are secretly or not so secretly wishing for a plunge to send a message to Congress that this type of brinkmanship is not acceptable (and to buy on the cheap).  But nobody is voting with their feet as averages remain near record highs and the yield on the 10-year Treasury not remains solidly within its 3-month range of 2.48%-2.99% finishing the week at 2.XXXX%.  So, until the politicians on the Hill decide to act like adults and settle this matter, all we can do is stay tuned.

SGK Blog--Update September 27, 2013: Traders Follow Budget Negotiations With Trepidation 

Stocks started out the week on shaky ground as traders were still digesting the implications of last week’s Fed meeting.  Comments from influential Fed members this week just seemed to add to the confusion. Fed Bank of New York President William C. Dudley stated Tuesday the central bank may reduce the pace of its quantitative easing program beginning in 2013 but that it was dependent on the economy’s performance. Last week Fed Bank of St. Louis President James Bullard said policy makers may decide to reduce their monthly bond purchases at the meeting in October. Our view is that it seems more likely, barring a really strong September employment report, that the process will begin in December, just in time to rain on, or should we say reign in, our Christmas stock rally! We just don’t believe there are enough data points between now and the October meeting to change their view dramatically from the September meeting. The December meeting will be followed by Bernanke’s last press conference before his tenure ends in January so it seems right in terms of the timing. Of course – they could surprise us again! Most believe that the process of buying bonds to suppress interest rates and assist the economy was really driven by the current Fed Chairman and that he will want to see the process of unwinding the program begin on his watch. Just in time to pass the baton! Negotiations over the budget and whether or not the government will remain open beyond September 30th added to the uncertain environment pressuring stocks throughout the week. The administration also warned this week that unless the $16.7 trillion debt ceiling is increased, the Treasury will have less than $50 billion in cash by mid-October.  

Home prices continued to demonstrate strength as the S&P/Case Shiller index of property values in 20 cities increased 12.4% from July 2012, the largest increase in 7 years. This data is backward looking and somewhat dated when released as it takes a while to compile. Given it runs through July 2013, it would not surprise us to see this slow in the coming months as the effects of the rapid rise in interest rates over the past few months takes hold. Still this is a far cry over where we were during the depths of the financial crisis and housing has been a major contributor to the rebound we have experienced here in the U.S. economy. This report was tempered on the day of the release by the consumer confidence figure for September which dropped to a four month low of 79.7 from a revised level of 81.8 for August. Again, we have come a long way since the financial crisis as this figure averaged 53.7 during the recession that ended in June 2009.  

New home sales in the U.S. rose 7.9% to 421,000 for August which was ahead of expectations although the July figure was revised down slightly. Although a nice increase for August, given demand had slumped 14.1% in July this raised concerns that higher interest rates are having an undesired impact on the housing market. Pending home sales reflected this as well as they were down 1.6% in August although that was better than expected. Orders for durable goods rose less than forecast for August at +0.1% versus the expectation for +0.5%. Excluding the volatile transportation component, orders actually came in at -0.1% versus the expectation for +0.9%. Weekly initial jobless claims for the week ending 9/21/13 came in 20,000 less than expected at 305,000. The third estimate for second quarter GDP was slightly below expectations at +2.5% versus the +2.6% forecast. Wrapping up the week we had figures for personal income and personal spending which were both slightly better than expected at +0.4% and +0.3% respectively.    

Germany is benefiting from unemployment near a two decade low and the end of the euro area’s longest recession. The Ifo institute’s business climate index, based on a survey of 7,000 business executives in that country, climbed to 107.7 for September from a revised 107.6 in August. The gauge has gained in five consecutive months reaching its highest level since April 2012. This helped propel Chancellor Angela Merkel’s Christian Democrats to take the largest share of the vote in their September 22nd elections and set her up for a third term as leader. The European Central Bank has pledged to keep interest rates low to support what it calls a fragile euro area recovery. The euro area region’s GDP finally expanded 0.3% in the three months ending June, snapping six quarters of contraction. ECB President Mario Draghi indicated this week that the ECB is ready to use another longer term refinancing operation if needed to curb market rates. The bank had introduced two three year LTROs starting in December 2011, which we had written extensively about back then, to ease the credit crunch at the time. As we stated then, this was done to buy time and that is exactly the impact that it has had.

SGK Blog--Update September 20, 2013: Surprise!  No Taper by Fed

The Fed blinked. There is really no other way to describe the result of the latest meeting of the Federal Reserve Open Market Committee where they decided to stay the course and continue buying $85 billion of fixed income securities per month. What the market found surprising was that Fed officials had spent months dropping hint after hint that a tapering of the latest quantitative easing was quite likely. In May Bernanke said the job market’s improvement and anticipated faster GDP growth would lead to a pullback on the bond-buying program. In June he said slowing bond purchases would be like “letting up a bit on the gas pedal as the car picks up speed, not applying the brakes.” In subsequent meetings and speeches, there was always a nod to interpreting the latest economic releases—the so-called “data dependent” clause—but  few solid signs that the tide had turned against tapering. Nevertheless, the press release disseminated yesterday stated, “the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.” They added, “the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.”  In a press conference after the meeting, Bernanke said, “Conditions in the job market today are still far from what all of us would like to see.” Apparently, it was a close call, but that only counts in horseshoes and hand grenades.

Frankly, we were surprised by the announcement as well as a little disappointed and somewhat confused. Granted the most recent economic data on employment was not robust by any means. The unemployment rate was at 7.3% in August according to the Labor Department. That was an improvement from the 9.6% for 2010, 8.9% for 2011 and 8.1% for 2012. However, much focus recently has been placed on the labor participation rate. With that number declining, it brings into question the robustness of the nationwide unemployment rate. This is a key point because the Fed had stated that a reduction of the bond buying program would likely occur, in the absence of inflation, when that rate reached 6.5%. Or was it 7%? In June, Bernanke said at that post-meeting press conference that officials expected the jobless rate to be about 7% when the Fed ended the program. When asked specifically about that 7% level on Wednesday, he played it down, responding, “There is not any magic number…We’re looking for overall improvement in the labor market.” Adding to the confusion, he stated this week that the unemployment rate was “perhaps the best single indicator of the state of the labor market” but later proposed “the unemployment rate is not necessarily a great measure in all circumstances of the state of the labor market overall.” 

As if that confusion wasn’t enough, the Fed as a whole seems to be a poor predictor of the future. Granted, their job is not easy, and we are well aware of the challenges of steering a $15 trillion economy with blunt monetary tools while having no input into fiscal policy. Yet, since mid -2011 the Fed has been guilty of overestimating the growth of the economy. The “central tendency”, or best estimate excluding outliers, for annual GDP growth for 2013 was 3.5%-4.3% as of 4/27/11, fell to 2.7%-3.1% by 4/25/12 and currently stands at 2.0%-2.3%.    Meanwhile, their projections on unemployment have been underestimated. Chairman Bernanke has conceded these mistaken forecasts but refuses to face the terrifying fact that the Fed’s QE’s programs haven’t worked. Maybe they saved the country from a outright economic depression, but they have not ignited the country’s output at the level they thought it would. So, by decreasing GDP forecasts at the latest meeting, it would have been highly irrational to also decrease the bond purchase program in the face of such weakness. This reminds us of the timeless saying: Beatings will continue until morale improves. In other words, these policies have not worked as intended, so they must be continued until they do.

Europe has similar problems. Several banks, especially those in the financially challenged south, have started to lobby the European Central Bank (ECB) for a lending program to replace a current one—over a year before it is due to end. In late 2011, the ECB disbursed about €1 trillion in three-year loans to hundreds of banks that could not borrow through ordinary channels. This program, called long-term refinancing operation or LTRO, is widely credited with easing some of the eurozone’s crisis. Yet with only €334 billion paid off, banks are already anxious for another plan to replace it before they come due in 2015.

The message is clear: the markets like quantitative easing and it will not be easy to remove this “drug” from the system. On a short-term basis, in the midst of emergency conditions, that is fine. We have argued for the use of a monetary “bazooka” to help jawbone the markets back in line both here and abroad. However, is the patient, i.e., the U.S. economy, still on life support? Is there more of a political angle at play with Bernanke side-stepping the question concerning the end of his term? With Vice Chairman Yellen confirmed this week by the White House as the front-runner to replace him after Obama-favorite Summers dropped out over the weekend, might Bernanke be trying to keep a clean slate for his well-respected colleague? Was the Fed spooked by the spike in 10-year rates to touch 3% earlier this month and the steady rise in mortgage rates? Sales of existing homes rose in August to the highest level in more than six years to an annual rate of 5.48 million. The median price rose by the most since October 2005. Skeptics point that it was a surge in August before borrowing costs really began to bite and affordability issues began to play more of a role. In fact, builders began work on fewer homes than projected in August as housing starts rose to a 891,000 rate that was below the median Bloomberg economists forecast of 917,000. Is that a temporary slowdown? Sentiment in the industry according to the National Association of Home Builders/Wells Fargo index held in September at the highest level in eight years. Regardless, there is no mistaking that Freddie Mac’s 30-year home loan average of 4.57% will have an effect on demand compared to the 3.81% level at the end of May.

Our biggest reason for concern is that the great experiment of QE has neither an end date nor a justifiable reason at this point given the economy’s signs of life that make life-support-type measures seem like overkill. It is quite likely that when tapering begins it will be accompanied by a press conference and since none are scheduled until December, the buying will continue even though Bernanke says they could switch gears at any time. Even after comments on Friday from St. Louis Fed President James Bullard which indicated October may be possible taper date, that only allows for one more employment reading instead of the three were a move made in December, with the added bonus of an early view into the holiday shopping season. We are in agreement with Fed officials that the economy is not yet healed. Yet, the Fed is putting $85 billion…that’s $85 BILLION (we used caps to emphasize the point)…per month into the economy. Banks and corporations are awash in cash. Somehow all this money is NOT finding its way into more loans, into new value-added projects, into job-creating activities. We know where it is going—into an already fully valued stock market.

SGK Blog--Update September 13, 2013: Uncertainty Mounts as Traders Await News on Syria & Fed 

Stocks rallied early in the week on news that a deal on Syria’s chemical weapons was in the works between the United States and Russia. As the week progressed we could sense nervousness as traders weighed the tough talk coming from Kerry and as they tried to anticipate what the Fed would say and do next week at their September meeting. Speculation that they would announce a reduction in their bond buying stimulus program has been tempered lately by mixed economic data, encapsulated by the August employment report which was weaker than anticipated. So the question on traders’ minds this week has been what will the Fed do? We anticipate some clarity around when they plan on reducing their purchases of Treasuries and mortgage-backed securities, even if they choose not to begin that process immediately. On Syria, it is a matter of wait and see as negotiations progress. Traders seemed to have discounted into prices a resolution not involving conflict as evidenced by the retrenchment in the price of oil this week. 

For the U.S. economy, traders were jolted awake Thursday morning with the headline that weekly jobless claims dropped to 292,000 for the week ending 9/7/2013 compared to the expectation for 327,000 until it was announced by the Labor Department that two states had underreported due to the fact they were upgrading their computers. Traders quickly shook off the report and stock futures remained stable. The retail sales figures for August released Friday were disappointing as they showed a 0.2% increase versus the expectation for a 0.4% increase. Even when the figure excluding autos (a less volatile measure) was released it still came out below expectations at +0.1% versus the +0.3% expected. Combined with the disappointing figure released by the University of Michigan on consumer sentiment for September which came in at 76.8 versus the expectation for 82.0, this actually caused stocks to rally. Why you ask? In the view of many traders, disappointing economic figures here in the U.S. means that the Fed may be less likely to announce a reduction in their bond buying stimulus program next week. The release of the producer price index for August helped support this view as although the headline number came out a little hotter than expected at +0.3% versus the expectation of +0.2%, the less volatile core rate measure which excludes food and energy came out flat (no increase, no decrease) versus the expectation for a +0.2% increase.  So equity traders fed off of the combination of weaker than expected data and tame inflation figures while fixed income traders basically were waiting to see what the Fed will actually say in their meeting next week as bond prices barely moved at all Friday. 
SGK Blog--Update September 6, 2013: Employment Data Breed Doubt in Taper  
Payrolls in the U.S. rose 169,000 in August following a revised 104,000 increase in July that was smaller than initially estimated according to the Labor Department.  Given that the forecast of 96 economists surveyed by Bloomberg called for an August increase of 180,000, some view the actual figure as a disappointment.  Unemployment dropped to 7.3%, the lowest level since December 2008.  Treasury bonds rose as investors interpreted these numbers as a roadblock to the Federal Reserve and its efforts to “taper” the $85 billion per month of bond buying.  The benchmark 10-year Treasury bond saw its yield drop to 2.904% after reaching 3.005% overnight on Thursday according to Tradeweb data.  Incidentally, that was the first trade over the 3% yield level since July 2011.  Stocks initially rose in pre-market futures action before being weighed down by further military action on Syria.

What is our take on the payroll figure?  As we have previously mentioned, focusing on one number is likely a mistake.  These monthly amounts are revised frequently (as July’s figure was) and they are not as timely as the weekly initial unemployment claims.  Actually, those claims fell by 9,000 in the week ended August 31.  The figure of 323,000 was just shy of the 322,000 reported in January 2008.  This suggests that employers are not aggressively paring their ranks, but they are not robustly hiring either.  A lot of focus has been put on the labor force participation rate which indicates the share of working-age people in the labor force.  For August, this number declined to 63.2%, the lowest since August 1978 when it reached 63.4%.  This is an important number until it is not an important number.  That is, there could be a number of explanations for this including the rise of adult offspring returning to live at home, dual income households dropping to one income or a rise in “black market” activities which generate income and no W-4 forms to fill out.  The importance of this statistic is further reduced when a plethora of other economic data is nothing short of awesome.  Cars and light trucks sold in August at the fastest annualized rate since 2007 according to Ward’s Automotive Group.  All the major brands—GM, Ford, Toyota and Honda—exceeded analysts’ estimates.  Ford said it will boost fourth-quarter production by 7% and, in the telecom world, AT&T needs to fill hundreds of positions in the San Francisco Bay area.  The Institute of Supply Management’s manufacturing index rose in August at the fastest pace since June 2011 and the service index posted the highest reading since December 2005.  It will not be until next Friday when retail sales for the month of August will be released, but estimates are calling for decent gains during the crucial back-to-school selling season.

The unemployment rate has been falling because there have been less people in the workforce and more discouraged folks who cannot find full-time employment (though the number of male discouraged workers actually fell year-over-year).  However, families are finding a way to afford a new car and are confident enough to provide fuel for a resurgent housing market.  The measure of employee output per hour rose to a 2.3% annualized pace in the second quarter which was not far from last week’s GDP figure which came in right at 2.5% growth.  The average annual gain in productivity in the 2000-2011 period has been 2.4%.  In other words, businesses are more productive than they have ever been and a low participation rate may be one result of that.  We cannot predict where this figure will go, but we can guess that demand for workers will likely increase especially if we see a rebound in Europe (which decided this week to remain very accommodative on their rates) and a lack of government shrinkage from the effects of the sequester (in fact, government workers actually increased in August).  We will find out in about two weeks what decision the Fed has come to about their purchases.  Stay tuned.

SGK Blog--Update August 30, 2013: Tensions Over Syria Cause Stocks to Retreat  

Equities rebounded from Tuesday’s eight week low for the major indices as energy stocks climbed on higher oil prices. Oil prices were sent higher amid growing speculation that a military strike by the United States and our allies in response to a chemical weapons attack near Damascus last week would disrupt supply. Throughout the course of the week Obama administration officials were in consultations with NATO allies including the U.K., France, Germany and Turkey as well as Arab nations to determine which countries would participate in a military strike against Syria. The British parliament voted “no” to participating in a limited military engagement leaving the Obama administration without a key ally. The situation is complicated because Syria maintains a relatively robust air force and counts as allies both Russia and Iran. In Tuesday trading, stocks here in the U.S. dropped 1.6% as financials, industrials and technology stocks led declines. Markets behaved worse overseas as European indices declined 1.8% on average and emerging market indices were varied. The Dubai DFM General Index plunged 7% on the news of possibly military action by the U.S. 

News of potential instability in the Middle East also caused commodity prices to rise as oil spiked higher throughout the week. The price of Brent crude popped up briefly over $117 per barrel in Wednesday trading. West Texas Intermediate, or WTI for short, also rose to finish the day over $109 per barrel. WTI is the pricing we often reference in our weekly email as it is a more pertinent price to us here in the U.S. We should draw a distinction for you between the two – Brent crude and West Texas Intermediate. Brent crude is actually considered a better indicator of global oil prices. Brent essentially draws its oil from more than a dozen oil fields located in the North Sea. It represents the Northwest European sweet market, but since it’s used as the benchmarks for all West Africa, the Mediterranean and now also for some Southeast Asian crudes, it’s directly linked to a larger global market. Anyway, you look at it – prices rose this week and this can spill over and have a dampening effect on major economies across the globe. This is particularly concerning for Europe given they already pay high taxes for gasoline and are just now showing signs of coming out of their economic slump.    

Events in Syria overshadowed a mixed but not bad week for economic data here in the U.S. The week did start out on a bit of a sour note with the report on durable goods orders. For July, durable goods (goods built to last longer than one year) declined 7.3% relative to the expectation for a 5% decline. Stripping out the volatile transportation segment (autos and airplanes) it still showed a decline of 0.6% versus the expectation for a 0.6% gain. The impact of the sequester is evidenced in these figures as military spending on big ticket items was down sharply for the month. The Case-Shiller 20-City Index for home prices rose 12.1% for the month of June (year-over-year) which was slightly better than expected. Any positive news on the housing sector is welcome indeed! This was followed on the same day (Tuesday) by the release at 10 am of the consumer confidence figure for August which was a robust 81.5 versus the expectation for 77 and up from the prior month’s level of 81. Pending home sales for July were slightly lower than expected at -1.3% compared to the expectation for +0.2% but this is not a total surprise as we have witnessed quite a jump in mortgage rates over the previous three months. Initial weekly jobless claims for the week ending 8/24/2013 fell to 331,000, which was in-line with expectations and down from the prior week’s figure of 337,000. Second quarter GDP (Gross Domestic Product) here in the U.S. was revised upwards to +2.5% up from the previous estimate of +1.7% as a smaller trade deficit and gains in inventories overshadowed the effects of federal budget cutbacks under the sequester. Does this mean the Fed will announce the beginning of their “taper” at their September 17-18 meeting? We will have to wait and see – stay tuned!

SGK Blog--Update August 23, 2013: Fed Views "Mixed" on Economic Direction  

Remember when Europe was on the brink of collapse?  Actually it was just last summer when bond yields on Italian and Spanish debt widened versus the benchmark German bund and had many economists and traders thinking the days for the eurozone were numbered.  Flash forward to 2013 and the consensus is markedly different.  According to data provider Markit, the euro-zone purchasing managers indexes showed expansion in August including the previous trouble children Spain and Italy.  The composite—which combines data from the services and manufacturing sectors—rose to 51.7 from 50.5 in July.  The 50.0 level separates contraction from expansion.  Germany’s manufacturing index rose to 52.0, the highest level in 25 months.  Other nations were not as high, but new orders were solid and expectations were positive for the future.  This comes on the heels of a 0.3% eurozone GDP reading for the second quarter which broke a string of six consecutive negative quarterly figures.  The 17-nation common currency bloc cannot be considered completely healthy, but clearly it is on much better ground than many had predicted.

Meanwhile, the U.S. economic engine continues to look solid based on reported data.  The number of weekly initial jobless claims rose by 13,000 to 336,000 in the week ended August 17 but the four-week average was down.  Separately, the National Association of Realtors reported that sales of previously owned homes climbed more than forecast in July to the fastest pace since November 2009.  Friday saw a decline in new home sales but that was more related to builders holding back construction rather than a sharp decline in demand.  Though units of new home sales were down compared to the previous month, the median price increased 8.3% last month from a year ago to $257,200.

This week, the general public got to read the minutes from the Federal Reserve’s July policy meeting.  Officials are divided about the appropriate timing of the first reduction in their $85 billion per month bond-buying program.  Some members thought growth would pick up in the second half of the year while “a number of participants indicated, however, that they were somewhat less confident about a near-term pickup in economic growth than they had been in June.”  The minutes also stated, “it might soon be time to slow somewhat the pace of purchases as outlined in the plan.”  According to a Bloomberg survey taken August 9-13, 65% of 48 economists believe there will be a cut in purchases at the Fed’s September 17-18 meeting.  The median estimate called for a cut to $75 billion per month.  That two-thirds number is not high enough to claim it will definitely happen, but it does show the market is leaning in that direction.  As we have written previously, the Fed’s direction is no longer in doubt, the only question which remains in how quickly and convincingly they want to end the quantitative easing program.  Anything more than baby steps would be a surprise.

SGK Blog--Update August 16, 2013: More Good Economic News  

With only a few more weeks left before the unofficial end to summer arrives with Labor Day weekend, the U.S. economy has been heating up.  Retail sales rose in July for the fourth consecutive month.  The 0.2% increase followed a 0.6% gain in June.  Though that was slightly below the 0.3% expectation, it was offset by the fact that June’s figure was revised higher from an original 0.4% increase.  At clothing chains, sales were up 0.9% and 0.4% higher at general merchandise stores.  Heading into the very important back-to-school period, these figures are promising.  Meanwhile, there remains an absence of pricing pressure.  The consumer price index rose 0.2% in July.  Excluding food and energy, the “core” figure was up a similar 0.2%.  On a year-over-year basis, overall prices were up 2% but only 1.7% in the core figure.  That is still within the 1%-2% range the Fed likes to see, but there has not been a worrisome disinflationary trend either.

Fueling these gains has been the employment picture.  Claims for jobless benefits fell to the lowest level in almost six years.  In the week ended August 10, unemployment insurance payments fell by 15,000 to 320,000 from the week previously.  That was the fewest since October 2007 and below the median forecast of 44 economists survey by Bloomberg which called for a 335,000 claims.  As mentioned in previous weeks, the summer months can be quite volatile due to season factors, but the Labor Department said that there was nothing unusual about this week’s data and no states were estimated.  The number of people continuing to receive jobless benefits dropped by 54,000 to 2.97 million in the week ended August 3.  These better payroll figures is fueling a better housing market, too.  Housing starts climbed 5.9% to an annualized 896,000 in July according to the Commerce Department.  Multifamily construction—i.e., apartment buildings—surged about 26%.  Building permits rose 2.7% also helped by a jump in multifamily.  Building applications for single-family homes exceeded the number of starts which bodes well for a pickup in construction in the coming months.  The National Association of Home Builders/Wells Fargo index rose to 59 in August from a revised 56 in July (previous level=57).  Readings above 50 suggest builders view conditions as good.  This is the highest measure for this index since November 2005 when it reached 61.  A rise in mortgage rates may temper some of this enthusiasm in the coming months but it is clear that things are on solid footing in the real estate area. 

Also, surprisingly, there was some good news out of the eurozone in terms of economic growth.  Gross domestic product in the 17-nation financial bloc rose 0.3% in the second quarter after a 0.3% contraction in the previous three months according to the EU’s statistics office in Luxembourg.  That was higher than the median estimate of 0.2% and ended six straight quarters of contraction.  Germany and France led the way with 0.7% and 0.5% growth, respectively.  Still, four of the 17 nation’s remain in contraction including both Italy and Spain.  With the eurozone’s collective unemployment rate at 12.1%, the highest since the euro’s inception in1999, European Central Bank President Mario Draghi called progress “tentative.”   We would call it a miracle given the state of affairs just last year.  Of course, the continent is far from out of the woods.  Growth rates still remain too low to help bring down that dramatically high unemployment rate, and, though interest rates on sovereign debt are relatively calm, they remain perilously close to danger levels.  Nevertheless, the spread between Italy’s and Spain’s 10-year yield premium over benchmark German bunds shrank to the smallest level in two years this week.  For example, in Spain, the spread now is only about 265 basis points (a basis point is 1/100 of a percent) compared to 650 basis points in July 2012. 

While it is too early to claim a global recovery is underway, the signs are obvious that the worst of the recession is past and sustainable growth is apparent in the U.S.  That means the Federal Reserve will have to take a long and hard look at its policies to see if a change is needed.  Many market players are betting that the Fed removes some fuel from its quantitative easing program next month and futures are expected a 10-year yield over 3% by year end (versus this week where it closed near 2.78%).

SGK Blog--Update August 9, 2013: Stocks Held in Check on Speculation Fed Will Announce Start of "Taper" at September Meeting  

Stocks were weaker this week on speculation the Fed will announce a tapering of their quantitative easing stimulus or bond buying program when they meet in September. According to a Bloomberg poll, 44% of economists predict the Fed will reduce their bond buying by $20 billion to $65 billion when they meet on September 17-18. Further fueling this speculation were comments from Fed Bank of Cleveland President Sandra Pianalto when she said, “a tapering of the central bank’s stimulus may be warranted if the labor market continues to strengthen.” The Bank of England raised its outlook for the economy for this year and next year and said price stability remained a primary objective. But for the first time, the Bank of England followed in the Fed’s footsteps by linking interest rates specifically to the jobless rate. Their magic number is 7% unemployment as opposed to our central bank’s target of 6.5%. In summary, concerns about the Fed’s quant easing removal are outweighing the economic data now that we are through the bulk of second quarter earnings reports. The focus has shifted from how companies are doing to what the Fed plans on doing.

For the most part, the data we had on the U.S. economy was solid this week. Our Institute of Supply Management (ISM) Services Index beat expectations coming in at 56 in July relative to forecasts for 53.2. We are a services and consumer spending driven economy here in the U.S. so this is an important indicator. Our trade balance fell to $34.2 billion for June relative to expectations for $43.4 billion as oil and gas imports continue to drop here in the U.S. based on our continued output. Will we eventually become a net exporter of oil and/or natural gas? We will have to wait and see but it will be nice when we are less reliant on oil imports from the Middle East. We have not written about OPEC meetings in many months whereas in years past they had much more influence on market prices. Initial weekly jobless claims were 333,000 for the week ending 8/3/2013 relative to the forecast for 340,000. On the whole then, the major releases on our economy this week were pretty strong. 

The National Association of Realtors reported that prices for single family homes climbed in 87% of U.S. cities in the second quarter as the national housing recovery accelerated amid competition for properties in the marketplace. The median transaction price rose from a year ago in 142 of 163 metropolitan areas measured. At the end of the second quarter, 2.19 million previously owned homes were available for sale, 7.6% fewer than last year. The median price for an existing single family home was $203,500 nationally in the second quarter, up 12% from a year ago. At the same time, in a separate report the Mortgage Bankers Association indicated that the share of U.S. mortgages that are seriously delinquent plunged to the lowest level in almost 5 years based on the improving employment picture in this country. The percentage of home loans more than 90 days behind or in the foreclosure process fell to 5.88% in the second quarter compared to 7.31% in the same period last year. All good news on the home front! 

Finally, data points released on the Chinese economy this week helped lend a measure of support to stocks in Thursday trading. China’s exports and imports exceeded economists’ forecasts, adding to signs that the world’s second largest economy is stabilizing following a two-quarter slowdown. Improved trade may bolster Premier Li Keqiang’s chances of achieving the year’s 7.5% target for expansion, after manufacturing and service-industry indexes rose in July as well. We will have to wait and see as China’s stock index has been a drag on global indices with it down over 7% year-to-date. They are due for a rebound there!

SGK Blog--Update August 2, 2013: Fed Has Tough Balancing Act 
The Fed has to remove accommodative bond buying but at the same time make sure the economy does not slip back into a recession.  That’s a tough balancing act.  Data this week showed that the economy grew more than projected in the second quarter.  According to the Commerce Department, GDP rose at a 1.7% annualized rate after a 1.1% gain during the first quarter of the year.  Consumer spending, which is the biggest part of the economy, rose 1.8% after increasing 2.3% in the first quarter.  That added 1.2 percentage points to growth while a gain in stockpiling inventory boosted the second quarter growth by 0.4 percentage points.  Domestic final sales while excludes inventories, exports and imports rose 1.3%, a strong rebound from the 0.2% bump in the first quarter.  The Commerce Department also issued comprehensive revisions to all previous GDP data—all the way back to 1929.  It showed that the recovery from the latest recession in 2009 was actually stronger than previously estimated.  With the effects of fiscal drag from the sequester lessening as the year progresses, many economists project that the second half of the year will have even stronger growth.  With employees now re-adjusted to a higher payroll tax (it reverted to the 2010 level of 6.2% in January after being at 4.2% for two years), we could see much stronger retail data especially if the job market stays healthy.  With big-ticket items like autos remaining strong, a key indicator coming up will be back-to-school sales over the next six weeks.  This time period represents the second most important time of the year for retailers after the holiday season as stores from discount chains to electronic boutiques try to capture sales from families as they gear up for the fall and the next school year.

This week at the regularly scheduled Federal Open Market Committee meeting, the Fed governors did not change the overall tone of their outlook.  The press release stated: “Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated.”  Further, they believe, “economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate (maximum employment and price stability).”  Of the 54 economists polled by Bloomberg News in a July 18-22 survey, none of them expected the central bank to alter the pace of bond purchases linked to their quantitative easing.  They were right.  The Fed will continue purchasing $40 billion per month of mortgage-backed securities and $45 billion per month of longer-dated Treasuries.  That same survey, however, says that 50% of those economists believe that the Fed will first reduce bond buying at its September 17-18 meeting.  The Fed is well aware that is making a bet on the economy to start to grow faster.  In order for the economy to reach the lower end of the 2013 Fed’s GDP growth forecast range of 2.3%-2.6%, that metric will have to rise at an annualized rate of 3.2% in the second half of the year.  An even stronger spike will increase the pressure to stop the bond buying and maybe even give some thought to increasing the Fed Funds rate which has remained near 0% since December 2008.  It will not be hyperbole to state that the eyes of the financial world and beyond will be squarely focused on the Fed’s next meeting in mid-September. 

Friday’s payroll figures were a bit less than expected, but there were signs of hope.  For July, the Labor Department reported that nonfarm payrolls grew 162,000 following a 188,000 rise in June.  The median forecast from Bloomberg called for a 185,000 gain and there were some whispers of as high as 200,000.  Private employment, which excludes government agencies, rose to 161,000 versus the 195,000 median expectation.  Average hourly earnings fell 0.1% in July from June but was up 1.9% over the past 12 months.  Meanwhile, the unemployment rate fell from 7.6% to 7.4%.  The unemployment rate is based on a different survey than the payroll jobs figure so there are times when one figure could be improving while the other declines.  The household survey showed that part-time employment rose by 174,000 in July and the number of discouraged workers, those not looking for a job because they do not believe they will get one, rose to 988,000 from 852,000 a year ago.  The bottom line is that these numbers were not up to expectations but they were far from a disaster.  The six-month average for private sector growth is 199,000 which is quite good.  Today’s figures show that the economy still remains vulnerable on the employment front even with the better data we see in the housing market.  That weakness is, in fact, getting weaker.  The weekly initial jobless claim data for the week ended July 27 was 326,000, the smallest figure since January 2008.  The weekly data is thought to be more timely than the monthly job data and is a better indicator of the current direction of job growth.  Plus, the monthly data is subject to far more seasonality adjustments especially during the summer months when auto factories re-tool their lines for new model years, teachers are hired or fired and newly graduated students seek employment plus much more overall building construction takes place between June and August than other months of the year due to the better weather.  Data released this week also shows that consumer spending rose in June by 0.5% versus the 0.2% increase in May suggesting that rising home values, stock price gains and an improved job market compared to previous years is encouraging the masses to spend and their spending comprise nearly 70% of GDP. 

SGK Blog--Update July 26, 2013: Earnings Season Continues 
We received two different reports on the housing market this week. On Monday,, the National Association of Realtors reported that sales of previously owned houses, a.k.a. existing home sales, unexpectedly dropped in June. Purchases fell 1.2% to a 5.08 million annualized rate. That was below the Bloomberg median forecast of economists of 5.26 million. The drop was primarily because the supply of homes was the fewest for any June since 2001. Rising prices depleted the amount of less expensive homes on the market. With home mortgage interest rates creeping higher, this was enough to slow down the previously robust trend we were seeing in these numbers. The median price climbed 13.5% to $214,200 from $188,800 a year earlier. At the current sales pace, it would take 5.2 months to clear out the inventory of 2.19 existing homes on the market. That is still a healthy pace but recent worries have risen about how first-time home buyers were being priced out of the market. They are a key contributor to the “upgrade” cycle as money from first-time buyers is often used as the fuel for previous first-time buyers to upscale to bigger and more expensive properties.

On Wednesday, the Commerce Department reported that sales of new U.S. homes rose more than forecast in June to the highest level in five years. Sales rose 8.3% to an annualized pace of 497,000 homes from May’s figures. The median selling price of a new home appreciated 7.4% to $249,700 and purchases rose in three of four U.S. regions, led by an 18.5% rise in the Northeast. The supply of homes at the current sales rate was 3.9 months which matched this January’s level as the lowest since 2004.

How can these numbers move in such opposite directions? First, clearly existing home sales dominate the transactions in the housing market and with such a large base, it is harder to move the needle. Second, sales of new homes are counted when purchase contracts are signed. Sales of previously owned houses are counted when sales are final, i.e. after closing, which may take place one to two (or more) months after the sales contract is signed. Thus, the current health in the housing market seems to be true as new home sales are more indicative of current trends. Third, higher borrowing costs spur demand in the short run for those “on the fence” and with the median price of new home sales higher than existing homes, there is more to finance. Thus, they are more sensitive to rates which have risen to 4.37% last week for a 30-year fixed mortgage according to Freddie Mac, versus a record low of 3.31% in November. The bottom line to take from this exercise is that the housing market has enough underlying demand to move supply which is on the market, but with prices rising future data points are likely to be influenced more and more by the increasing interest rate environment.

The picture from the employment sector has not changed much this week. Jobless claims rose by 7,000 in the week ended July 20 according to the Labor Department. Retooling at carmakers and school closings influenced figures as they usually do during the summer. We are no passing the peak of the drag from government budget cuts and the trend in claims is fairly stable which is good news for the economy. However, as we have pointed out previously, there is not a great deal of momentum in hiring leading to a sharp drop in the weekly claims figure. This optimism is also reflected in orders for durable goods defined as goods meant to last at least three years. That metric rose 4.2% in June after a revised 5.2% gain in May.

SGK Blog--Update July 19, 2013: Earnings Show Signs of Continued Corporate Health  

While this week we had plenty of news out on the U.S. economy, we had several companies release earnings as well so we will focus more on the results down below. With that said, we had several important indicators of the health of the U.S. economy out this week. It began with the retail sales figures for the month of June which came out below expectations. Economists had forecast growth of +0.7% and +0.4% excluding the volatile auto sector which fluctuates a lot month to month but those figures came out at +0.4% and 0% respectively. Housing starts for June were also substantially below expectations at 836,000 versus the forecast for 958,000 while building permits also came out below expectations at 911,000 versus the 1,000,000 expected. Is this a sign that higher interest rates are taking their toll? We will have to wait and see if the trend continues show up as we receive the July and August figures. The index of leading indicators for June was also below expectations coming in flat versus the expectation for +0.3%.  

Not all was negative as the figures gauging the health of the U.S. manufacturing sector were pretty solid for the month of June and so far here in July. Empire manufacturing (NY area gauge) for July was above forecasts at 9.46 vs. the anticipated 3.6 while the Philadelphia Fed, a survey of businesses in that region, was a robust 19.8 for July vs. expectations for 5.3. Both U.S. industrial production and capacity utilization for June came out about as expected at +0.3% and 77.8% respectively. Finally the all-important figures for the consumer price index (CPI) for June were not too bad as the overall figure was +0.5%, which was above the forecast for +0.3%, but when the volatile food and energy components are stripped out, the core rate was as expected at +0.2% for June. Traders closely watch this gauge for hints of inflation which may cause the Fed to “taper” their bond buying sooner than expected. On that note, Bernanke in Congressional testimony this week helped ease concerns that this process would begin real soon as he continued to emphasis that for the Fed to stop acquiring bonds, the economy would have to improve from current levels. He has been consistent with this message so despite rumblings from other Fed members, this helped ease market concerns a bit this week. 

SGK Blog--Update July 12, 2013: Markets Zoom to New Records
It was another interesting week concerning the Federal Reserve. On Wednesday, Fed officials released minutes from the June policy meeting which showed a split amongst the group about the end of bond buying.    According to the minutes: “While recognizing the improvement in a number of indicators of economic activity and labor market conditions since the fall, many members indicated that further improvement in the outlook for the labor market would be required before it would be appropriate to slow the pace of asset purchases.” Given that these minutes are released with a three-week lag, it did not come as too much of a surprise to traders and the markets were much more focused on the press conference remarks of chairman Bernanke. Wednesday’s activity in the market can best be described as tepid. Yet, after the market closed, at a conference held by the National Bureau of Economic Research, Bernanke stated, “You can only conclude that highly accommodative monetary policy for the foreseeable future is what’s needed in the U.S. economy.” That was enough to spur markets higher on Thursday both here and abroad.

That left us scratching our heads a bit. Is there something different about what is written and what is spoken even though they say the same thing? The Fed minutes themselves, released at 2pm on Wednesday said, “Many members indicated that decisions about the pace and composition of asset purchases were distinct from decisions about the appropriate level of the federal funds rate.” This is nothing new. But the front page headline in The Wall St. Journal the next day was “Fed Affirms Easy-Money Tilt” with an emphasis on Bernanke’s talk at the conference where he highlighted the fact that pulling back on bond purchases does not mean the Fed is stopping its easy-money policies. It just seems a little weird that it took Bernanke’s words to spur a market reaction as if traders either did not read the minutes or were ignoring them in case Bernanke said something different later that day.   Adding a little more mystery is the fact that the days are pretty much numbered for Bernanke to hold that position. This episode merely highlights the challenge Bernanke faces in trying to develop consensus among 19 Fed governors and not let his personal views overwhelm the need to talk with one voice. 

Markets also may have received a little boost from the weekly read on initial employment claims. In the week ended July 6, those filing for unemployment benefits rose by 16,000 to 360,000, a two-month high.  The median Bloomberg forecast of 47 economists called for a drop to 340,000. The four-week moving average climbed to 351,750 from the previous 345,750. The number of people continuing to receive jobless benefits rose by 24,000 to 2.98 million in the week ended June 29 according to the Labor Department. Thirty-three states and territories reported an increase in claims, while 20 reported a reduction. One factor that could explain the increase is the typical summer auto plant shutdown to retool for the new model year. Ford said it would idle most of its North American assembly plants for one week this summer instead of two while Chrysler and GM will mostly skip this scheduled output slowdown. Higher unemployment will keep the Fed in status quo mode with $85 billion in bond buying per month, but higher production will lead to higher incomes and a sooner end to this quantitative easing. 

We continue to hold to our view that the Fed will be culling its monthly bond buying program no later than spring of next year. Of course, a blowup in Europe or exogenous event in the Far East may change that outlook, but, for now, the economy seems to have gained the necessary traction to grow itself back to health. When all is said and done, a healthy, functioning economy is in the best interest of both Wall St. and Main St. It is in these “transition” periods when economic data is improving but not robust that creates the uncertainty that traders dislike. 

SGK Blog--Update July 5, 2013: Stocks Rise on Employment Report Shaking Off Global Tensions 

Traders that were working on Wednesday were glued to their TV’s watching the protests and events unfold in Egypt. Oil futures spiked up as high as $102.18 per barrel in volatile trading before settling at around the $101 level that day. Apparently people in that country were not happy with waiting in mile long lines for fuel and food despite President Mohamed Mursi’s promises of a brighter future. We should say ex-President Mursi because after defying an ultimatum from the Egyptian military who gave him 48 hours to work out a political solution to the unrest in that country, they simply ousted him and voided the constitution he had put in place after trading closed here in the U.S. Wednesday. The military announced an early presidential election as well to calm the citizens concerns. This contributed to stock market declines in Europe in early trading but in U.S. trading the impact was muted as we have seen the military act this way before and in this case the general consensus is they potentially acted prudently. European markets were also negatively impacted on the same day when the Prime Minister of Portugal told voters in a televised speech from Lisbon that he is trying to hold his coalition government together after Foreign Affairs Minister Paulo Portas, leader of the junior coalition party CDS, quit. This was considered a move to protest the austerity measures the country has been enduring. This caused Portugal’s ten year bond to rise above the 8% level and drove down their stock market, particularly their key bank stocks. Again, U.S. markets shook this move off as our economic data painted a rosier picture than the events that were unfolding overseas. 

This was a slow week for trading as many traders had left NYC for the Holiday shortened trading week. With that said, we did have a fair bit of key economic data released this week including the employment report for June. 195,000 new jobs were added to nonfarm payrolls and this exceeded economists’ average forecast for 166,000 for the month of June. The jobless rate stayed at 7.6%, above the estimate for 7.5%, and average hourly earnings rose 0.4% which was twice the expectation and the most since July 2011. Although stocks responded favorably, trading remained light and the U.S. Ten-year Treasury yield climbed above 2.7% for the first time in recent memory.  The growth in jobs was primarily driven by the service sector as retailers, business & professional services, health care, leisure and hospitality industries all posted job gains while manufacturing and government workers were shed in the month.  

There was plenty of other news out on the U.S. economy as our Institute of Supply Management (ISM) Index for June, a gauge of manufacturing health in the U.S., came out at 50.9 which was above the expectation for 50.5. May’s figure had been 49 which would technically signal a contraction so the release of this figure was welcome news. Factory orders for May were slightly above expectations at +2.1% while construction spending was in-line with expectations at +0.5%. Initial weekly jobless claims for the week ending 6/29/2013 were 343,000 which was less than the forecast for 348,000. The ISM services figure for June was weaker than expected at 52.2 versus the expectation for 54.0. All-in-all it was not a bad week for U.S. economic data. 

By Friday, some measure of calmness had taken hold in overseas markets as European Central Bank (ECB) President Mario Draghi pledged that key rates in Europe would remain at present or lower levels for an “extended period of time.” This definitely shook up the foreign exchange markets as this was a departure from ECB tradition as they put a downward bias on interest rates for the foreseeable future. “An extended period of time is an extended period of time, it is not six months, or twelve months,” said Draghi, when pressed for a time frame by journalists. “Our exit is very distant.” God bless the Europeans as you never know what is going to come out of the mouths of their central bankers! If Bernanke uttered such comments here traders would be freaking out at the vagueness of his statements! Draghi also indicated he was open to all rate options, including a negative deposit rate to stimulate growth. This position was seconded by the Bank of England, which in another departure, also provided longer term guidance. So it seems European monetary policy is deviating from U.S. monetary policy and this caused the euro to decline sharply relative to the dollar in currency trading. It did provide a boost to European equity indices in Thursday trading as their markets were open while ours were closed for Independence Day. Events in Portugal and Egypt seemed to at least settle down a bit too on Friday which helped calm markets further, even though a high degree of uncertainty remains in terms of how both situations will play out.
SGK Blog--Update June 28, 2013: Stocks and Bonds Continue Volatility Streak on Fed and China Concerns  

Rising interest rates continued to worry traders on speculation a reduction in accommodation by the Federal Reserve will lead to slowing economic growth. Bernanke has indicated the central bank may begin to taper its bond purchases this year and end it mid-2014. The Treasury auctioned $99 billion in notes this week and it is almost as though the primary dealers, there are 21 that trade direct with the central bank, do not want to step in front of a speeding train. Following suit, yields on ten year securities in countries across the globe, as diverse as Germany, Australia, Belgium and Portugal, rose in tandem with our own U.S. Ten-year Treasury. Particular attention is being paid to the daily release of economic data as with the Fed having less of an influence on markets, daily fluctuations in interest rates have more to do with how the actual economy is doing. 

In China, the Shanghai Index got off to a rocky start this week dropping 5.3% in Monday trading on concerns a cash crunch there will hurt the economy. China’s central bank said there is a reasonable amount of liquidity in the financial system and urged banks to control risks from credit expansion. This was interpreted as a signal that there will be no immediate relief from their tightened liquidity platform. Their overnight repurchase rate was running at 6.47% early in the week which was double this year’s average. As a result the U.S. dollar continued its advance relative to 16 major currencies and this will potentially have an impact on the value of overseas sales for many companies when translated back to U.S. dollars so this bears watching. 

Equities were lifted in Wednesday trading interestingly on a weaker than expected update on first quarter gross domestic product (GDP) here in the U.S. This was the third revision to first quarter GDP so the market expectation was for it to be at least close to the previous figure of 2.4%. When it came out at 1.8% that was a surprise and the lowered estimate was driven by a lower figure for household expenditures. This latter figure was revised down to 2.6% from the previous estimate of 3.4%. Households cut back on travel, legal services and personal care expenditures along with curbing expenditures on health care as the 2% increase in the payroll tax took a bite out of paychecks causing incomes to drop the most in 4 years. Bonds reacted as they should as interest rates declined as prices rose. Stocks therefore got a lift as equities have become very sensitive to movements in interest rates. Stock prices are driven by several factors but two primary focal points are earnings and interest rates. Rising interest rates make future cash flows less valuable when discounted to a present value figure and they can also squeeze corporate margins through higher debt expense. This becomes part of our analysis here at the firm so companies we own such as Accenture, for example, tend to be insulated from this latter factor as they have no debt. According to Bloomberg, second quarter earnings are expected to grow 3.4% year-over-year but this has been revised down from forecasts at the beginning of the year calling for 6.8% growth. Additionally, revenues for companies in the S&P 500 are projected to grow at an anemic 0.46% which, if not cause for concern, is certainly a reflection of the current stage we are at in the business cycle. Given these factors, the additional volatility we are witnessing these days is not surprising at all. 

Tuesday’s rebound in equity trading was triggered by some healthy data here in the U.S. and comments lending support to banks and money market funds in that country by the central bank in China. Orders for durable goods here in the U.S. (good built to last longer than 1 year) for the month of May were up 3.6% and excluding transportation the figure was up 0.7%. Both figures beat expectations for +3.0% and -0.5% respectively. The housing figures were really good as the Case-Shiller 20-city Index for April was up 12.1% year-over-year, above the forecast for an increase of 10.5%. New home sales for May at 476,000 also beat the expectation for 460,000. This may have helped contribute to the strong consumer confidence figure for the month of June which came out at 81.4 relative to the forecast for 75.0 and the previous month’s figure of 74.3. Later in the week we received a lot of data as pending home sales for May rose a very robust 6.7% versus the expectation of 1.5%. Personal income for May rose a healthy 0.5% compared to forecasts for a 0.2% rise while personal spending rose 0.3% compared to forecasts for a 0.4% rise. Initial weekly jobless claims at 346,000 for the week ending 6/22/2013 were about as expected.  Chicago PMI for June on Friday disappointed investors sending equity indices down in initial trading as it came out at 51.6 versus forecasts for 55.5. All-in-all the data for the week generally had a positive tone with a couple of exceptions. 

SGK Blog--Update June 21, 2013:   Bernanke Speaks, Markets Listen  
Judging from the reaction of the markets, June 19th may go down as one of the more important recent dates in financial history. The Federal Open Market Committee completed its scheduled two-day meeting and issued a press release followed by a press conference with Fed president Ben Bernanke. The release stated: “Labor market conditions have shown further improvement in recent months.” It also added: “The Committee sees the downside risks to the outlook for the economy and the labor market has having diminished since the fall.” The Committee decided to continue to purchase $40 billion of mortgage-backed securities and $45 billion of longer-term Treasury securities per month but there was no mistaking the shift in tone in the language of the press release or the responses of Bernanke. He said the bond buying program could be completed by the middle of next year as the jobless rate reaches a projected 7%. In fact, economic projections released by the Fed lowered the expectation for unemployment for 2013-2015 from their March projections. For example, instead of an unemployment rate range of 6.7%-7.0% in 2014, the current members believe it will be closer to a range of 6.5%-6.8%. Real GDP projections for next year also raised the lower and upper range of forecasts. As a result, 15 of 19 policy makers said the federal funds rate will be increased in 2015 or later. (The federal funds rate is a separate monetary tool from the quantitative easing bond buying program. It is the rate Federal Reserve banks charge each other for overnight loans. Before the 2008 financial crisis, it was the primary monetary tool.)   On the surface, this is good news for “Main Street.” It means the economy is growing, unemployment is falling, interest rates are likely to remain on hold for a few more years. For Wall Street, the picture was less rosy.

As we have suggested, the push by equity markets to higher record levels and the decline in interest rates to record lows was due in large part to the aggressive actions of the Fed. After pushing the fed funds target to nearly zero in December 2008 and announcing multiple rounds of quantitative easing or QE, the Fed’s balance sheet has ballooned to a record $3.41 trillion. The $3.41 trillion question was always, “What’s next?” How does the Fed shrink this massive stock of securities without doing harm to bond markets and indirectly the equity indices? How much was QE priced into the markets? We are getting the answer to the last question this week as both equity and fixed markets decline. Rates on the 10-year Treasury bond touched 2.4% in early trading Thursday morning, the day after Bernanke’s conference. They have not been this high since the spring of 2012. Traders assumed that QE was responsible for about 60-80 basis points (0.60%-0.80%) meaning that without it, rates would be higher by that amount. Since the rate on the 10-year touched 1.38% in July 2012, one would expect a jump to about 2.0%-2.20% which is close to what we have seen. Remember, the Fed will continue buying $85 billion of fixed income securities. That has not changed. And one would argue that the Fed would be its own worst enemy if it held over $3 trillion in bonds and actively supported a sharp rise in yields (prices move in the opposite direction of yields). Clearly, the bond market has been nervous since Bernanke testified before Congress on May 22 that the Committee “could” consider reducing bond buying within “the next few meetings.” That day was getting closer with each passing month. At the end of the day, the Fed is charged with two mandates: stable prices and full employment. Nothing in those mandates require new equity records or steady financial markets. Of course, Wall Street and Main Street must work hand-in-hand for the U.S. economy to function. Nevertheless, Bernanke knew it would be a thankless task to notify traders and investors that the party was still going and the punch bowl was still on the table, but it would not be refilled.

SGK Blog--Update June 14, 2013 Stocks Retreat on Strength of U.S. Economic Data  

So why would equities retrench this week on stronger than expected U.S. economic data? It seems counterintuitive but basically stronger than expected U.S. data implies higher interest rates and an increase in the likelihood the Federal Reserve will begin to taper their bond buying program sooner than expected. As we wrote last week, Ben Bernanke hinted at this in his prior testimony before Congress. This does not mean to imply the Fed will begin the process of increasing interest rates in the form of the Fed Funds rate any time soon. They established a target of 6.5% unemployment with the caveat that inflation must be within 0.5% of their target tolerance level (2%), implying less than or equal to a 2.5% rate. Neither of these bogies has been hit. The market however is distinctly having a difficult time establishing an appropriate target level for interest rates. We can see the competing forces at work and we can imagine the discussions amongst traders, particularly at the large institutions that acquire Treasuries directly from the Treasury Department. Do they step in front of the Fed and risk getting creamed if they are wrong? It is time now or is it still too early? Remember the Fed has hinted at tapering their buying program but that implies they are still buyers in the market. In their last statement they indicated they have the flexibility to increase or decrease bond buying at any time. Despite their so-called new transparency, this effectively leaves traders in the dark as to what exactly they are doing at any given moment. As we wrote last week, market rates have reset at higher levels and that trend continued this week. Although Thursday trading was confusing – we had better than expected data on retail sales and initial weekly claims, as we highlight below, yet bonds rose in price and stocks were relatively stable at the open. So it boils down to the market has become less predictable and a little more volatile and that can certainly create opportunities in attractive stocks and bonds for our clients as we monitor events very closely.

Retail sales were better than expected here in the U.S. for the month of May coming in at +0.6% versus the expectation for +0.3%, a sign of increased consumer confidence. When autos were stripped out of the equation, a less volatile indicator month-to-month, they came in at +0.3% which was as expected. Initial weekly jobless claims were also better than expected at 334,000 for the week ending 6/8/2013 versus the expectation for 345,000. Part of what offset the potential for further declines in stock and bond prices when these data points came out Thursday was the release of the World Bank’s outlook for global growth in which they tempered expectations for future growth. The World Bank in their report forecast the global economy will expand at a 2.2% rate for 2013 versus their previous forecast of 2.4%. They lowered their forecast for developing economies and said the euro area’s gross domestic product will decline 0.6%. International equity indices retrenched on this report, and it was particularly felt in Asia as indices in Hong Kong and Shanghai dropped over 2% while the Japanese stock market erased its gains for the year dropping another 6.35% in overnight trading. So we had a situation where there was a global flight to quality in the form of overseas investors buying U.S. Treasuries and this helped lend support to high quality bond prices. The decline in interest rates helped spark some buying in stocks here in the U.S. as well in Thursday trading.    

Friday we had several data points released that caused bond prices to push higher (interest rates declined) and stocks prices to trend lower as most of the data points missed their mark. Industrial production for May was flat versus the expectation for a +0.1% increase, capacity utilization came in at 77.6% versus the expected 77.8% and the University of Michigan consumer sentiment index for June was 82.7 versus the forecast for 83. The producer price index initially spooked traders coming in at +0.5% for May versus the expectation for +0.1%, but the less volatile core rate, which excludes food and energy, came in exactly as expected at +0.1% so traders quickly shrugged off that bit of news. So Thursday and Friday were very good trading days for high quality bonds but mixed results for the equity markets. We are quickly approaching the second quarter earnings season and we have two of our core holdings due to release earnings in two weeks, Accenture and General Mills, so it will be interesting to get their take on the outlook for the remainder of the year.

SGK Blog--Update June 7, 2013 Equities Retreat Early in Week on Concerns Fed Will Reduce Stimulus 

Actually, the pullback in equity indices earlier this week was related to two factors. Markets are still jittery over Fed Chairman Ben Bernanke’s comments two weeks ago, combined with the release of the Fed minutes from their last meeting, which hinted that the Fed is considering reducing their bond purchase program at some point over the next few meetings. This would effectively have the impact of reducing liquidity in the market and could potentially send market interest rates higher, even though they will not take action on the Fed Funds rate for many months. These concerns, combined with weaker than expected data on manufacturing here in the U.S., gave stock market traders reason to pause.  

The primary concern would be that we are still not fully recovered from the last recession to the point where the economy can stand on its own without support from the Fed. We should caveat this by saying we do not fully support that viewpoint, but that is the concern amongst market participants. The fact is the Fed at some point will reduce their bond buying program – it cannot continue perpetually – and the market for stocks and bonds is starting to discount that fact. Interestingly, after the initial reset of interest rates post-Ben Bernanke’s comments two weeks ago, interest rates are now actually behaving as they should. When we get weak economic data they drop and when the data is stronger they rise. Some would welcome the day when the Fed is out of the bond market in terms of purchases as they clearly have had the effect of distorting stock and bond prices. Also, their actions by their nature increase the appetite for riskier assets. That is part of their plan, so it is not all negative, but it clearly carries its own set of unwelcome risks. We read in Wednesday’s WSJ that the London desks of both JP Morgan and Morgan Stanley are back to creating synthetic CDO’s based on “client demand.” Certain forms of these products, when not used for strictly hedging purposes, were a contributor to the financial crisis back in late 2007, 2008. As we have stated before, the best hedge against current volatility in both stock and bond markets is a well-balanced and diversified portfolio. You may notice additional liquidity in your portfolios at this time. There are periods of time where that additional liquidity can be beneficial. If we are not finding value in either stocks or bonds at a given moment, then holding some levels of added cash becomes a component of our decision making process. When volatility strikes, it allows us to take advantage of those opportunities that additional volatility can create. Sometimes we do receive questions from clients about cash levels in accounts and we always view that as temporary in nature. 

On the economic front this week, the Institute of Supply Management’s (ISM) Manufacturing Index for May came in well below expectations at 49 versus the forecast of 50.9. One month does not indicate a trend but a number below 50 signals contraction so it is a cause for concern. Construction spending for April was +0.4% versus the expectation of +1.1%. Factory orders for April at +1.0% were also below the expectation of +1.6%. The one bright spot this week was the ISM Services Index which at 53.7 for May was ahead of the forecast of 53.5. Services do account for a large part of the U.S. economy. We mentioned in the previous paragraph the issue over the higher level of interest rates and that interest rate reset has had an impact. An index of homebuilders slumped 2.4% as mortgage applications fell for the fourth month in a row. In fact for the week ending 6/1/2013, the Mortgage Bankers Association weekly mortgage applications index dropped 11.5%. This is a direct reflection of the sharp move in interest rates that occurred last week. Housing has been a key component of the success story here in the U.S. recovery. The news this week, combined with the manufacturing data, was cause for concern. Productivity in the first quarter of 2013 at +0.5% was as expected. Unit labor costs for the first quarter fell 4.3% and this was largely ignored as traders paid more attention to the words uttered by central bankers as opposed to this particular data point. 

The national unemployment report came out Friday and provided a welcome relief to stock market traders. It basically boiled down to the fact that the report was not too weak but was not overly strong either. It was very close to expectations. The economy created 175,000 new jobs in the month of May compared to the expectation for 158,000. The unemployment rate ticked up to 7.6% (remember the Fed’s target is 6.5%) compared to expectations for it to remain the same at 7.5% and average hourly earnings were flat compared to an expectation for an increase of +0.2%. So basically jobs were created in the month but not enough to push the unemployment rate down. The fact that it actually rose was welcomed by stock traders as they figure the Fed is a little further away from reducing their bond buying as a result. The fact that wages did not rise was also viewed as a positive from the standpoint of traders as wages are an important component of the inflation measures the Fed uses. So overall, this was almost an ideal report from the standpoint of equity traders and as a result they pushed up the prices of stocks in the early going Friday.      

SGK Blog--Update May 31, 2013 Economic Data Helps Keep Indices High
The second estimate of first quarter GDP rose at a 2.4% annualized rate, slightly lower than the 2.5% first estimate rate according to the Commerce Department.  Consumer spending increased at a revised 3.4% annualized rate which was higher than the previous estimate of 3.2%.  The gain added 2.4 percentage points to GDP.  Business investment on equipment and software also grew faster than previously estimated.  Government outlays declined again.  They were down for the 10th time in the past 11 quarters.  In particular, defense spending dropped at an 12.1% annualized rate.  When combined with a 22.1% fall in the fourth quarter of 2012, it was the largest consecutive decline on average since 1954 when the U.S. was finishing the Korean War.  Inventory accumulation was slower than initially estimated.  While that hampered first quarter growth a bit, it sets the stage for second quarter growth if higher sales encourage more stockpiling.  Inventories added 0.63 percentage point to GDP.  Domestic sales, which exclude inventories and net exports, rose 1.8%, more than the prior estimate of 1.5%.  According to a Bloomberg survey, GDP is expected to grow at 1.6% this quarter and an average pace of 2.4% in the second half of the year.

Besides GDP figures, the Commerce Department released data this week on personal incomes and expenditures.  Incomes were unchanged versus the expectation of a 0.1% increase.  Personal spending fell 0.2% compared to an estimate of no change.  The drop in spending was the first since May 2012.  Strength in consumer spending is being supported somewhat by a wealth effect due to a better housing market.  According to the latest S&P/Case-Shiller index of property values, home prices rose in the 12 months through March by the most in seven years.  Specifically, the index rose 10.9% after advancing 9.4% in February.  The index is based on a three-month average which means the March data were influenced by transactions during the first two months of the year.  Thus, when April’s data is released it will incorporate a solid February and March.  All 20 cities in the index recorded a year-over-year gain, led by a 22.5% rise in Phoenix and a 22.2% increase in San Francisco.

The one headwind this week came from initial unemployment benefits.  Applications rose 10,000 to 354,000 in the week ended May 25 according to the Labor Department.  The median called for 340,000 claims.  The less-volatile four-week moving average rose to 347,250 from 340,500 in the week prior.  The number of people continuing to collect jobless benefits rose to 2.99 million in the week ended May 18.  The continuing claims figure excludes about 1.7 million who are receiving extended or emergency benefits under federal programs.  Next week, the monthly payroll figure will be released on June 7.  Economists predict employers hired a net 165,000 workers, the same as in April.  Private payrolls, which exclude government hiring, are expected to be 175,000 higher with an unemployment rate holding steady at 7.5%.  In order for GDP growth to have a chance of reaching 2%+, there will have to be more robust payroll hiring as the second half of the year approaches.

SGK Blog--Update May 24, 2013 Ben Bernanke Rattles Global Markets with Comments

In testimony before Congress this week, Fed Chairman Ben Bernanke rattled markets by appearing to contradict himself, thereby shaking international confidence in the direction of U.S. Federal Reserve policy.  In prepared remarks released prior to Q&A, he stated that a premature withdrawal of quantitative easing would put the economic recovery at risk.  Equity indices initially opened strongly higher on this thesis.  Demonstrating he has markets on a string with traders hanging on every word, when he subsequently said in answer to a question that the central bank would “step down” the pace of asset purchases in the next few meetings, equity indices proceeded to drop as if he had given that string a strong tug.  He based this response on the criteria of an improving labor market and if “we have confidence that that is going to be sustained.”  Many economists had been forecasting that the asset purchases would be reduced beginning in 2014 so this indication that the process could begin prior to that clearly sent global markets on a tailspin.  In overnight trading Japan’s Nikkei stock index dropped a whopping 7.32%!  Europe opened down 3% across the board but as U.S. indices showed resilience throughout the day Thursday, the European bourses clawed their way back to show approximate 2% declines across the board.  The Fed minutes released late Wednesday also hinted that a number of members were willing to consider tapering their bond buying as soon as their June 17-18 meeting if economic reports show “evidence of sufficiently strong and sustained growth,” according to the record of their April 30-May 1 gathering.  As we have indicated, it is easier to implement these policies than to taketh away!  It will get very interesting when that process begins.  Interest rates reset across the board on Bernanke’s testimony Wednesday and the release of these minutes as the U.S. ten-year Treasury closed above 2% for the first time in a while.

Not helping matters in overnight trading Wednesday/Thursday was the release of a manufacturing report in China that was considerably weaker than expected.  The preliminary reading for their Purchasing Managers Index for May was 49.6 which missed the average forecast of economists who called for a reading of 50.4.  The reading in the prior month of April was 50.4 and given a figure below 50 represents a contraction, this did not sit well with traders on the heels of Bernanke’s testimony.  Hence the volatility in intraday trading Thursday!  There was not a lot of data on the U.S. economy released this week but what came out was generally positive and helped account for the rebound in trading in U.S. equity markets on Thursday.  Our economy is proving to be resilient in the face of global economic uncertainty.  Helping matters is the slow and steady recovery in our housing market.  While the data on existing home sales for April released early in the week came in as expected at 4.97 million, Thursday’s release of the figures for new home sales for April helped lift spirits.  Sales of new U.S. homes rose to 454,000, the second-highest level in 5 years as lower borrowing costs and an improving job market drew more buyers into the market.  Economists had forecast a figure of 425,000 so this was a nice surprise to the upside.  Housing prices continued to climb as well as the FHFA Housing Price Index for March rose 1.3%.  Also helping matters Thursday was the fact that initial weekly jobless claims for the week ending 5/11/2013 stopped the recent negative trend by coming in better than forecast at 340,000 while continuing claims fell below the 3 million level which is the first time that has occurred in recent memory.   

SGK Blog--Update May 17, 2013 Busy Economic Week Powers More Records
With earnings season mostly complete, investors and traders turned their attention to the economic calendar.  This week was a busy one with a lot of information to digest.  On Monday, retail sales data was released which surprised to the upside.  Versus the 0.3% decline expected in April versus March figures, the Commerce Department reported that sales rose 0.1%.  Excluding the volatile auto industry, sales did fall 0.1% month-to-month.  Overall, nine of the 13 major categories showed gains last month with clothing stores up 1.2%, the largest move in more than a year.  Lower prices at the fuel pump also helped.  On Wednesday, the Labor Department reported that producer prices fell 0.7% in April from March, the biggest decline since February 2010.  Excluding food and energy, producer prices were up 1.7% year-over-year.    Essentially, input costs are benign.  Taking a peek further down the production line does not change that view.  Charges for intermediate goods (compared to finished goods which make up the producer price overall index) declined 0.6% last month while costs for crude goods (the raw materials where the whole process begins) fell 0.4%.  The Labor Department was busy on Thursday with the release of the monthly consumer price index.  Excluding food and energy, those prices were up 0.2% in April after a 0.1% rise in March.  Year-over-year, this so-called core indicator was up 1.7%, decelerating from March’s year-over-year rise of 1.9%.  The cost of hospital and related services fell 0.6%, the most on record while clothing and air fares also registered decreases.

Given the release of this data, the question arose once again if the economy is slowing down.  The Federal Reserve is assuming that inflation remains moderate, but must be on the watch for an increase in disinflationary price trends or outright deflation.  Other data pointed to this being a definite possibility. Initial jobless claims jumped by 32,000 to 360,000 in the week ended May 1.  According to a Bloomberg survey, the median forecast was for a rise to 330,000 with estimates ranging from 315,000 to 355,000.  Thus, the actual figure was even outside the broad range which is a rare event and certainly an unwelcome surprise.  This was the biggest jump in claims since the aftermath of superstorm Sandy in November.  Housing starts fell 16.5%, the biggest decline since February 2011, to an 853,000 annualized rate after a revised 1.02 million pace in March.  This number was below consensus, too, with the Bloomberg median at a 970,000 annualized figure.  Offsetting this disappointment was the fact that building permits rose to an almost five-year high.  Permits rose 14.3% to a 1.02 million annualized rate, the highest level since June 2008.  When permits are a higher number than starts, it usually is a positive sign as it suggests that construction will rebound in the months to come.  However, a permit is not the same as a start and builders can always not follow through on a permit application once it is time to break ground.

Our view is that the economy continues to be solid.  The volatility of initial unemployment claims means it will take at least another two or even three weeks of poor figures to bring up the four-week moving average.  Even with modest expectations of GDP growth for 2013 around the 2.5%-3.0% range, the U.S. remains on much better footing than other parts of the world.  The 17 nation eurozone suffered its sixth consecutive quarter of declines.  Eurostat, the EU’s statistics office, said this week that region contracted at 0.2% in the first quarter from the fourth quarter of last year.  Though that is an improvement on the 0.6% decline in the fourth quarter, it  shows that the single currency bloc continues to struggle with their problems.  This recession is not as deep as the one in 2008-2009, but it is the longest in the history of the euro which was launched in 1999.  The wider 27-country EU saw its quarterly rate shrink by 0.1% in the first quarter following a 0.5% drop in the previous period thereby technically dragging it, too, into recessionary territory.  Recently, there has been some signs that governments are willing to relax deficit-reduction targets and austerity programs.  In fact, some economists are predicting a return to growth in the second half of the year.  The troubling sign is that the main engines of the eurozone—Germany and France—are showing signs of wear and tear.  Germany barely grew at 0.1% while France actually contracted a 0.2% for the second consecutive quarter.  What has saved these nations is the growth coming from the U.S. and China and some emerging markets.  But China’s GDP looks to be stuck under 8% growth—still robust but not enough of a change from previous quarters to pull the eurozone out of its misery.  And, as discussed, the U.S. seems to be on solid footing and is a major trading partner with Europe.  Nevertheless, recent economic data does not show a significant pickup in imports versus exports suggesting that our nation will not be the panacea either.  As we have reiterated for some time, the financial jawboning from the European Central Bank has averted a panic but it has not solved the myriad problems on the Continent—inflexible labor policies which contributes to high unemployment, high taxes which supports and validates the welfare-state status of many countries, extensive black market operations in countries like Greece and Italy where graft is merely a way of life—which can be best summed up as a lack of competitiveness in today’s global economy.

SGK Blog--Update May 10, 2013 Earnings Season Winds Down

In international economic news this week, China’s General Administration of Customs in Beijing reported that export growth for that country has accelerated in April by 14.7% even as shipments to the U.S. and Europe fell, begging the question as to how that is even possible!  Economic data reported by China’s government agencies is frequently somewhat suspect.  Adding to the speculation of bogus data, the increase was fueled by a 57.2% jump in shipments to Hong Kong, raising speculation that false transactions were used to mask capital flows into China.  This would involve speculative money flowing into China chasing a yuan that’s already exceeded last year’s gains against the dollar.  A customs spokesman said that they would investigate the “extraordinary” gain in trade with Hong Kong.  Translation – that is probably the last we will hear of it!  By comparison, South Korea indicated that exports rose just 0.4% in April from a year earlier while Taiwan said their shipments actually fell 1.9% in the same period.  At first glance, the data from China hinted at a possible turnaround there boosting global economic growth, but given the weak figures out of other countries it was taken with a grain of salt.

On the flip side, we saw positive data coming out of Germany.  German industrial production rose for a second straight month in March, contrary to forecasts, in a sign their economy may be returning to growth.  This would provide a boost to the entire euro region.  Production increased 1.2% from February when it gained 0.6% over the previous month.  Economists had forecast a decline of 0.1%.  Additionally, factory orders unexpectedly jumped for a second month in March according to their Economy Ministry, whose data is in fact reliable!  Germany actually benefits from using the euro which is why Merkel is adamant about keeping the union together. Otherwise if they reverted back to the deutsche mark they would experience the same time of currency appreciation the Swiss have found so difficult to control using the franc.  These economic reports helped boost Germany’s DAX stock index this week.

We had a relatively light week for U.S. economic news as traders focused more on earnings announcements in setting market direction.  So far the results have been pretty good.  At the time of this draft writing, 425 of the 500 S&P 500 companies had released results and of those 72% had exceeded profit expectations and 53% had missed revenue projections.  As we have written, it has been difficult for firms to increase their top-line revenues in a relatively anemic global economic recovery.  At the same time, many companies have been doing a good job managing their cost structure and they have been able to increase their earnings per share through frequent share buyback programs.  This reduces the number of shares outstanding (the float) and helps the figures come earnings release time.  This is not a bad thing for shareholders, we just need to be wary of firms overpaying for their own company stock and really focus on other important metrics in evaluating stocks, such as price relative to free cash flow, global revenue growth and profit margins to name but a few.  Initial weekly jobless claims for the week ending 5/4/2013 fell to 232,000 relative to the expectation for 336,000 continuing the downward trend for this figure.  U.S. consumers tightened their belts a bit in the month of March as U.S. consumer borrowing climbed $7.97 billion which was well below the expectation for a $16.3 billion rise following February’s $18.6 billion increase.  This can be a volatile measure on a month-to-month basis so we will not read too much into it.  As we indicated, the data was very light on the U.S. economy this week.

SGK Blog--Update May 3, 2013 Another Record Week 
This was a busy week for economic data.  On Monday consumer data was the focal point.  Personal consumption rose 0.2% in March according to the Commerce Department, above the 0.1% consensus expectation but below the 0.7% rise in February.  The same group also reported that personal incomes rose 0.2% in March after climbing 1.1% the previous month.  Disposable income which is the money left over after taxes, rose 0.3% versus a 0.7% rise the prior month.  It seems that the jump in the payroll tax at the beginning of the year coupled with the $85 billion in automatic budget cuts (known as the infamous sequester) that began March are finally beginning to be felt in the broader economy based on these figures.  That may lead to a decline in GDP numbers for the second quarter according to a survey of Bloomberg economists taken in early April. 

On Tuesday, the S&P/Case-Shiller index of property values in 20 cities rose 9.3% from February 2012 to February 2013.  That compares to a 8.1% advance in the year ended in January suggesting that the housing market is gaining momentum.  The index is based on a three-month average, which means the February figure was influenced by transactions in December of last year and this past January, months that are traditionally weaker than the warmer spring and summer months.  For the second straight month, all 20 cities in the index showed a year-over-year advance.  Phoenix was up 23%, San Francisco 19% higher and Las Vegas up by 18%.  Price figures from the National Association of Realtors (NAR) showed the median value of an existing home rose by 11.8% in March.  The NAR survey includes more than just 20 cities so it gives a broader view of the industry.  According to the NAR, there were only 1.93 million previously-owned homes on the market in March, the fewest of any March since 2000.  Tight inventories as well as low mortgage rates have been the prime drivers of better pricing figures.

Wednesday brought more subdued data.  The Institute of Supply Management’s factory index fell to 50.7 from the prior month’s 51.3.  A reading of 50 is the dividing line between expansion and contraction so the manufacturing component just barely remains in the growth state.  Manufacturing makes up only 12% of the economy but is a key bellwether in the pace of change because factories start humming in response to higher demand figures weeks to months before product starts to show on the shelves.  If the index is falling, then the need to rebuild inventories a few months down the road is not pressing.  China’s manufacturing index also showed some weakness with its Purchasing Managers’ Index at 50.6 in April, down slightly from the 50.9 in March.  A gauge of new orders  and new export orders also fell.  The benchmark Shanghai Composite Index is down 11% from the high reached on February 6.

Also on Wednesday the Federal Open Market Committee ended its regularly scheduled two-day meeting.  As expected, there was little changed in their response to the current economic environment.  They will continue to buy $85 billion in total of mortgage-backed securities and longer-term Treasury securities which, according to their post-meeting statement, “…should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”  The committee will “increase or reduce the pace of its purchases” which is a slight change from previous releases where only curtailing of the program was discussed.  Whether the added language is merely to provide more flexibility or a hint that an increase may be coming is unknown.  Regardless, the market took it in stride with government bonds trading higher in general on the day of the release.   

Thursday brought confirmation of a move that was expected for some time as the European Central Bank (ECB) dropped their main interest rate by 0.25% to 0.50%.  It was at 0.75% since last July.  ECB president Draghi seems to think that weak euro zone activity has filtered from the periphery countries—Greece, Italy, Ireland, etc.—to the core nations like Germany and France.  Falling business confidence in those countries is the latest sign of this weakness.  Over nineteen million people are out of work in the euro zone, a 12.1% unemployment rate for the area.  Meanwhile, inflation remains subdued at 1.2% in April, well below the ECB’s target of about 2%.  Draghi also signaled an openness to more “drastic” action such as a negative deposit rate on funds held at the ECB (thereby nearly forcing banks to lend money rather than hoard it) and the purchase of private-sector assets as the central bank in Japan is planning to do.

The biggest highlight of the week was Friday’s employment report.  Thursday’s initial unemployment claims gave the market some hope.  Applications fell 18,000 to 324,000 in the week ended April 27, the lowest figure since January 2008 according to the Labor Department.  Friday’s number did not disappoint, in fact it fueled another record run in the major averages.  Payrolls increased 165,000 in April following a revised 138,000 in March according to the Labor Department.  Revisions added a total of 114,000 jobs to the initial reports of February and March.  The unemployment rate fell a tick to 7.5%, the lowest level in four years.  A median survey of 90 economists called for a 140,000 advance with a range of 100,000 to 238,000.  Private payrolls, which does not include government data, rose by 176,000 in April after a revised gain of 154,000 in March.  Government employment dropped by 11,000.  Industries adding jobs include leisure and hospitality, retail and health services.  The only slight negative in the report was the fact that employees worked on average 12 minutes less than the prior month.  That suggests that pressure to continue hiring may be abating.  Conversely, there was an increase in part-time employment and the average hourly earnings rose 1.9% for a year earlier.  Those two signs mean employers may actually be needing more permanent workers soon and higher rate pressure means jobs are harder to get.  The civilian labor force participation rate was 63.3% in April, unchanged from March but down from the 63.6% in January. 

The last bit of Friday news might have been overlooked due to the robust jobs report.  The Institute of Supply Management’s non-manufacturing index fell to 53.1 in April from 54.4 in March.  With the U.S. economy heavily dependent upon services (88%), this is a key statistic.  It was above the 50 level indicating expansion in these industries, but the gauge averaged 53.6 since the recession ended in June 2009 suggesting that growth is slowing.

What does all this data suggest to us?  We continue to believe that the economy has reached a stage of sustainable, moderate growth.  With the sequester having started on March 1st, we knew it would take a few weeks to filter through the economy.  We saw some of that with the flight controllers issue which led to coast-to-coast flight delays in April.  Second quarter GDP is likely to take a bit of a hit, but not seriously enough to bring us back to stall speed.  While we are unlikely to see any 5%+ GDP numbers anytime soon, there is enough momentum in both the labor markets, corporate investments and the resurgent housing market to support the consensus 2.5%-3.0%.  While that means a slow slog to the sub-7% level for unemployment, we remain headed in the right direction. 

SGK Blog--Update April 26, 2013 Earnings Drive Markets as U.S. 1st Quarter GDP Weaker Than Expected 

The week started on a bit of a sour note as we got a negative surprise in an important housing number released Monday. Sales of previously owned homes unexpectedly declined in March to 4.92 million from 4.95 million in February and below the expected 5.01 million. One positive note within this report, prices did climb, reflecting more demand for higher priced homes. Tuesday saw the release of new U.S. homes sales which were more robust coming in at 417,000 in at 417,000 for March compared to February’s 411,000 and the expectation for 415,000. This figure lends support to the economic lift the housing sector is providing to the U.S. economy as it continues to recover. Combined with strong earnings reports from Netflix and our core holding and Dow component Travelers Companies, this provided a lift to equity indices in Tuesday trading. 

While earnings have helped support markets, as our headline would indicate, there are signs of cracks in the global economic growth story that we are hearing as we listen to corporate executives and in some of the data we are receiving even here in the U.S. Obviously Europe is weak and has been for some time. Some companies have indicated that the situation there is worse than the headlines would have you believe. Secondly, Asia is really mixed right now. Many companies have said they see solid growth in China but sales in Japan have weakened considerably, despite effort on the part of their central bank and government to try to stimulate their economy. This is in part due to the dramatic weakening of the yen relative to the dollar, which negatively impacts the value of sales in Japan when the currency translation takes place, but also there has not been evidence of much of an uptick in demand in that country.  

Here in the U.S. durable goods orders for March came in at -5.7% vs. the expectation of -3.1% and when transportation is factored out (a less volatile number) the figure was still negative at -1.4% vs. the expectation for it to be flat. The figure for first quarter gross domestic product (GDP) here in the U.S. came in at +2.5% which was lower than the estimate for +2.8%. Many economists had forecast GDP to be in excess of 3% after the weak +0.4% final figure we got for 4th quarter GDP 2012 so this was a negative surprise and helped contribute to the weakness in trading Friday. On a positive note, initial weekly jobless claims for 4/20/13 were 339,000, well below the estimate of 351,000 and the University of Michigan consumer sentiment survey for April surprised to the positive side coming in at 76.4% versus the expectation for 72.4 and the prior month’s figure of 72.3. As we said, we are getting mixed signals regarding economic growth across the globe.

SGK Blog--Update April 19, 2013 Markets Rocked By China Weakness and Boston Bombings  

China made headlines this week causing stock and commodity markets to fall sharply in Monday trading as first quarter growth in gross domestic product came in at 7.7%, lower than the expectation of 7.9%, according to their National Bureau of Statistics. March retail sales in that country grew at 12.6% year-over-year but this was down from 15.2% at the end of 2012. Many economists cite the burgeoning up-and-coming middle class in China and their ability to spend money as a significant opportunity for global companies so any downward tick in the retail sales trend raises worries. Combined with the fact their industrial production growth faded in March, all together it provides evidence that a late 2012 rebound may be losing some steam. China continues to have one of the world’s fastest expanding economies, but it faces a painful downshift from annual growth rates that spiked at 14.2% in 2007. Two key drivers of growth – demand for Chinese goods abroad and breakneck investment at home – have since slowed.  Many companies, including those in our core portfolio, have cited China as one of the most significant opportunities for future growth in history. Combined with the fact that it can be challenging to do business in China, any hints of slowing growth dampens investors enthusiasm for owning global stocks. 

Once the tragic and unfortunate events in Boston – our hearts and prayers go out to the victims and their families of this senseless tragedy - were digested by traders, markets once again turned to the domestic front and the economic data and earnings. Equity indices were lifted Tuesday by the strong earnings releases of two of our core holdings Coca Cola and Johnson & Johnson. Based on the solid first quarter results from these two companies, many analysts determined that both these companies would be able to meet or exceed their full year forecasts and this lent support to a shaky market. Helping matters in Tuesday trading was the strength of the U.S. economic data released that day. Housing starts for March at 1,036,000 were much higher than the expected 930,000 although building permits at 902,000 were weaker than the expectation for 945,000. Also for March data, industrial production at +0.4% and capacity utilization at 78.5% were both a tenth of a percent higher than expected. The data for the consumer price index indicated that inflation remains subdued. The CPI figure for March was -0.2% while the core rate, excluding the volatile food and energy data, was +0.1% and again both figures were a tenth of a percent below expectations. For the CPI data though, coming in lower than expected is a positive as it would reinforce the fact that the Federal Reserve is not seeing hints of inflation creeping into the economy putting pressure on them to end their stimulus programs. 

The Federal Reserve each month releases their beige book which is a summary of their assessment of the economy across the country as reported by businesses surveyed across their 12 regional banks across the country. They noted, “most districts noted increases in manufacturing activity since the previous report.” Also that most regions reported, “residential and commercial real estate improved markedly” as housing prices rose in many areas and demand for home loans was “steady to slightly up.” They noted that consumer spending “grew modestly” but was hindered by higher gasoline prices, higher payroll taxes and severe winter weather in places at times. Overall, their assessment for April was that the U.S. economy grew modestly. Subsequent to that release we received more data on the economy as the Philadelphia Fed survey came in at +1.3 versus the expectation for +2.5 for April. The index of leading indicators fell 0.1% versus the expectation for it to be flat for March. Finally we had initial weekly jobless claims for the week ending 4/13/2013 come in at 352,000 versus the expectation for 355,000. All-in-all the Fed’s assessment of the economy seems to be on target at this point.   

SGK Blog--Update April 12, 2013 Fed Debates Monetary Policy as Earnings Season Heats Up 
Minutes from the March 19th and 20th Federal Open Market Committee were released early on Wednesday morning instead of that afternoon as is the usual practice.  These minutes were actually released apparently by mistake a day earlier—around 2pm on Tuesday—to congressional employees and some trade groups.  So far there have been no evidence to suggest foul play or trading done to take advantage of this error.  However, with markets keenly tuned to the Fed’s actions and words, it was a crucial mistake.  Had the minutes included any bona fide “insider” information, it might have gone down as one of the worst mistakes in premature release history.  As such, it was a disaster averted but not easily forgotten.

As for the minutes themselves, they showed that “all but a few” Fed officials wanted to keep the aggressive monetary stance going “at least through midyear (2013).”  They concluded that the economy was performing better than expected but were worried that higher taxes and spending reductions through the sequester might hold back growth.  There were also some Fed governors who wanted to keep the program going at its current pace--$85 billion of Treasury and mortgage-backed security buying per month—through 2013 and into 2014.  In conclusion they stated: “Several participants emphasized that the asset purchase program was effective in supporting the economic expansion, that the benefits continued to exceed the costs, and that additional purchases would be necessary to achieve a substantial improvement in the outlook for the labor market.”  We had heard through various Fed speeches since this meeting took place those desires to throttle back the program.  As we have stated, the markets’ current record-breaking environment has been fueled in large part by the accommodative monetary policies.  If this was taken away, it would surely lead to a decline unless the economy was performing so strongly that it could be easily dismissed.  Currently, the economy is not at that point.  Last Friday’s below-expected payrolls report shows that growth is happening but not at a pace that can be considered “substantial improvement”.  This Friday the Commerce Department reported that retail sales for March fell by the most in nine months on the heels of a 1% gain in February.  Even excluding the volatile auto sales component, retail sales were unexpectedly weak, down 0.4% compared to a flat consensus expectation in a Bloomberg survey of economists.  Additionally, a 0.6% drop in producer prices reported by the Labor Department will keep any inflation fears muted.  But the 0.2% rise in wholesale prices excluding food and energy continues to suggest sluggishness in the economy as a whole.   

We also track a weekly report called the National Financial Conditions Index (NFCI) released by the Federal Reserve Bank of Chicago.  The adjusted NFCI indicates financial conditions that are tighter or looser than on average (dating back to 1973).  Currently, we are in a period where the adjusted NFCI is looser on average than would be typically suggested by economic conditions.  This suggests that the not-so-secret fact that the globe is nearly drowning in liquidity as evidenced by last week’s action by the Bank of Japan to spark their moribund economy with their own version of quantitative easing.  Various sub-indices on risk, credit and leverage give more detailed examination of the NFCI.  It would be hard to conclude that a red warning light is flashing, but it is not a stretch to say that economic fundamentals are not the key driver of financial asset value growth at the present moment.  As we recently pointed out, today’s record-setting levels have better ratios when compared to 2007 on a debt-to-capital and earnings growth basis.  However, markets always move in cycles and the current length of the economic recovery and financial bull market lends itself to comparisons to overextended and overvalued periods of the past.  Which is why the next few quarterly earnings periods will be closely monitored to see if companies deserve their current valuation heights and if further buying is warranted.

SGK Blog--Update April 5, 2013 Stock Traders Jittery on Mixed Economic Data 

This week we saw signs of cracks in the strong economic data we have recently witnessed here in the U.S. The Institute of Supply Management’s (ISM) manufacturing index came out at 51.3 for the month of March. While a figure above 50 signals expansion in the economy, this was down from a level of 54.2 for the month of February and the expectation was for 54. Mid-week we had the ISM services index which also came in below expectations at 54.4 although the margin for the miss was not as dramatic. Still, U.S. economic growth is very dependent on health in the services sector so this tick downwards was concerning for traders. Also coming out mid-week, the ADP employment report, which we discuss in more detail below, was weaker than economists had projected by a fairly wide margin. Adding to traders jitters ahead of the March employment report, Thursday’s initial weekly jobless claims figure for the week ending 3/30/2013 at 385,000 was considerably higher than the expectation for 345,000. On a positive note, both construction spending at +1.2% and factory orders at +3% for February exceeded expectations. All eyes were focused on Friday’s release of March’s jobs report and it was disappointing to say the least! The negative trend in initial weekly jobless claims over the past 4 weeks was an effective precursor to the national report which came out in today’s trading. For the month of March, nonfarm payrolls rose by only 88,000 versus the expectation for 192,000. While the unemployment rate dipped to 7.6%, this is in large part due to people leaving the labor force, particularly individuals seeking part-time work. This dropped by 350,000 in March and could be because they have simply given up their efforts in finding jobs. Average hourly earnings were flat versus the expectation for an increase of 0.2%. January and February payroll growth was revised higher by a total of 61,000. Other than this latter fact, if one was perusing the data for a silver lining, there was none. Stocks opened sharply lower in Friday trading, reflecting the inherent weakness in the jobs report. We can attribute this weakness to a number of different factors. Hiring in construction slowed substantially, probably as a result of the rebuilding effort post superstorm Sandy slowing down. The services sector job growth was weak. If we stop for a moment and think about this – it makes sense. For example, we have been hearing from people in the restaurant sector that as a result of the payroll tax increase, people are eating out less. Think about all that goes into maintaining a restaurant. We have hostesses, waiters, cooks, etc. We are still a services driven economy so naturally if restaurant owners see their business slowing they are going to hire less people. This is sometimes why we point out that a lot of economic data is frequently like looking in the rear view mirror. Stock prices are a reflection of future expectations. If the expectation is that economic growth is slowing, whether due to concerns over the impact of the sequester or whatever, then this often will not show up immediately in the economic data. But it makes sense to us that businesses would hire more conservatively when faced with economic uncertainty.    

While we here at SGK focus on fundamentals in doing our equity and fixed income research and, as you can tell from our weekly summaries, in our approach to analyzing the broader global macroeconomic data, it is interesting to note that from a technical perspective on markets, there were some concerning signs that crept into trading patterns early in the week. We first noted that there was a clear divergence between trading patterns in the Dow Transportation Index and the Dow Jones Industrial Average (DJIA). The Dow transports tend to be somewhat of a leading indicator – the trend in terms of the direction they go frequently precedes a similar move in the DJIA. This can make sense as the transports are followed very closely and the typical companies within the index, companies like FedEx and Norfolk Southern, are highly sensitive to a pick-up or a slowdown in economic activity due to the nature of their businesses. We also saw a clear divergence between the S&P 500, the large cap index, which was up 0.52% on Tuesday, and both the S&P 400 mid-cap index and the S&P 600 small cap index which were both down 0.4% and 0.48% respectively on that same day. That is highly unusual and we would have to go back a long way in reviewing trading records to find a similar patter, at least one that dramatic. Both the small and mid-cap sector have been very strong over the past six months and we have trimmed back on our weightings in these areas on concerns over valuation. There were a number of other indicators highlighted in an article written by Doug Kass who gets a lot of attention from CNBC in part because he is not afraid of making bold short-term markets calls, although his record on that count is somewhat spotty. Regardless, he made several good points in his article. Bank and brokerage stocks lagged the broader indices while safe plays such as consumer staples and healthcare stocks have recently led market advances. He noted too that despite a positive index performance in Tuesday trading, the actual total number of stocks that declined in New York Stock trading on that day eclipsed stocks that advanced by over 200. We would also note that the U.S. ten year Treasury declined steadily throughout the week and that can be an indication that traders are concerned about the outlook for economic growth, not just here in the U.S. but globally. Stocks tend to climb a wall of worry, but the worries seemed to be mounting this week. 

While it seems like the world has been revolving around the U.S. economic data, at least from the standpoint of our stock market, we cannot ignore the information we are getting from overseas. Contributing to heightened losses in trading Wednesday were concerns over rising tensions between the U.S. and North Korea. Equity indices took another leg lower and high quality bond prices rose when it was announced that the U.S. would supply missile defense technology to Guam. Additionally, the 17 nation euro-area jobless rate rose to a record 12% in February and the January figure was revised up to the same level from the previous estimate of 11.9%. That is the highest level since they started collecting data for the region in 1995. The euro area zone has contracted for five straight quarters and it is expected that trend will continue in the first three months of this year. The European Central Bank has forecast the economy will shrink 0.5% in 2013. The strains in the region have also spread to the U.K., where a measure of manufacturing contracted for a second month amid weak demand in Europe for British exports. A gauge of factory activity was 48.3 in March, the second month of contraction, according to Markit Economics. For the euro area region their March manufacturing gauge came in at 46.8 and for the all-important German economy, the largest in the region, the figure was 49. Again, a figure below 50 signals contraction. China, the world’s second largest economy, on the other hand is showing signs of trending in the right direction. Their Purchasing Managers Index for March rose to 50.9, an 11 month high and this was up from 50.1 in February. Hence why we have the term “mixed economic data” in the title of this weekly! Finally, coinciding with our release of payroll data for March, Statistics Canada noted that employment in that country in March fell by the most since the last recession four years ago, which caught both economists and traders off-guard. That country tends to be highly sensitive to shifts in the global economic outlook because, similar to Australia, it is a country rich in natural resources. This contributed to weakness in equity trading Friday, while high-grade fixed income securities rose in price.
SGK Blog--Update March 28, 2013  Records Are Made To Be Broken
Another week brings more positive economic news.  The U.S. economy grew at a faster pace than previously estimated in the fourth quarter of last year.  Real GDP rose at a 0.4% annual rate, up from the 0.1% prior estimate according to the Commerce Department.  This was down from the 3.1% pace in the third quarter thanks to lower military spending and a reduction in the rate of inventory building.  The boost from the prior reading was due to a bigger gain in business spending and a smaller trade gap.

According to the S&P/Case-Shiller index of property values in January, prices climbed 8.1% from the same month in 2012.  This follows a 6.8% rise in December and the latest figure exceeded the median forecast by economists in a Bloomberg survey.  This is the biggest gain since June 2006 suggesting that the residential real estate market continues to strengthen.  All 20 cities in the index showed a year-over-year increase led by a 23.2% rise in Phoenix.  San Francisco also showed the big adjusted monthly increases while prices also advanced in areas that were hit hard by the housing bubble bursting such as in Las Vegas, NV and Tampa, FL.  The average rate on a 30-year fixed loan fell to 3.54% compared with 4.08% a year ago according to Freddie Mac.  That, plus continued strong housing formations, are leading to more demand for property.  The Commerce Department also reported this week that purchases of newly built homes fell 4.6% to a 411,000 annualized pace in February.  Nevertheless, it was the best back-to-back months in more than four years.  Importantly, the median sales price rose 2.9% in February from the year-ago level.  Last week, existing home sales sold at a 4.98 million annualized pace in February.  The figures for both new and existing homes saw price increases even in the face of new supply on the market. 

The Commerce Department also reported that goods meant to last at least three years, also known as the durable goods report, rose 5.7% in February.  The data were boosted by a 95.3% surge in bookings for commercial aircraft.  Excluding demand for transportation equipment, orders declined 0.5%, the first decline in six months.  However, January’s figure was revised upwards.  Unfilled orders for non-defense capital goods excluding aircraft, rose 0.2% even with the decrease last month.  This indicates that manufacturers are struggling to keep up with demand and this category is used as a proxy for future business investment in items like computers and engines.

What can stop this upward momentum in the economy?  First, the full effect of the budget sequester still has yet to be fully felt.  While the cutback officially began March 1st, it takes time for layoff notices to be sent and previous contracts to run out.  It may not be until the second or third quarter when GDP figures really reflect the issue.  Plus, this week Dallas Fed President Richard Fisher, who is not a currently voting member of the Fed’s monetary setting committee, said he would like the U.S. to reduce its mortgage-backed security purchases thanks to these signs of stronger economic growth.  The Fed has committed to buying $40 billion of mortgage-backed securities and $45 billion of Treasuries each month until the labor market improves “substantially.”  Given that this week’s initial unemployment claims actually rose by 16,000 to 357,000 in the week ended March 23rd, his comments may not have been the most timely.  However, it would be a mistake to assume that line of thinking is not going on in the heads of Fed members who do currently vote on policy.  If the Fed takes away the proverbial punch bowl, the markets are likely to react negatively unless growth is very strong at the time.  We believe that the Fed is likely to follow tradition and react later than it should.  The real question is how much later which will have a real affect on both the markets and the real economy.

Internationally, the Cyprus situation seems to have calmed.  The latest proposal will involve setting up a “good bank” and a “bad bank”.  The nation’s second largest bank will be effectively shut down and transferred to the country’s largest bank.  Deposits above €100,000, which under EU law are not insured, will be frozen and used to resolve debts.  It is not sure how much funds will come from which bank so it is uncertain the extent of the losses that will be imposed upon depositors.  When the banks reopened today after being closed since March 16th, there were lines of those waiting to withdraw funds but not the widespread panic some had feared.  In fact, some depositors turned their anger toward the media, handing out pamphlets reading “Why must international media be so greedy of horror scenarios?  Is decent and investigative journalism dead?”  We could not agree more especially after the hype of the dreaded Fiscal Cliff and the feared Sequester dominated domestic outlets for the past few months.  News should be reported, not created.

SGK Blog--Update March 22, 2013 Equity Indices Feel Pressure of Fed and Cyprus Uncertainty 

Two items in the aftermath of the FOMC meeting stood out for traders this week: 1) concerns over the uncertainty as to how and when the Fed will reduce their stimulus in the form of their bond buying program and 2) whether or not Ben Bernanke, the mastermind of the Fed’s creative stimulus programs, will be around to unwind the programs he put in place. These are legitimate concerns. The Federal Reserve is developing a strategy to gradually reduce its $85 billion monthly bond buying program. Bernanke indicated the Fed will vary the amount of its bond purchases depending on how the economy is performing. Translation – they will reduce the amount of buying they do as they see progress on the jobs front, provided inflation remains contained. As this notion became digested by traders, it was determined that this heightens the level of uncertainty as to when the Fed’s historically novel stimulus programs will officially come to an end. As we have said, they cannot continue forever and it carries its own set of risks. The second area of concern relates to a passing comment Bernanke made in response to a question as to whether or not he is going to stick around for another term. He declined to answer the question directly, but he commented, “I don’t think that I’m the only person in the world who can manage the exit.” This clearly spooked traders. The reality is, as controversial as his policies have been, traders have developed a sense of confidence in the man himself. He has been steady at the helm and he is an effective communicator, something that was sorely lacking at the Fed under Greenspan. Traders dislike uncertainty and because of these two factors, equity indices sold off the day after the Fed indicated with their official statement they were basically not changing their policies at the present time. 

Who would have thought that a nation the size of Cyprus, which accounts for less than half a percent of European Union GDP, could cause such a ruckus in financial markets? The brilliant strategists at the helm of the EU and the IMF decided that instead of actually simply bailing out the Cyprus banking system, which is actually approximately 800 times the size of the nations actual economy, they would have depositors, including foreigners, at the Cyprus banks contribute significantly to the eventual bailout. In other words, the government would basically step in and take a portion of a depositor’s money.  This would include both individuals and corporations, both foreign and domestic. This came about, without overcomplicating the explanation, because bailout weary people in Germany, in particular the Social Democrat Party, are not comfortable giving money to banks to insure the deposits of Russian mobsters. Are we being a little facetious here? Well maybe but given Cyprus role as a (former) bank haven, this is actually a legitimate concern. Of course it would hurt everyone – not just the depositors of those engaged in illegal activities, but also average hard-working Cypriots as well. Irrespective of the percentage, at the time of this drafting none of this had passed the Cypriot parliament, it’s the precedent that would be established if this went through that concerned traders. We have come full circle from a plan in Europe to have a central banking authority and a form of depositor insurance backed by the European Stability Mechanism (ESM) to a plan to raid people’s bank accounts in order to bail out a country’s banking system. While not leading to panic in financial markets, it clearly led to panic on the part of a number of Cypriot depositors – understandably so! Would it ultimately lead to a run on their banks? Would people with deposits in smaller banks in Italy, Spain or Portugal think twice about holding large deposit accounts in those systems? Who knows, like we said, this is uncharted territory. So far markets have to a certain degree taken it in stride, but when/if the backing of the ECB for the Cypriot banking system runs out (March 25th is their established deadline for coming up with a solution) then things will get really interesting. As always, stay tuned! 

On the economic front, the data on housing continues to show us heading in the right direction, helping cushion the impact of the above mentioned uncertainty. Housing starts and building permits for February nicely exceeded consensus estimates from economists. Existing home sales came in just slightly below expectations for February but it was close enough it was considered basically in-line with expectations. Initial weekly jobless claims for the week ending 3/16/2013 came in at 336,000, below the expectation for 345,000 and this continued this winning trend of coming in better than forecast. The index of leading indicators was positive for February coming in at +0.5% which was as expected. The Philadelphia Fed survey for March was +2.0 which exceeded the forecast of -3.0. All-in-all, not a bad week for those actually paying attention to the economic data and not their NCAA tournament brackets!

SGK Blog--Update March 15, 2013 Blue Skies  

In February, sales at retailers rose by the most in five months according to data from the Commerce Department.  The 1.1% rise exceeded projections in a Bloomberg survey of 0.5% and followed a revised 0.2% gain in January.  Excluding the more volatile auto and gasoline categories, sales rose 0.4%.  In the overall report, eight of the 13 major categories reported increased sales, led by a 5% jump in receipts at gasoline stations.  Spending rose 1.1% at auto dealerships which reversed a decline in January’s figure.  According to data from Ward’s Automotive Group, cars and light trucks sold at an annualized rate of 15.3 million last month versus a 14.4 million rate a year ago.  Retail sales are a coincident indicator.  This means they take the temperature of what is going on in the economy and the stock market basically as it is happening.  That is, strong retail sales seem well matched with the solid economic numbers and record-pushing stock indices.

Sales are being boosted by a better job market.  Last week’s payroll number was strong.  This week’s initial unemployment claims figure suggests that momentum is going to continue.  The number of people filing for unemployment claims fell by 10,000 to 332,000 according to the Labor Department.  That was below the Bloomberg median estimate of 350,000 and brought the less-volatile four-week moving average down to 346,750, the lowest level since March 2008.  Even though monthly payroll figures are a lagging indicator (i.e., it gives a snapshot of economic health from a recent past), initial claims are seen as a leading indicator.  The latest data are for a week that has already occurred, March 9th, but the trend in the figures point to what is going to happen in the near future.  On November 30 of last year, the four-week average was 408,300.  Since that peak, it has been sharp drop to the most current level just below 350,000.  It would take a number of weeks of above-trend figures to reverse this trend which suggests that when the next monthly figure for payrolls is released in early April, it will be strong, too. 

This growth is taking place without pronounced inflation.  Although with rising gasoline prices, health care costs and tuition payments some would disagree. Producer prices for February climbed overall due to higher energy costs.  Without the volatile food and energy component, producer prices rose only 0.2%, the same as January’s rise.  Moreover, the bump due to energy costs is likely to dissipate because the cold winter months where heating oil is used most heavily are about to end and the summer driving season is months away.  We had a great deal of data come out on Friday which influenced the direction of both stock and bond indices. The consumer price index was hotter than expected, sending equity indices lower in initial trading. Higher numbers for inflation are considered a negative because they would give the Federal Reserve pause in continuing their stimulus programs. The core CPI number came in as expected at +0.2%. Figures for both industrial production and capacity utilization came in better than expected at +0.7% and 79.6% respectively. This is in part a reflection of the domestic boom going on in energy production. A wet blanket was thrown over stock and bond markets when the Michigan consumer sentiment survey for March came out showing a decline to 71.8 versus the expectation for 77.6 and the February figure of 77.6. This is one of the early indicators and first data points we have received for the month of March and is concerning given how dependent the U.S. economy is on the consumer. Are higher taxes, delayed refunds, political strife and the higher payroll tax finally starting to impact the consumer? We will have to wait and see. As mentioned, a better job market will help alleviate a great deal of pain! 

As spring approaches, the question is whether the economy and the market can break the cycle we have seen the last two years where positive data in the first 2-3 months of the year was overshadowed by various events starting in April that brought down the equity averages.  Or will the positive momentum continue into the summer months and beyond?  Stay tuned!

SGK Blog--Update March 8, 2013 Europe in the News as Dow Sets Record 

Europe made headlines early in the week as the reality of the Italian election mess sunk in. The main politicians in Italy have been bickering through the media as Bersani, the “austerity” candidate, is claiming victory and indicating he is not willing to form a government with Berlusconi. Meanwhile comedian-turned-politician Beppe Grillo said he won’t form a coalition government with anyone. Really? The fact that a comedian won 25% of the vote given the history of Italian politics I guess is not terribly surprising. Italy may hold new elections this year if Bersani and his Democratic Party fail to win enough backing in parliament to form a government. Clearly Italian voters revolted against imposed austerity measures creating a backlash that sent Italian bonds higher. Their 10-year bonds jumped 34 basis points last week to 4.79%, as compared to our 10-year yield of 1.86%. German Chancellor Angela Merkel, whose party seems to always be in a dog-fight for power over there given how unpopular bailouts for the southern bloc of countries have been amongst German voters, had the following comments post Italy election: “Now in Europe, after the Italian election, it seems to be a case of either austerity and savings programs or growth, but that’s a completely false premise.” That’s easy for her to say but the average Italian voter does not see it exactly like that. In a speech in Greifswald on Germany’s Baltic coast last week she urged Italy not to stray from reforms, saying that her stance on deficits is “not about liking to whip people.” Frankly, that is just giving incredible material for Italian comedian Beppe Grillo! It’s a mess, and that is putting it politely. Germany, for understandable reasons as they are the primary ones financing the whole endeavor, is also balking at supporting direct bailouts for struggling European banks via the European Stability Mechanism (ESM). Wait, did we not write last year that they all had agreed on that? Apparently, the agreement carried some caveats, like Germany now insisting that ultimately the sovereigns are responsible for the funding of their own struggling banks. Wait a minute, we thought that was the whole point of coming to terms last year, to alleviate the pressure on already debt-straddled sovereign nations and come up with a central banking authority with backing from the ESM. Well apparently that was hugely unpopular in Germany, again for understandable reasons, so it looks like the agreed upon deal will play out once again not exactly as agreed upon. As always, stay tuned! 

China’s services industries expanded last month at the slowest pace since September. The non-manufacturing Purchasing Managers’ Index fell to 54.5 in February from 56.2 in January, according to the Beijing-based National Bureau of Statistics and China Federation of Logistics and Purchasing. The new Chinese government also took additional steps to curb their real estate market over there, intensifying a three-year effort, and that clearly spooked traders over there with property and housing companies declining the most in trading on their exchange. Traders here focus on every data point coming out of China given its prominence as the world’s second largest economy. In early Friday trading a figure showing that China’s exports exceeded forecast helped propel markets higher. Overseas shipments increased 21.8% which is a clear indication of growing global demand for their goods and probably an indication of a resilient U.S. consumer. Economists had forecast a figure of 8.1%. 

Here in the U.S., markets seem to have shrugged off the sequester as it was refreshing to see President Obama reach out to and have dinner in DC with several members of the Republican party. Senator McCain walked out and gave the press the thumbs up so we will assume some progress was made on introductory discussions regarding debt reduction and tax reform. Hopefully this will ease tensions somewhat on the Hill and real progress can be made on tackling tough but necessary issues such as entitlement reform. In economic data this week, the ISM Services index for February was 56 and surprised to the upside with its strength. Factory orders for January declined 2% but that was actually slightly better than anticipated. Both initial weekly jobless claims, 340,000 for the week ending 3/2/2013, and the ADP employment report for February at 198,000 we both much better than expected establishing hopes that Friday national employment figures would be robust. In Thursday reporting, 4th quarter productivity was revised to -1.9% while unit labor costs were revised to +4.6%. As we mentioned when the figures first came out, lower productivity and higher labor costs is not an ideal combination from either the standpoint of corporate earnings or continuing action on the part of the Fed.  

Equities were helped in Friday trading on the heels of the U.S. employment report for February. The U.S. jobless rate fell to a five-year low of 7.7%, which was not surprising to us given the recent trend in weekly claims and the ADP report which came out earlier this week, but it did surprise economists as they expected it to remain at 7.9%. Employment rose 236,000 in February after a revised gain of 119,000 in January that was smaller than initially forecast. Economists had forecast 165,000 new jobs created. Private sector payrolls increased 246,000 and this was consistent with the ADP report released earlier in the week. Hiring in construction at +48,000 new workers jumped the most in almost six years, a reflection of the improvement in the housing and commercial real estate markets. These figures point to signs that the world’s largest economy may weather both higher taxes and lower federal spending as a result of the sequester. Employers also boosted the average workweek to 34.5 and hourly earnings by +0.2%, both positive indicators for the typical worker. Governments shed 10,000 workers for the month and we will wait and see what happens for the balance of the year. It is estimated that reductions in the rate of government spending will reduce GDP growth by 0.5% this year and potentially wipe out 350,000 jobs if the sequester remains in place through December. That figure is likely high in our view as so far the discussion has been centered on furloughs rather than lay-offs and there are already bills flowing through Congress to adjust the impact of sequester cutbacks on certain critical areas of government spending. So we will have to wait and see how that plays out over the course of the year.
SGK Blog--Update March 1, 2013 Close to a Record but Not Quite There
This week it was hard to escape the sequestration barrage.  We are not going to spend a lot of print space here talking about it for that reason and also because the market is not really worried about it.  It is a convenient “excuse” to pullout when the equity markets decline or when a company needs a reason why they are lowering guidance.  However, its importance has been overstated.  The $85 billion figure is actually the amount that federal spending authority will be reduced.  According to the Congressional Budget Office (CBO), the actual amount of payments reduced will be about half that amount.  Though $42.5 billion is nothing to sneeze at, it doesn’t make for quite as dramatic a headline as “almost $100 billion.”  The CBO estimates that the impact of the sequestration will be to reduce real GDP growth by about 0.5% in 2013 and 0.2% in 2014.  Again, in a $13 trillion economy, even small percentages matter.  However, what seems to be lost in all the partisan rhetoric is the fact that this is happening because of the federal debt ceiling debate that came to a head in the summer of 2011.  As a nation, we cannot keep our foot on the accelerator and brake at the same time.  The reason why Standard & Poor’s downgraded U.S. federal debt in the late summer of 2011 was partly because of the bi-partisan bickering and also because spending was out of control.  The budget deficit has already fallen from over 10% of GDP in 2009 to 7% of GP in 2012 as the economy recovered.  Both S&P and Moody’s have stated that budget cuts would help put the U.S. on a more sustainable fiscal path.  Yes, that is good news.  We have argued over and over in these weekly reports that our fiscal problems were going to a combination of tax increases and spending cuts.  Neither are welcome, but some degree of both are necessary. 

What is more important in our opinion is the now nearly constant supply of good economic data news.  On Tuesday, the S&P/Case-Shiller index of property values increased 6.8% from December 2011, the biggest year-over-year gain since July 2006.  This followed a 5.4% rise in November.  Nineteen of the 20 cities in the index showed gains.  Particularly strong were Atlanta and Detroit which posted their biggest yearly gains dating back to 1991 and Dallas, Denver and Minnesota showing their biggest advances since 2001.  Only houses in New York lost value, falling a mere 0.5% over the 12-month period.  With the 30-year fixed mortgage rate at 3.56% in the week ended February 21 according to Freddie Mac, we remain near the record low of 3.31% reached in November. 

Orders for U.S. durable goods excluding transportation climbed in January 1.9% according to the Commerce Department data released Wednesday.  Total orders, including volatile items like commercial and military aircraft, fell 5.2%, the first decline since August.  However, those transportation items are often excluded when economist try to paint a picture of true underlying demand for goods and equipment meant to last at least three years.  Ex-transportation, this was the fifth consecutive month of gains.  Helping boost demand is the American automaker.  Cars and light trucks sold at a 15.2 million annual rate in January.  When combined with the November and December data, car sales in the past three months have been the strongest seen in the past five years.

Even modest bad economic news is being overwhelmed by a positive outlook.  Consumer incomes fell 3.6% in January thanks to payroll tax increases and rising gasoline prices.  It was the biggest decline since January 1993 and followed a 2.6% increase in December.  But instead of pulling back, consumers maintained their level of spending with purchases up 0.2% according to the Commerce Department.  The savings rate fell to 2.4% from 6.4% as consumers continued buying cars and other goods.  The Conference Board’s sentiment index rose in February 11.2 points, offsetting much of the 15 point slide over the previous three months.  A revised fourth quarter real GDP figure showed a meager 0.1% gain compared to a preliminary 0.1% contraction reported last month.  That was below the 0.5% Bloomberg survey median forecast.  Nevertheless, consumer purchases remained steady and a smaller gain in inventories contributed to the upward revision.  Depleted inventories could be a sign that a pickup in production will follow if demand stays constant or increases.

And, finally, weekly jobless claims once again fell.  In the week ending February 23, they declined 22,000 to 344,000 below the Bloomberg estimate of 360,000.  We will get the monthly payroll report next Friday which is anticipated to show another solid increase.  Recent increases in hourly earnings and average workweek suggest that hiring is likely to accelerate somewhat.  So even as President Obama and Congress bicker back-and-forth today about some sort of sequester “rollback”, there are plenty of signs showing that the economy is rolling along well and a sequester may end up being just a speed bump in the weeks to come.

SGK Blog--Update February 22, 2013 Sequester Looms Large

With equity indices trading just 4% below the all-time 2007 high for the S&P 500 of 1565 and the Dow just 2% below its high of 14,164, the wind was taken out of the markets sails with the release of the Federal Open Markets Committee (FOMC) minutes from their Jan. 29-30th meeting. Several participants at the meeting “emphasized that the committee should be prepared to vary the pace of asset purchases, either in response to changes in the economic outlook or as its evaluation of the efficacy and costs of such purchases evolved,” according to the actual minutes. One of the concerns highlighted by the committee is the question over whether it fosters excessive risk taking on the part of both individuals and institutions. Although we have not seen signs of inflation creep into markets, there is no question that the supply of junk bonds and demand for junk bonds is at the highest level since pre-financial crisis. Last year companies issued $274 billion of junk bonds, up 55% from the previous year and more than double the level seen before the 2008 financial crisis. If that is not a sign of froth than we are not sure what is! Many shaky companies are issuing covenant-lite paper to take advantage of this demand and the Fed’s policy of keeping a lid on rates. The concern is over whether this is creating another bubble in credit markets. Bernanke is inclined to believe it is not and that the Fed has a good handle on it but this is the same Chairman of the Fed that was in place prior to the previous financial crisis taking hold. The problem with asset bubbles is they are in fact hard to predict and when something comes out of left field it is the spillover effect in terms of loss of confidence that rattles markets. The fact is the Fed does not make money, they print it, so on their current schedule if all goes as planned they will have acquired $4 trillion of U.S. securities by the end of this year on their balance sheet that they will have purchased from the U.S. government. At some point, the bond buying has to slow down and stop and the market will not like it. Similarly, Congress has to come up with a fiscal plan that markets perceive as realistic and achievable long term, while limiting damage in the near term. We won’t write at length about the sequester as you are hearing about it in the news every day, but the fact is it is not the ideal way to address spending issues. We wrote favorably on the Simpson-Bowles plan in its original form when it was first announced but it never gained traction at that time. Time is running out and it looks like Congress will get more serious about negotiations after the sequester has actually kicked in, given they are all on break at the moment! 

As far as the economic news was concerned this week, we had a number of key data points out on the economy that were enlightening. Housing data remained solid although housing starts in January were below expectations coming in at 890,000 vs. the forecast for 914,000 and the previous month’s figure of 973,000. Existing home sales were also slightly below expectations for January at 4.92 million versus the 4.94 million expected. Building permits were slightly better than forecasts called for coming in at 925,000 for January versus the expectation for 914,000. Despite the mixed results the housing sector recovery remains a bright spot for the U.S. economy. The inflation numbers were tame as the producer price index came in at +0.2% for January as did the core rate (excluding food and energy) and the consumer price index was flat with the core coming in at +0.3% for the same month. The core rate is considered a more accurate measure as it is less volatile. The core rate for both figures was a tenth of a percent higher than expected so this bears watching as the Fed pays close attention to inflation figures these days. Helping add to pressure on equity indices the day after the FOMC minutes were released, the Federal Reserve Bank of Philadelphia’s general economic index for February (known as the “Philly Fed Survey” for short) dropped to minus 12.5, the lowest reading since June, from minus 5.8 in January. Readings lower than zero signal contraction in the area covering eastern Pennsylvania, southern New Jersey and Delaware. The median forecast of 48 economists surveyed by Bloomberg projected an increase to +1. This is one of the early data points we received for the month of February and it bears special attention as we approach the sequester scheduled to hit at the beginning of March. It is possible business decisions are slowing as is investment ahead of the uncertainty surrounding the impact on the overall economy. The index of leading indicators rose +0.2% in January versus the expected +0.3%. 

In Europe, continued problems arose when the euro-area services and manufacturing (a combined report) survey of purchasing managers for the 17 member currency bloc fell to 47.3 for February from 48.6 in January. Just when economists, who had forecast a reading of 49, were predicting that European economies were starting to turn the corner. A German services measure also came in below expectations, although at 54.1 it still signals their economy is expanding. This demonstrates that in fact the recession in Europe actually deepened early in 2013 as opposed to stabilizing or getting better. One of the main issues in Europe is that business surveys indicate that the recent growth impetus in Europe is coming almost exclusively from foreign demand. The problem with that is that it can be hampered by an appreciating European currency and a slowing U.S. economy due to all the uncertainty. The big question mark is will things continue to get worse before they get better. European stock indices witnessed sharp declines this week on the gloomy outlook for demand and the scare put into markets from the Fed minutes. Stocks did rebound some in Friday trading on a news report that Bernanke had addressed the “asset bubble” question in early February at a meeting with the Treasury Borrowing Advisory Committee when they brought up the issues in the junk bond market and the risks associated with mortgage real estate trusts. Apparently, Bernanke dismissed or minimized these concerns at the meeting, although that statement alone certainly does not give us confidence. The other newsworthy item sending stock indices higher was a report out on German business confidence, which jumped to a 10 month high amid the strength in corporate earnings in that country at such bell-weather companies such as BMW. The Ifo Institute’s business climate index based on a survey of 7,000 business executives rose to 107.4 in February from 104.3 in January and the expectation of economists for a figure of 104.9. Again, this combination of news lifter equity indices in Friday trading, although for the week they were decidedly in the red.     

SGK Blog--Update February 15, 2013 Earnings Season Continues
The economy received more good news this week.  According to the Commerce Department, retail sales rose in January for the third consecutive month.  Department stores and online merchants showed particular strength as improving job prospects boosted consumer confidence.  Purchases climbed 0.1% which matched the median forecast of economists surveyed by Bloomberg.  The gain was smaller than the 0.5% increases in both December and November.  Excluding automobile sales, which have been strong lately, the figure was still positive at 0.2%.  Ford’s deliveries rose 22% last month and General Motors sales climbed 16%.

The positive retail sales number are a reflection of the improvement in the job market.  The Labor Department reported that in the week ended February 9, jobless claims decreased by 27,000 compared to the week before to 341,000.  The median Bloomberg survey figure was 360,000.  In fact, the actual figure was below the lowest estimate in the survey of 350,000.  The less volatile four-week moving average increased slightly to 352,500 after last week’s figure was revised upwards by 2,000.  There still are about 2 million individuals who have used up their traditional benefits and are collecting emergency and extended payments.  Regardless, the trend is definitely moving in the right direction.  Monthly payrolls, which will not be released for a number of weeks, still need to increase sharply to bring the national unemployment rate, now at 7.9%, down further.

SGK Blog--Update February 8, 2013 European Worries Offset by Strong Earnings Reports  

The week started out on a rough note as Europe once again made headlines and they were not positive. Just before a European Union summit meeting this week, opposition political forces in Spain were calling for the resignation of Spanish Premier Mariano Rajoy based on allegations of illegal payments. At the same time news hit the wires that a 541 year old Italian bank, Monte dei Paschi di Siena SpA, was so strapped for cash in 2011 that it negotiated a covert $2.7 billion loan from the Bank of Italy at the same time executives were publicly describing the lender’s funding position as comfortable. We will spare you the complicated details, but needless to say the bank was in fact running short of liquidity based on two complex structured finance deals it had arranged with investment banks. These deals basically started to head south during the European financial crisis as the value of the Italian government bonds used as collateral were pummeled. This financial scandal has embroiled the Bank of Italy as well because they essentially turned a blind eye to what bank executives were disclosing and not disclosing to the public under the guise of not wanting to roil Italian capital markets further. This is yet just one more example of the far superior approach the U.S. took in undergoing rigorous stress tests post financial crisis in order to disclose fully and publicly problem areas (and areas of strength) in the U.S. banking system. Knowledge is power and provides confidence amongst traders. Cover-ups do not and this is yet one more example of why they need a central banking authority for the European Union. 

All eyes were also focused on European Central Bank President Mario Draghi Thursday as he signaled policy makers are concerned that the euro’s strength will hamper efforts to pull the economy out of recession. He stated, “the exchange rate is not a policy target, but it is important for growth and price stability.” This helped send equity markets here in the U.S. lower on the day as concerns continue to mount over the possibility of a global currency war occurring. With our Federal Reserve buying billion in bonds each month issued by the Treasury in an attempt to keep interest rates low, this also can be viewed as a strategy not just to support our domestic housing market but also to keep a lid on dollar appreciation relative to other currencies in order to support our export business and other central bankers are clearly taking note of this. Thus, Draghi’s comments were generally viewed as somewhat downbeat – he indicated that an economic recovery in the eurozone should begin later this year as an absence of inflation risks allows the ECB to maintain record low interest rates. We could see the impact in trading immediately as the euro declined sharply in value relative to other currencies. Part of what has driven our recovery here in the U.S. since the financial crisis has been the strong rebound in our export manufacturing sector so anytime the dollar appreciates sharply in trading relative to the euro and other currencies this is viewed as a negative for U.S. equities.    

Domestically, markets have been driven by earnings as we have written most recently. It seems like most of the bickering has been over what to do with the giant cash hordes that companies like Apple have accumulated, as evidenced by the lawsuit against the company filed by David Einhorn, the famous hedge fund manager who seems to relish the limelight. As we indicated in previous e-mails, many companies have set conservative expectations for first quarter 2013 earnings, particularly given the uncertainty surrounding the pending sequester negotiations and the higher payroll taxes consumers are paying and what impact that will have on consumer spending. In general the economic data on the U.S. economy was weaker than expected this week. Factory orders increased 1.8% for the month of December but the expectation was for a 2.4% increase. The Institute of Supply Management Services index for January was 55.2 (a number above 50 signals expansion) which was slightly below the expectation for 55.6. Initial weekly jobless claims for the week ending 2/2/2013 came in at 366,000 versus the expectation for 360,000, ending the trend of expectations being soundly beaten in a positive way that we experienced for almost the entire month of January. Fourth quarter productivity declined 2.0% versus the expectation for a 1.2% drop while unit labor costs rose 4.5% far exceeding the expectation for a 2.4% increase. These latter figures are troubling because from a corporate earnings standpoint that is not the combination we want to see. Paying workers more for less productivity obviously eats into corporate profit margins and can definitely squeeze the bottom line. The productivity number can in part be explained by the sharp drop in government spending on the military as the fiscal cliff loomed. We would expect productivity to rebound somewhat over the next two quarters as some of these temporary issues get resolved.
SGK Blog--Update January 25, 2013 Overall Real GDP Declines but Job Growth is OK 
Real gross domestic product, the volume of all goods and services produced in the country, fell at a 0.1% annual rate during the fourth quarter according to the Commerce Department.  Though the overall number was negative, by digging deeper into the figures, a more positive picture emerges.  Household consumption rose at a 2.2% rate following a 1.6% advance in the third quarter and compared to a 2.1% median forecast in a Bloomberg survey.  Consumer spending comprises approximately two-thirds of total GDP so it is the key figure to focus on each quarter.  This sector contributed 1.5 percentage points to growth.  Nonresidential fixed investment (i.e., corporate spending) and residential fixed investment (i.e., homes) contributed 1.2 percentage points to growth last quarter.  Corporate spending had declined at a 2.6% rate in the previous quarter, the most in more than three years.  The headwinds which pushed the overall number into negative territory were inventory changes and government spending.  Combined, they subtracted 2.6 percentage points from growth.  Businesses built up inventories in the third quarter in anticipation of the holiday selling season late in the year.  By the fourth quarter, with consumers a little more tepid in their spending, companies decided to sell items from the warehouse and let store shelves become sparser rather than place new orders with manufacturers.  Government outlays fell at a 6.6% annual pace last quarter.  Highlighting this decline was a 22% fall in defense spending, the largest contraction since 1972, following the Vietnam War.  State and local governments continued to trim their budgets.  Virtually every state in the union is required by law to have a balanced budget so politicians, wary of increasing debt loads, must turn to layoffs in order to balance the books.  Real final sales, which is real GDP less the change in private inventories, was 1.1% in the fourth quarter following a 2.4% rise in the third quarter.  Thus, there definitely was some slowing which took place October through December of last year, but not to the sharp degree which the overall number suggests.  For all of 2012, the economy expanded 2.2% after a 1.8% rise in 2011.

GDP numbers are backwards-looking, plus this latest figure will be revised twice more before a final number is released sometime in March.  That is why the monthly jobs report takes on more meaning.  It is not only more frequent but a better indicator of what direction the economy is going since jobs and income are the lifeblood of what GDP is really all about.  Non-farm payrolls in January rose 157,000 according to the Labor Department.  December’s number was revised higher to a 196,000 increase and November’s was moved up to a 247,000 gain—a 127,000 improvement overall in those two months.  The jobless rate, which is based on a survey of households versus the business-centric payroll figure, rose slightly to 7.9% from 7.8% in December.  A Bloomberg survey had a median forecast expecting a gain of 165,000 payrolls in January.  The Labor Department also released data showing that the economy had recovered 5.5 million of the 8.7 million jobs that were lost during the recession.  Private payrolls, which do not include government agencies, rose 166,000 last month following a revised increase of 202,000 the previous month and versus a consensus figure of 168,000.  Average hourly earnings rose 0.2% while the average work week held steady at 34.4 hours.  This is a sign that people are getting paid slightly more for working the same hours.  Should the trend continue or intensify, there is a definitely possibility that wage pressures may start to be felt across the economy.  The GDP report showed that after-tax income rose at a rate of 6.8% adjusted for inflation, the fastest pace since the recession. 

Concerning incomes, the Commerce Department in a separate release said that incomes rose in December by the most in eight years.  Though the weekly initial jobless claims did rise by 38,000 in the week ended January 26 according to the Labor Department, this has been one step back for the two steps forward the economy has taken recently in this metric.  The Commerce Department income report says that disposable income, or the money left over after taxes, rose 2.8% inflation adjusted while the savings rate increased to 6.5%, the highest since May 2009.  Granted, some firms paid dividends and employee bonuses earlier than usual late last year before tax rates went up this year.  Thus, it would not be a surprise to see these income numbers more moderate when January and February data is released. 

Nevertheless, there can be no doubt that the economy is growing.  Not tremendously.  Not robustly.  But we have often characterized the $16 trillion U.S. economy as a massive battleship.  Once it starts going in one direction, it takes something massively unexpected to stop the momentum.  The Federal Reserve still sees the need to treat the recovery as fragile.  As such, in their regularly scheduled two-day meeting this week, they had no change in their policy of monetary easing stating, “The Committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate (maximum employment and price stability).”  That involves purchasing $40 billion per month of mortgage-backed securities and $45 billion per month of longer-term Treasury securities (and reinvesting principal payments for both).  Until unemployment reaches the “magic” level of 6.5% and forward inflationary pressures remain absent, this policy will not be altered.  Today the pace of the recovery puts these targets still far off in the future.  However, it cannot be ruled out that markets could be surprised with better than expected data in the months to come.

SGK Blog--Update January 25, 2013 Traders Focus on Earnings and China Data  

We will get to the earnings reports from companies we own below but before we do we will discuss the other drivers behind market moves this week, primarily based on global economic data. We will begin with China as we pay close attention to this important market economy although it does not often receive headline attention in major news publications. This week we received a key data point indicating that growth in the important Chinese factory sector accelerated to a two-year high in January. This was indicated by the HSBC purchasing managers index (PMI) which rose to 51.9 and indicates that the country’s two-year slowdown is at worst receding and at best moving the other direction. What’s interesting about China right now is the factory report indicated that there is a healthy demand for both export related goods and for domestic purchases. That has been one of the issues with respect to their economy – it has been so export dependent. With Europe embroiled in recession and growth having been relatively slow in the U.S., this has put a damper on demand for Chinese goods over the past two years. The entire Asia-Pacific region seems to have regained its footing and you have a burgeoning middle class in China demanding items such as smartphones and tablets, and this is a real opportunity for many companies – both foreign and domestic. So this bears watching and if China begins to trend upwards in terms of their economic growth it would translate into better earnings for many companies. 

Domestically the economic data we did receive this week was generally positive. Initial weekly jobless claims came in at 330k for the week ending 1/19/2013 which was much better than expected. This follows the week prior which also exceeded economists’ forecasts. This is a hopeful sign that here in 2013 the job market is improving. The index of leading indicators for December came in at +0.5% which was in-line with expectations but an improvement over November’s figure which was flat. Existing home sales were slightly below expectations, bucking the recent trend on housing data, but the FHFA Housing Price Index for November rose 0.6% which is again a positive sign for that sector and consumer confidence in general.  

The CBOE Volatility Index, an options measure of market fear, is hovering around the 12.5 range. The VIX, as it is called, has only traded below 14 about 21% of the time in its 21 year history and has closed below 10 just nine times in nearly 6,000 trading days. Typically, based on our experience, that level of market complacency frequently does not end well. It makes sense therefore to treat general equity prices at these levels with real caution. That is not to say that there are not value opportunities within the market. Traders are responding to a more benign macro environment with China showing signs of improvement and Europe not making negative headlines on a daily basis. We would note however that for companies that have reported so far in the S&P 500, fourth quarter year-over-year profit growth has come in at approximately 3% (vs. the expectation for 11% growth just a few months ago) and 70% of those companies have lowered their guidance for the first quarter of 2013. It makes sense to pick and choose our opportunities carefully in this environment. 

SGK Blog--Update January 18, 2013 Stocks Move Higher As Earnings Season Heats Up
Applications for jobless benefits fell by 37,000 to 335,000 in the week ended January 12 according to the Labor Department. That is the lowest level since the January of 2008. A Bloomberg survey had predicted that the level would be closer to 369,000 so this was a positive surprise. Based upon monthly data, the national unemployment rate is 7.8% but the weekly indicators are deemed to be more timely so there is clear evidence that the employment picture is improving bit by bit. Nevertheless, we did get a number of negative headlines this week from American Express which will be eliminating 5,400 jobs this year and Morgan Stanley which will cut its ranks by 1,600 jobs in the upcoming weeks. Such events are not unusual in an expanding or contracting economy as individual firms adjust their size to deal with the factors affecting their particular industry. 

Another bit of good news came on the housing front. According to the Commerce Department, housing starts rose 12.1% last month to a 954,000 annual rate. This was the most since June of 2008. Low borrowing costs, less foreclosures and a slowly improving employment picture is aiding household formation. This in turn spurs builders to break ground on more planned houses. Building permits climbed less than housing starts and suggests that builders may take a breather in the coming months. On an annual basis, housing starts rose 28.1% in 2012 versus 2011, the biggest annual gain since 1983. The number of starts averaged 1.74 million from 2000 through 2004, so current figures still allow some room for growth and remain below the peak year of 2005 when 2.07 million housing starts occurred.

On the inflation front, both consumer and producer prices remained tame. Consumer prices rose 2.4% over the past decade, but for the month of December, the reading was for 0% change. The core index, which excludes food and energy costs which are volatile and can distort the month-to-month analysis, rose 0.1%. For 2012, core prices rose 1.9% compared with a 2.2% increase in 2011 according to the Labor Department.   Producer, or wholesale, prices actually declined 0.2% in December. Excluding food and energy, core producer prices rose just 0.1%. These figures helped spur solid retail sales last month. The 0.5% increase according to the Commerce Department followed a revised 0.4% in November and was more than double the 0.2% expected by economists surveyed by Bloomberg. For all of 2012, retail sales climbed 5.2% after a 7.9% gain in 2011. Excluding autos, retail sales rose 0.3% in December after falling 0.1% in the prior month and that figure was in-line with expectations. The Federal Reserve compiles activity in its 12 districts on a monthly basis and releases it in the so-called beige book. It showed for January that economic activity expanded at either a moderate or modest pace in recent weeks with consumer spending picking up which matches the retail sales figures just discussed. The bottom line was “cautiously positive” about the economy gathering steam over the course of the year. There remains a lot of uncertainty about hiring plans and also the looming sequestration and debt ceiling debate could play a big role in how the various districts react.

SGK Blog--Update January 11, 2013 All Eyes Focused on Earnings Season  

Given there was not much in the way of news out on the economy and we are waiting for the 4th quarter earnings results from companies, we thought we would touch on an item that did not make front page news this week but has important implications for future periods of financial stress, which will inevitably take place. We wrote extensively over a year ago about the positive aspects of the new Basel III rules that were to come into effect in the coming years. The Basel Committee on Banking Supervision, a group of the world’s top regulators and central bankers, had come together back in 2010 and they had finalized a set of rules, particularly relating to capital ratios of large global banks, with the idea of preventing future financial crisis of the extent we experienced in 2008. A much needed and, as we wrote, a positive development in our view. Now they have come out and, go figure, relaxed the rules making it easier for banks to comply with the rule known as the “liquidity coverage ratio.” While seemingly innocuous, it is an important metric and it appears as though the committee has bowed to the pressure from the intense lobbying by financial institutions over the past two years. So they have delayed the full implementation of the rule until 2019 and it is up to individual countries to decide how to apply the rules. Basically the liquidity rule requires banks to be holding enough liquid assets, originally limited to cash and government securities, to be able to withstand an intense 30-day liquidity crisis similar to what was experienced in 2008. The liquid assets were to total 100% of the funds a bank would theoretically lose access to in a crisis. The biggest change to the rule involves what banks can now count as “high-quality liquid assets.” So now banks are allowed to use less traditional assets to satisfy up to 15% of their requirements under the rule. These include, for example, highly rated residential mortgage-backed securities (wait isn’t that what triggered the financial crisis in the first place!) That change was obviously precipitated by the large U.S. banks which hold a lot of these types of securities. The banks argue the rules would restrict lending, we would argue that banks are going to lend if demand is there and the point of the rules is to prevent what happened before. So we are disappointed frankly the regulators seemed to have caved on this issue and it is not the only Basel III rule that has been watered down since they have been announced unfortunately. 

Battle lines have already been drawn on the next hurdle Congress faces and this issue is approaching faster than many politicians are ready for. So Republicans in the House and the Senate have indicated that further tax increases are off the table as we approach the deadline for breaking through the current debt ceiling and the two month delay for the automatic spending cuts known as the sequester. Republicans argue cuts have to involve entitlements such as Social Security, Medicare and Medicaid, which Democrats have been reluctant to target. We had been outspoken supporters of the Simpson-Bowles Plan when it was first announced what seems like eons ago. The approach was a multi-faceted plan that tackled the tax code along with entitlement spending and seemed a common sense approach at the time. Basically, as we have written in the past, we need a plan! Hopefully Congress will come around to supporting a similar approach to Simpson-Bowles but, as always, getting there will not be pretty! Both sides are now once again staking out their positions in the public press. 

As indicated, there was not much out on the economy this week and we have not really kicked into 4th quarter earnings season yet. What little data we did get on the economy was mixed. Initial weekly jobless claims for the week ending 1/5/2013 came in at 371,000 which was a bit disappointing as that figure had been trending lower and it was slightly higher than expected. The figure for wholesale inventories came out for November at +0.6% vs. the expectation for +0.2%. This is considered positive as it is an indication businesses were stocking up in anticipation of brisk sales. Alcoa is typically the first big high profile company to release earnings and they have a history of disappointing investors. This time they issued a surprisingly positive forecast for 2013 which took analysts off-guard but set a positive tone for the early going in terms of earnings season. Wells Fargo however was the first high profile bank to release earnings Friday and consistent with the headlines in the Wall Street Journal on the same day, it is evident from sifting through their results that banks are sitting on large amounts of cash but are having difficulty finding credit worthy borrowers demanding loans. One of the key financial metrics used to measure banks success is the net interest margin. This is the basic difference between what banks pay on deposits relative to the rates they earn lending. When they are flush with deposits but not finding enough businesses or people to lend to this margin gets squeezed. This is not unique to Wells, we believe we will see this in all the banks results this quarter. This is not a bad problem at all from the standpoint of the economy and also avoiding future financial crisis in our view. On the first point, as demand picks up in the economy it means banks will be eager to lend. On the second point, irresponsible lending is one of the key contributing factors that led to the previous financial crisis so the fact that banks are being more prudent is not a bad things at all. It does inspire us to run our stock screens though in the search for a quality perhaps regional financial institution that is doing it right and whose net interest margin is heading in the right direction.
SGK Blog--Update January 4, 2013 Half of Fiscal Cliff Deal Passed  

First off we want to wish our clients a hearty Happy New Year! We here at SGK had a record year in terms of our assets under management thanks to you our clients. Our client retention sets a standard that we believe may be unmatched in our industry. We are looking to add an associate financial planner to our staff this year and we are excited about the candidates for this position. We will keep you posted on our progress! 

First, here is a quick summary of some of the major components of the tax package that passed the Senate and the House this week. When we say half the job got done, we are being only slightly facetious. They focused on the tax aspect of the cliff and postponed the tough decisions on spending. For example, here is a component of the bill. It simply postpones for two months the start of the $1.2 trillion in automatic spending cuts over 10 years, known as the “sequester.” For those two months, $24 billion in savings would be substituted. Half of those savings would be split between defense and non-defense programs. The other half includes new revenues.   

So the key component of the bill that passed is on the revenue side of the equation.  It raises $600 billion in revenue over 10 years through a series of tax increases on wealthier Americans. It permanently extends tax cuts made in 2001 by President Bush for income below $400k for individuals and $450k for families. Income above that level will be taxed at 39.6% vs. the current 35% rate. Above that income threshold, capital gains and dividends would return to the 20% tax rate from the current 15% (add on 3.8% for high income earners for the Medicare surcharge under the new health plan). It caps personal exemptions and itemized deductions for income above $250k on individuals or $300k per family. It raises the estate tax to 40% for estates of more than $10 million from the current level of 35%. The other key component is that it permanently fixes the alternative minimum tax and builds in a cost-of-living adjustment which had been sorely lacking. There are other components to the legislation but those are the key points potentially impacting our client base. One last thing, it cancels a cost-of-living raise for members of Congress – which makes sense to us! If you have specific questions on how it will impact you personally, Darren Koch our CFP here in the office is currently studying the legislation and can help answer your questions. 

Helping markets firm up on Friday were two pieces of key economic data. First the December employment report here in the U.S. showed that 155,000 new jobs were created in the month of December. While only slightly better than expected, November figures were revised upwards by 15,000 to 161,000 new jobs. Even better, private sector payrolls for November were revised up to 171,000 from 147,000 and this was in the face of concerns that levels would fall in the aftermath of hurricane Sandy. The overall unemployment rate remains stubbornly stuck at 7.8% however. This may have quelled some concerns after the Fed minutes from their December meeting were released Thursday showing that at least half the members of the committee wanted to end the bond buying program as early as the mid-point of this year. Either way, we believe the market is beginning to price in an end to the Fed Stimulus, whether that occurs at the mid-point of the year or the end of the year. We witnessed a relatively dramatic increase in the interest rate of the U.S. ten-year Treasury this week as it is beginning to approach the 2% level. Also released Friday was the Institute of Supply Management’s ISM Services index which came out a 56.1 versus the 53.5, a surprisingly strong number. The services sector accounts for a good portion of economic activity here in the U.S. so this was a positive development and surprised many economists. The ISM index for manufacturing released earlier in the week was 50.7 which was pretty much in-line with expectations.  

It is an interesting phase of the business cycle as we really will be looking for a bigger dent in the unemployment picture in order to propel corporate earnings higher. This however would be tempered by the potential for rising costs for companies if we see movement in either labor costs or a sharp increase in interest rates. The latter would typically occur ahead of any actual movement by the Fed as traders anticipate their next move. It is always much easier for the Federal Reserve to add stimulus to the economy than remove it. At some point however the continual trajectory of ballooning their balance sheet, combined with the large amount of debt we have fiscally, can potentially lead to a more dramatic shock to the system down the road when they do try to reign the stimulus in. This can lead to sharper business cycle fluctuations, including those retrenchments which are so painful, and that is something the Fed desperately wants to avoid. All the more reason to develop a sound fiscal plan for the country as a whole – we are hopeful the new Congress has more success than the last!
SGK Blog--Update December 28, 2012 The Final Countdown
All those New Year’s Eve countdown clocks have been replaced by the Fiscal Cliff countdown clock.  Sad but true.  Even the Y2K fad wasn’t this bad.  Only three days left to get a deal done.  We will see if the weekend can bring about some sanity on Capitol Hill. 

Meanwhile, the economy just keeps chugging along.  On Thursday, initial unemployment claims showed that in the week ended December 22, applications fell by 12,000 to 350,000.  That brought the four week average to 356,750, its lowest level in more than four years according to the Labor Department.  The news on housing was also positive.  New home sales rose 4.4% in November to an annualized 377,000 pace according to the Commerce Department.  The median price rose 14.9% last month compared to the year-ago figure.  Dwindling foreclosures and less inventory are giving a boost to the housing market.  Low interest rates are not hurting either.  The Standard & Poor’s Case-Shiller index of 20 major cities released Wednesday showed that prices rose 4.3% in the 12 months ended in October.  Chicago and New York were the only two cities with negative annual returns in October.  In Phoenix, home prices rose for the 13th month in a row, and Detroit, which fell severely during the housing crash, saw a 10% annual gain.  Housing is a very key variable in the economy because it fuels so many other industries—homebuilders, insurance, home improvement, furniture, gardening services, etc.  If this momentum can continue into the spring then, assuming no ill effects from the fiscal cliff,  the economy will be well positioned for better growth in 2013 given the friendly interest rate environment. 

SGK Blog--Update December 21, 2012 Ferris Bueller's Day Off

We can only imagine a similar conversation with President Obama calling from the White House playing the role of Ferris and House Speaker Boehner playing the role of abused best friend Cameron:

Ferris: I'm serious man, this is ridiculous making me wait around the house for you.
Cameron: Why can't you let me rot in peace?
Ferris: Cameron, this is my ninth sick day. If I get caught, I don't graduate. I'm not doing it for me, I'm doing it for you.
Cameron: Do you know what my diastolic is?
Ferris: Be a man, take some Pepto-Bismol, get dressed and come on over here, I'm tired of this stuff.
Cameron: Oh, shut up!

After pulling the infamous “Plan B” from the House floor without a vote, Speaker Boehner disbanded the group and left until after Christmas.  Clearly this will not help improve the approval rating of Capitol Hill.  But the elections are over so popularity contests are not important right now.  What is important is that the country continues to barrel towards the “fiscal cliff” with no brakes.  An article in the Wall St. Journal mentioned September 2008 when the Republican House voted down the Bush administration’s first Wall Street bailout plan.  By the close of business that day, the Dow had fallen 778 points.  News of the latest setback was not greeted fondly on Wall Street but not to that degree.  In what can be viewed as a bit snippy, Boehner’s written statement after he walked out stated: “Now it is up to the president to work with Senator Reid on legislation to avert the fiscal cliff.”  The problem is that Boehner could not even muster enough support from his own party to pass Plan B.  Bottom line, this was a personal embarrassment to him.  It initiated rightful questioning of his leadership and is a setback to the GOP.  Representative LaTourette (R., Ohio) put it best: “We are going to be seen more and more as a bunch of extremists that can’t even get a majority of our own party to support policies we’re putting forward.”  If the party’s losses in the November elections were not a low point, this is close.  The disappointment extends to the c-suite, where many CEO’s have expressed frustration going so far as to say, “…as an American, I’m embarrassed.”

Meanwhile, economic data points to an improving economy.  Though initial unemployment claims came in ahead of expectations, consumers are still earning and spending more than previously.  Personal income in November rose 0.6% compared to October according to the Commerce Department.  Personal spending rose 1.7% at an annual rate in the third quarter and November was the strongest reading of this metric since August 2009.  There is no hint of inflation with the personal consumption expenditure index, the Fed’s preferred method of measurement, flat last month.  Non-defense capital goods excluding aircraft rose 2.7% last month and October’s figure was revised higher.  U.S. auto sales in November rose to a five year high for that month thanks to some pent up and replacement demand following Superstorm Sandy in October. 

The Commerce Department also said that GDP rose to an annualized rate of 3.1% in the third quarter.  This followed earlier estimates of 2.7% growth.  New data revealed that spending on health care and exports were stronger than previously estimated.  A potential negative could be that businesses’ inventories contributed 0.73 percentage points of growth.  Thus, it boosted third quarter GDP, but, unless sales begin to pick up this quarter, it will be a drag on the current quarter and future quarters as manufacturers cut back on production rather than have unsold goods pile up along the distribution chain and on retailer shelves.  Also, federal government spending contributed 0.71 percentage points of growth but that will likely be seriously curtailed in the future as the “cliff” approaches.

Housing was also a positive contributor.  This week, the National Association of Realtors said purchases of existing homes rose 5.9% to a 5.04 million annual rate, the most since November 2009.  Property values rose 10% over the past year as inventories dropped to the lowest level in 11 years and buyers responded to ultra-low mortgage rates.  The current sales pace suggests that it would take 4.8 months to sell the 2.03 million previously owned homes on the market.  That ratio is the lowest since September 2005 and a number below 6.0 is considered healthy.

Thus, even with all the trouble over fiscal concerns, the American economy is finding ways to heal itself.  As we have previously stated, the growth is not robust and there remain millions upon millions out of work and struggling from day to day.  That is why the rhetoric on Capitol Hill is so toxic.  It could provide a real roadblock to future growth.  It harkens back to another movie released recently based upon J.R.R. Tolkien’s The Hobbit.  The following is a riddle proposed to the story’s hero Bilbo Baggins:

This thing all things devours:
Birds, beasts, trees, flowers;
Gnaws iron, bites steel;
Grinds hard stones to meal;
Slays king, ruins town,
And beats high mountain down.

Just before the protagonist was eaten by the creature Gollum, he stumbled upon the answer:  Time.  That is exactly what Congress does not have much of anymore yet it will not stop as the end of the year approaches.

SGK Blog--Update December 14, 2012 Fiscal Cliff Drama Continues

The saga continues and as it is on the front page of every newspaper and news report every day, we won’t bore you with the details of progress or lack thereof regarding fiscal cliff negotiations. They are operating with very little time so you would think that House Speaker John Boehner would choose not to head off to Ohio for an extended long weekend after meeting the President at the White House last night, but we do not pretend to have insight into the Republican negotiating strategy so it is a head scratcher! As most Americans and business executives that are polled have a strong preference for a compromise solution to be reached you would think they would get the message on Capitol Hill so we can only hope there is more being done between their respective staffs to work out a deal than they are saying publicly.

Europe made progress this week on the banking front as EU finance ministers agreed to a joint banking supervisor for big banks in the euro zone. This is a positive step as an agreement was in no way guaranteed and it paves the way for the first time since the start of the euro crisis for a permanent mechanism for the pooling of debts and fiscal transfers (albeit limited) within the currency bloc. This deal was hard to achieve because Germany (the principal underwriter) insisted on a transfer of sovereignty within the euro zone. So henceforth the European Central Bank will take direct responsibility for supervising Europe’s biggest banks; those with assets of more than 30 billion euros ($39.22 billion), or banks that make up more than 20% of their country’s gross domestic product, or that operate in at least two countries.  This is a big step for the region and the real impact will ultimately be felt if they move onto the next planned phase which will be the creation of a single euro-zone bank resolution authority backed by a common resolution fund. This will involve a significant degree of potential fiscal transfer and is therefore being delayed until 2014 by which point leaders are hoping the crisis will have eased up by then, the hope being the common resolution fund would never need to be actually tapped into. The creation of this fund would go a long way to breaking the link between the banks and the sovereigns that has fueled the crisis. So, remarkably and unlike our fiscal cliff situation here in the U.S., the Europeans are making slow but steady progress. Who would have thought we would be writing that a year ago! 

On the economic front, the main focus of attention this week on the part of traders was the announcement by the Fed at the regularly scheduled meeting of their open markets committee (FOMC) that they are going to purchase $45 billion a month beginning in January of Treasury securities in addition to the $40 billion a month of mortgage-debt securities.  This effectively continues their path of infusing plenty of cash in the system in order to prevent any type of stresses showing up in the credit markets with what could be a slowdown in the economy on concerns over the fiscal cliff. Ben Bernanke in his speech continued to apply pressure on Congress to resolve the issue or it will be damaging to the economy. What was interesting about this announcement was that the Fed set a precedent by establishing firm parameters around unemployment and inflation before they would begin the process of raising interest rates. This approach continues Bernanke’s philosophy of being considerably more open and transparent as opposed to the secretive nature of the Fed under Greenspan. They do not expect to raise the main interest rate until 2015 when they forecast the jobless rate to fall to between 6% and 6.6%. The Fed expects gross domestic product to be between 2.3% and 3% next year, which is fine but there is obviously a lot riding on a resolution to the fiscal cliff. While their long-term target for inflation remains at 2%, they did seem to provide for some wiggle room on that by allowing it to get as high as 2.5% if the unemployment rate remains above 6.5%. As we said, this is interesting because it is the first time in one of their statements they have actually set specific parameters around inflation and unemployment rates before taking action. 

In other economic news, figures for both the consumer price index and the producer price index for November came in below the expected rates (a good thing) at -0.3% and -0.8% respectively.  November retail sales came in below expectations at +0.3% despite what was considered to be a record setting Thanksgiving period. Initial weekly jobless claims ending 12/8/2012 was a surprisingly good 343,000 compared to the expectation of 375,000 as economists anticipated hurricane Sandy to have a more meaningful impact on the figures. The week ended on a strong note as both industrial production and capacity utilization for November came in above expectations at +1.1% and 78.4% respectively. Overall the economic data for the month of November has been better than expected.
SGK Blog--Update December 7, 2012 Silver Bells
We are a few weeks removed from Black Friday and Cyber Monday, and the tone of the holiday season got a little merrier with the release of the monthly payroll data.  Superstorm Sandy suggested that this month’s figures and maybe a few to come would be negatively affected by the event.  However, nonfarm payrolls grew by 146,000 following a revised 138,000 gain in October.  The median estimate from Bloomberg was for a gain of only 85,000.  According to the Labor Department, Sandy “did not substantively impact” the data.  The unemployment rate fell to 7.7%, the lowest since December 2008, and was below the 7.9% median forecast from Bloomberg surveys.  This month’s info still had a number of twists and turns to contemplate.  The household poll, used to calculate the jobless rate, showed that 369,000 people were not a work because of bad weather.  The average of the last ten Novembers was 70,000.  The Labor Department also conducted its survey a week earlier than typical because of the Thanksgiving holiday.  Nonetheless, private payrolls, which exclude government agencies, rose by 147,000 in November which was much higher than the 90,000 expected.  A key factor which is somewhat hurricane-proof is average hourly earnings.  That gauge rose to $23.63 from $23.59 in the prior month while the average work week held at 34.4 hours.  That is good news because it shows that real earnings are moving in a positive direction for employees which can translate into better economic growth down the road.

Job data was not the only positive news print this week.  Industry sales of cars and light trucks rose to 15.5 million at an annual rate in November which was the best pace since February 2008.  The ISM Services index for the month of November was 54.7.  A reading above 50.0 indicates expansion.  Productivity data for the third quarter was revised up from 1.9% to 2.9%.

However, everything did not come up roses.  ISM Manufacturing failed to meet expectations and came in at 49.5 for November signaling a contraction in that part of the economy.  This disappointing reading matches the purchasing managers’ indices from various parts of the world—France at 44.5, Germany at 46.8,, U.K. at 49.1, Australia at 45.2 and Greece at 41.8.  In a slight twist, China’s reading was 50.6 according to their National Bureau of Statistics following a 50.2 in October.  According to the bank HSBC, that figure was 50.5 in November after a 49.5 reading in October suggesting that last month was the first in which the manufacturing part of the economy switched from contraction to expansion.  The difference between the two sources means that China’s official bureaucracies may not be putting forth accurate numbers—but that was not a big surprise to anyone.  The bottom line is China seems to have arrested some of the decline that was evident in the summer and fall periods.  Whether that turns to robust growth is still very much open for debate.

SGK Blog--Update November 30, 2012 Fiscal Cliff Countdown Continues  

It is just 31 days until we potentially careen off the fiscal cliff so it remains the central focus of attention as traders once again are paying very close attention to the words and actions taken by our political leaders. For example, overshadowing positive news Tuesday on U.S. housing coinciding with announcements on progress being made in Europe, were comments from majority Senate leader Harry Reid when he said little progress had been made to date to avert the fiscal cliff and specifically, “we only have a couple of weeks to get things done so we have to get away from the happy talk and do specific things.” Well we would agree with that and we would hope and expect that political leaders are working around the clock to resolve the potential crisis. That may simply be too much to expect – at the same time it is difficult to conceive of them actually coming to a broad agreement over the next two weeks. Obviously from his comments they do not plan on working weekends! 

On Tuesday we had surprisingly upbeat news on the U.S. economy as durable goods orders came in flat which was better than the -0.4% expected. Excluding the transportation sector (airplane orders tend to be erratic and can skew the figures fairly dramatically from month-to-month), the figure came in at +1.5% which was a solid beat over the -0.4% expected. The news on the housing front continued to be good as housing prices climbed in the year ending in September by 3.0%, the most since July 2010. That in part explains the figure for consumer confidence which climbed to 73.7 for November which was the highest in 4 years and better than expected despite hurricanes and fiscal cliffs! Thank goodness for the resilient and happily spending American consumer! On-line sales on “cyber-Monday” apparently increased 28% year-over-year according to a report from IBM so the Thanksgiving holiday proved to be a robust one for retailers. This just proves to us that a) the American consumer is oblivious to the fiscal cliff or b) they will simply worry about it after Christmas or c) they can’t really believe that our politicians would be so blatantly incompetent to allow us to actually go over it! Anyway, despite all the good economic news and news coming from Europe Tuesday, Harry Reid managed to send the major indices lower with his simple but probably realistic comments with respect to the lack of progress on the all important cliff issue. 

In Europe, finance ministers agreed to cut the rates made under the first bailout of Greece in May 2010. They also suspended interest payments for a decade on lending agreed under the country’s second bailout. The ministers outlined a plan for the Mediterranean nation to buy back its debt at distressed rates. They authorized Greece to receive a 34.4 billion euro ($44.6 billion) loan installment in December. “All initiatives decided upon today will bring Greece’s public debt clearly back on a sustainable path,” Luxembourg Prime Minister Jean-Claude Juncker told reporters in Brussels after chairing a 13 hour meeting that ended early Tuesday. This certainly helped the European bourses in Tuesday trading and perhaps the happiest country of all was Spain as it also facilitated a robust auction of their debt in a relief rally as their yields declined. In fact both Spanish and Italian bond yields dropped to 8 month lows this week at auctions based on the news coming from the finance ministers regarding Greece. 

In other economic news this week, further dampening enthusiasm for equities in Wednesday trading was the release of information on new home sales for October which surprisingly weakened. Sales dropped 0.3% to 368,000, a far cry from the estimate for 388,000. Additionally, the figure for September was reduced to 369,000 from the previously reported 389,000 pace. All-told this was disappointing to say the least as the majority of housing data we have received recently has been positive and relatively robust. The median price for a new house did climb 5.7% in October from the same month last year to $237,700 so that was a move in the right direction. Now we would add that data from the Northeast did seem to drop an unusually high amount dragging down the national figures as it declined 32.3% which may be partially attributed to hurricane Sandy. Initially, traders focused on the headline number but the selling subsided as they dug deeper into the data. Third quarter figures for gross domestic product (second estimate) came in about as expected at 2.7% as did the figure for initial weekly jobless claims ending 11/24/12 at 393,000, still at elevated levels due to the aftermath of hurricane Sandy. Pending home sales for October climbed at a higher rate than expected at +5.2% whereas the forecast was for +1.0%.   This is based on contracts signed to purchase existing homes and this release on Thursday was more consistent with the robust housing data we have recently been receiving. Figures for personal income and spending in October that came out Friday were slightly below expectations at 0.0% and -0.2% respectively but this was not surprising as consumers buckled down in anticipation of and in the aftermath of hurricane Sandy. As we previously wrote, data for this period will be impacted by the hurricane that hit the Northeast and we are witnessing that now.
SGK Blog--Update November 21, 2012 It's Beginning to Look a Lot Like Christmas
With the most important retail shopping day right around the corner, investors and bargain hunters alike are anxious to see what will happen.  The health of the economic environment has been improving but, as we have mentioned previously, it is far from robust.  Last year’s shopping season was decent but not spectacular so with unemployment lower than last year, there is hope for optimism.    Data released this week also pointed to a brighter future.

Housing starts rose 3.6% to a 894,000 annual rate according to the Commerce Department.  That was the fastest since July 2008 and exceeded all estimates taken in a Bloomberg survey.  Superstorm Sandy had minimal effect on the estimates according to the press release.  Work on multifamily homes, such as apartment buildings, rose 11.9% percent.   The National Association of Home Builders/Wells Fargo index of builder confidence climbed to a six year high which bodes well for future construction.  Purchases of existing homes, which comprise the vast majority of housing transactions, rose 2.1% in October to a 4.79 million annual rate according to the National Association of Realtors.  Importantly,  the median price also rose 11.1% as inventories of unsold homes dropped to the lowest level in almost a decade.  At the current sales price, it would take 5.4 months to clear out all the inventory.  A figure below 6.0 is considered a healthy market so we are in the range.  In July 2010, the annual rate of existing home sales was 3.39 million so we are averaging nearly a million more per month today versus two years ago.  According to Freddie Mac, the average 30-year fixed mortgage rate is 3.34%, the lowest since 1972 and a big contributor to the resurgent state of the residential housing industry.  Thus, the Fed can be applauded for helping play its part in the recovery.  However, tight lending standards still present a considerable roadblock for many families.  The big question is where to draw the line?  Looser standards helped lead to the real estate bubble but tighter controls today may be more strict than necessary and present a recovery that still remains fragile and very rate dependent. 

Against this backdrop, Federal Reserve Chairman Ben Bernanke spoke this week to the New York Economic Club.  His comments covered a lot of ground, but the most important in our opinion is his belief that the long-term growth potential of the U.S. has been curbed.  We mentioned this in a previous newsletter and highlighted how this was a serious debate within the Fed governors.  The implications are immense.  In an $13.6 trillion economy, if growth slows even a half a percent, that is a $68 billion reduction.  The U.S. economy grew from 1991-2011 at an average annual rate of about 2.75%.  The potential growth rate is an economic construction which combines the growth in the labor force plus the rate of growth in output per hour.  The combination of severe job losses during the latest recession combined with the persistent long-term unemployment means that one component of that equation is hamstrung.  The Congressional Budget Office projected 0.5% labor force growth in the future and 1.7% labor productivity enhancement.  The Fed believes the unemployment rate can fall to the 5%-6% range without generating inflation (the so-called “full employment” rate).  But since the economy is hovering near the 8% unemployment mark and the fiscal cliff+debt ceiling issues have curtailed investment spending, the likelihood of reaching the CBO level of 2.2% growth is diminished and falls far short of the 2.75% 20-year pace.    Bernanke does not give explicit detail as to what he or the committee believes the long-term rate to be currently (likely because that discussion is ongoing within the halls of the Federal Reserve), but he does say that all is not lost and the potential for increases remain.

He mentions that one of the reasons why our long-term potential is threatened comes from Europe.  Bernanke states that “Weaker economic conditions in Europe and other parts of the world have also weighed on U.S. exports and corporate earnings.”  This week Moody’s Investors Service lowered France’s debt rating by one notch on the credit quality scale from “Aaa” to “Aa1”.   The reaction from the markets was somewhat muted because Standard & Poor’s already cut their rating on Europe’s #2 economy earlier in the year.  Bernanke says credit spreads would be narrower if the situation in Europe was better.  The 10-year note in France is currently yielding about 2.0% which is better than troubled southern nations like Italy (4.8%) and Spain (5.9%) but still leaves a sizeable gap with stable Germany (1.4%) and the U.K. (1.8%....the U.K. does not use the euro but is still part of the European Union).

The main pressing issue remains the fiscal cliff.  Bernanke has repeatedly said that “the federal budget is on an unsustainable path.”  The Fed will keep interest rates low for many moons, but the president and Congress must come to a deal quickly or face a sharp decline in annual output from tax increases and spending cuts or run head-first into the rapidly approaching federal debt ceiling.  It is clear to us that at this point, the fiscal cliff cannot be fully avoided.  The question that remains is how far over the edge will the politicians push us before grabbing hold of a branch on the way down?

SGK Blog--Update November 16, 2012 Fiscal Cliff Negotiations Begin in Earnest 

U.S. stocks finally reversed course this week and rose on Friday after House Speaker John Boehner indicated he had constructive talks with President Barack Obama on their first real day of discussion regarding the looming fiscal cliff. With respect to the budget, he indicated they would accept government revenue increases coupled with spending cuts. The President did make a good point earlier in the week by reminding Republicans that he won the election and a key component of his platform was the goal of raising taxes on the “wealthy.” He is of course facing a Republican majority in the House who up until recently were dead set against any form of tax increase whatsoever. “What folks are looking for, I think all of us agree on this, is action,” the President said at the start of the meeting today with Boehner and other congressional leaders in the Roosevelt Room at the White House. Well Amen to that we say! Business leaders across the country have been asking for compromise in order to achieve a solution. The economy would benefit from a stable predictable environment both in terms of taxation and spending. If we need to spend a little less and tax a little more so be it but please let us consider a long term deal to address our structural deficit issues in this country. 

Speaking of the economy, the news was decidedly mixed this week as the effects of hurricane Sandy that ravaged the East coast started to show up in the data. It was particularly evident with the initial weekly jobless claims number for the week ending 11/10/12 as it spiked to 439,000 versus the expectation for 388,000 and the Philadelphia Fed survey, a measure of manufacturing in that area, came in at -10.7 versus the expectation for 0.0. Figures for retail sales came in below expectations for October at -0.3% versus the expectation for a -0.2% decrease. Both industrial production and capacity utilization came in below expectations at -0.4% and 77.8% respectively for October. These latter figures are pre-Sandy but mainly reflect a concern on the part of businesses about investing ahead of the uncertainty surrounding the fiscal cliff. We expect the November data to show a similar trend and perhaps be even worse as the uncertainty over the state of the economy in 2013 heightens. Figures for both the producer price index and the consumer price index were either better or in-line with expectations for the month of October coming in at -0.2% and 0.1% respectively. Is the producer price figure hinting at a deflationary environment? It is too soon to tell as one month does not make a trend. We suppose this will permit the Fed to continue its bond buying spree unfettered! Certainly the Fed is hoping for some help on the fiscal side of the equation and we do hope they get it! 

SGK Blog--Update November 9, 2012 How Soon Is Now?
After the last bit of confetti is swept up, the noisemakers put away and the concession speeches are given, the cold reality of the now sets in.  With the fiscal cliff approaching, it is not a pretty picture.  After a tightly contested race for the White House, the final results revealed an interesting conclusion: more of the same is desired.  Regardless of who won, those on Capitol Hill and in the various state houses still have to confront an economy which is healing but far from healthy.  At the time of this writing, there are exactly 53 days until January 1st which does not leave much time to tackle issues that have been years in the making.  The good news is that the problems are not insurmountable or unsolvable.  The somewhat bad news is that many of the participants who got us in this situation and must now come to the bargaining table have not changed.  So what does the road forward look like?  We provide a blueprint.

First, all participants must embrace the fact that excuses are limitless but solutions are priceless.  The somewhat twisted logic of politics means that with the elections over, it is fine to upset the voters because they are virtually powerless for the next two years.  In other words, Democrats are going to have to realize that entitlement benefits must be curtailed.  They have grown at an 11% annualized pace versus the 3% GDP past over the past several decades.  That is simply not sustainable.  Squabbling over minor issues has to stop and participants on both sides of the aisle are going to have to mess with the dreaded “third rail.”  Similarly, Republicans are going to have to be less adamant on tax increases.   As any economist and money market participant will tell you, taxes are a detriment to growth and investment.  But, as any realist will admit, it is the only thing that is going to get the Democrats to come to the table.  Moreover, there is room for an increase.  Without getting into the nitty gritty of the $250,000 AGI dividing line spoke of so often during the campaign, there are ways to rollback the Bush era cuts and also simplify the code in order to increase the overall tax revenues.  The Bowles-Simpson deficit reduction plan offers many sound ideas which Congress often speaks of but has not implemented yet. Now would be a good time to start.  Of the last 51 years, 46 of them have been spent in deficit and recently it has been deficit with a “t” as in “trillions”.  As we have argued previously, only through a combination of spending curbs and tax increases will this situation improve.  Given that approximately 3.1% of GDP, or $532 billion, would be affected by tax increases in fiscal 2013 according to the Congressional Budget Office (CBO), there remains plenty of “wiggle” room for deals.

Second, sequestration is not a bad thing.  Yes, the affect on many cities and towns very dependent on military bases or ports will be devastating.  But it is hard to argue that it must continue at the same pace—similar to entitlement spending.  The Pentagon’s budget has risen for 13 consecutive years which is unprecedented.  The U.S. spends more on defense than the rest of the world combined.  With actions in Iraq concluded and a goal for Afghanistan to end in the next few years, it is not unheard of for spending to decline based on historical records.  President Eisenhower cut spending 27% after the Korean War, President Nixon cut it 29% after Vietnam and President Reagan began scaling back which was continued by President George H.W. Bush and accelerated under President Clinton.  Having a vigilant and prepared national security apparatus means more today than having tanks at the ready and aircraft carriers near every port in the world.  It means smarter spending and better use of resources.  Even President Eisenhower, that is former 5-star General and Supreme Commander of the Allied Forces in Europe, argued that disarmament should be a continuing imperative in his farewell address from the White House.  After the tragic events of September 11, 2001, there was need for a response both militarily and politically.  It can be argued that we as a nation are safer than September 10, 2001 but balance and restraint should be the goal not something to be avoided or characterized as weak.  According to CBO estimates, the mandatory cuts should they occur in defense would be 0.5% of GDP in fiscal 2013, a fairly large amount when it is only growing at 2.0% annualized, but not the end of the world.  We are not alone in these thoughts as there is plenty of “chatter” on the Street about this being more likely than reaching a deal on taxes and entitlements.

Third, the “fringe” items are really major points.  Voters and the markets held their breath with every new report on jobs and unemployment.  And attention was spent on overseas affairs like the European sovereign debt situation and the sad events surrounding the Benghazi attacks.  But issues like immigration and the environment were questions that came up at a town hall and then quickly checked off as “addressed” once the debates were over.  Immigration reform is long overdue and with 11 million illegals in the country so it needs to be near the top of the “to do” list.  But it goes beyond day laborer sites and avoiding undocumented aliens.  We are losing many of the foreigners here legally on a temporary basis we educate in our universities and professional program because the path to citizenship is murky and more attractive opportunities exist in their native lands.  Though the U.S. remains one of the few industrialized nations to have a net inflow of individuals, imagine if the best and the brightest came and stayed.  The long-term positive implications would be enormous for every industry.  Similarly, though sources of energy like solar and wind remain players in a distant future, the boom created through fracking has completely turned the tables on the global energy picture and could have major repercussions in the future.  This country has never had a well-defined energy policy and that shortfall played no small role in the 1970’s inflationary period and subsequent spikes at the pump in the decades hence.  The amount of natural gas reserves available on domestic shores has the potential to rewrite our relationship with the oil-rich nations of the Middle East as well as be a source of supply for countries in Europe and the Far East if used intelligently.  That has implications in everything from employment levels to defense spending, but a growing and organized “green” movement must have their needs met, too.  The main takeaway is that the election merely brought many of these items to light.  But the time is now to confront their challenges in order to ensure a strong nation in the years to come.

(And on a semi-humorous side note, if the Democratic, Republican, Independent, Green, etc. parties are serious about putting America back to work, then they need to employ an army of people to go around and pick up these election signs littering the landscape.  It’s over, folks; clean up the mess.  We may knock a point off the unemployment rate that way!)

Overseas, we are seeing glum evidence of what happens after years of underinvestment and poor past fiscal and monetary policies.  The European Commission this week said the 17-nation euro-zone economy will expand at a measly 0.1% in 2013, down from a May forecast of 1%.  It even predicted the main engine of growth, Germany, will grow at only half the rate it previously expected.  It is no surprise that the southern countries—Greece, Cyprus, Slovenia, Italy, Spain and Portugal are expected to contract the most.  The next major date is November 12 when finance ministers judge whether Greece has made enough austerity reforms to deserve the next installment of €240 billion.  A parliamentary vote on the austerity measures barely passed this week but brought into question the coalition that Greek Prime Minister Samaras has assembled.  And just to add fuel to the fire, Germany will go to the polls in late 2013 with current Chancellor Merkel seeking a third term but suffering from a weakening of her own political base due to the stress of the situation.  Any guesses what happens to the euro if she is not around?  You don’t want to know.

SGK Blog--Update November 2, 2012 Atlantic Superstorm Sandy to Dent U.S. Economic Growth

Our thoughts and prayers are with those impacted by hurricane Sandy as it whipped its way through the Eastern seaboard of the United States.  New York City was basically shutdown for two days as stock and bond trading was appropriately halted for two days, the first such occurrence since New York was pounded by 2-3 feet of snow all the way back in 1888.  Although not having much impact on stock prices when they reopened for trading Wednesday, the storm will likely cut U.S. economic growth as it kept millions away from work in diverse industries ranging from restaurants to refineries in one of the nation’s most populated and productive regions.  Why would stock prices not decline further?  Well markets tend to be forward looking at it is very likely that the rebuilding and damage repair that eventually will occur will be a net positive for U.S. economic growth in the future.  Thus, the impact on markets from this type of occurrence tends to be muted.  While the price of oil was not impacted much, expect to see gas prices rise as refining operations were impacted up and down the East coast.  Again, our hearts go out to those impacted by the storm.

In U.S. economic news this week, we received good news on housing prices as the S&P/Case-Shiller index of property values in 20 major cities rose 2% in August from a year earlier.  This followed a 1.2% increase in July.  This exceeded analysts’ forecasts and showed housing prices continue to move in the right direction.  A business activity gauge from the Institute for Supply Management-Chicago Inc. increased to 49.9 for October from 49.7 in September, although this was below expectations and fell below the 50 level below which signals contraction.  Early in the week we received information on personal income and personal spending and both these figures were healthy either meeting or exceeding expectations as they came in at +0.4% and +0.8% respectively for the month of September. 

We had a lot of U.S. economic indicators released on Thursday and that helped propel stock indices higher in trading that day.  ADP released their employment report which showed 158,000 new jobs created in October – higher than the expected 143,000.  Initial weekly jobless claims ending 10/27/12 came in at 363,000 which was 12,000 less than expected.  Figures for third quarter productivity were better than expected at +1.9% while third quarter unit labor costs declined by 0.1% which was also unexpected.  That combination helps corporate profits so it was viewed by traders as a nice combination.  Construction spending was slightly lower than expected, but, at +0.6% for September, it showed improvement over the prior month’s -0.6% figure.  Finally, the Institute of Supply Management’s ISM Index for October surprised to the upside coming in at 51.7 signaling expansion as did the figure for consumer confidence coming in at 72.2. 

Taken together, all of this information was a real positive from the standpoint of the news on the U.S. economy.  It shows that the consumer in particular has remained resilient in the face of the election uncertainty and the looming fiscal cliff.  We are hearing however from CEO’s that businesses are being conservative in their investment decision making in the face of the looming fiscal cliff.  In combination with effects from the hurricane, we will likely see an impact on U.S. data prior to year end so we will keep an eye out for that.  The employment report provided a boost to the President’s re-election efforts as job creation in the month of October was better than expected as the private sector added 184,000 new positions to payrolls and the net figure of 171,000 new jobs was better than the forecast for 125,000.  The jobless rate came in at 7.9%, in-line with expectations, and below the psychologically important level of 8% above which makes it difficult for a sitting President to get re-elected. We’re sure the President breathed a sigh of relief based on the results of this final employment report prior to the election. 

In Europe, things continue to not look so rosy!  Unemployment in the 17-nation euro region rose to 11.6% from 11.5% in August according to the European Union’s statistics office in Luxembourg.  That is the highest level since they started tracking the data in 1995.  The rate of youth unemployment is particularly bad at 23.3% with Spain’s rate shockingly more than double that at 54.2%.  A separate report showed inflation in the area cooled to 2.5% in October from 2.6% in the previous month.  Economic confidence in the region fell as well and French consumer spending rose less than forecast in September.  We are witnessing job cuts in Europe across several large companies as they attempt to cut costs to deal with the slowing economic situation.  Even bellwether Germany’s business confidence has eroded based on recent reports.  After contracting 0.2% in the second quarter, it is likely that GDP in the euro region shrank again in the third quarter putting the region into its first official recession since 2009.  Elsewhere, indicators are showing that the worst of the declines in the Asia-Pacific region may be moderating.  Taiwan’s GDP rose 1.02% in their third quarter after a 0.18% decline in the previous quarter.  South Korea’s industrial output rose 0.8% last month while Singapore’s unemployment rate in the third quarter dropped to the lowest level in 1.5 years.  As we have indicated, it appears the economic slowdown in China has moderated and we have also seen signs of a pick-up in activity in that all important country.

SGK Blog--Update October 26, 2012 Tremors
As expected, the Federal Open Market Committee met and issued a statement that provided little surprises.  Make that no surprises.  They stated that “strains in global financial markets continue to pose significant downside risks to the economic outlook.”  Because inflation is expected to run “at or below” the 2% target, the Fed is very comfortable going all out to meet its non-price level mandate, namely “maximum employment”.  According to their statement: “The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.”  As such, they are committed to purchasing $85 billion of longer- term securities per month through the end of the year.  Their hope is that such actions will create financial market conditions that are so “accommodative” that businesses will hire and invest like never before!  According to money manager BlackRock, if their buying continues and rates are kept low into 2015, the Fed might own 80%+ of the outstanding Treasury securities in the 8- to 10-year part of the maturity curve by 2014.  That is simply mind-boggling and a recipe for disaster.  Unfortunately, the Fed cannot make jobs out of thin air, they cannot build plants because they do not manufacture anything and they play no factor in U.S. household formation because they cannot serve as the justice of the peace or a minister.  In other words, they can supply all the interest rate help in the world, but they cannot create demand where it does not exist.  As we wrote in previous newsletters, Fed actions can affect those on the margin.  Those thinking about buying a house.  Those thinking about investing in a manufacturing facility and filling it with skilled workers.  But it is not going to affect those who are not contemplating moving households.  Or those whose sales pattern has not shifted enough to even contemplate expansion.  We applaud Bernanke and company for their efforts, but they are going to need a lot of help to reach that “maximum employment” mandate.

The first reading of U.S. third quarter GDP was released this week.  The annual pace of growth was 2.0% which was above the expectation of 1.8% and better than the final second quarter reading of a 1.3% growth rate thanks to higher spending by consumers and the government.  Consumer spending, which comprises over two-thirds of the total, rose 2.0% during the quarter versus the 1.5% gain in the second quarter.  Federal government spending rose for the first time in two years (and what a coincidence it is during an election year!) by 9.6% versus a 0.2% fall in the previous quarter.  Most of the spending was on defense goods which are facing a massive cutback come January 1st unless the lame duck session of Congress can figure out a way to work towards a more balanced budget.  Real final sales, which excludes the effect of inventories, rose a healthy 2.1% compared to a 1.7% gain in the previous period.  All of the inflation figures were tame further giving support to the Fed’s massive bond buying efforts.  This report will be revised at least two more times once more data becomes available.  Second quarter’s initial reading of 1.7% eventually became 1.3% growth after going through its revisions.  Nevertheless, today’s figures are a bit of a bright spot in an economic landscape which needs one.

SGK Blog--Update October 19, 2012 U.S. Economic Data Comes in Strong While Executives at Companies Sound Notes of Caution

With corporate executives sounding notes of caution on slow European growth and the uncertainty surrounding the fiscal cliff, the economic data here in the U.S. came in surprisingly strong this week. Of particular note was the data on housing. Housing starts for the month of September surged to a 4 year high here in the U.S. with a 15% jump to 872,000 which far exceeded forecasts. Building permits also reflected health in this important sector for the U.S. economy as they also surged to 894,000 versus the 815,000 expected by the market. As much as analysts like to criticize the Fed for their stimulus policies, record low interest rates are definitely helping to revive the housing market as the sector appears to have turned the corner as supply has dwindled resulting in a pick-up in activity. There was a lot of concern over the back-to-school sales season and that concern was alleviated by a surprisingly strong retail sales figure for the month of September as they rose 1.1% versus the expectation for a 0.7% increase. Inflation also remains in check as both the consumer price index (CPI) and the core rate for CPI were tame coming in at 0.6% and 0.1% respectively. Industrial production and capacity utilization, measures of health in our manufacturing sector, both surprised to the upside as they came in at +0.4% and 78.3% respectively. The one downer for the week was the initial weekly jobless claims figure for the week ending 10/13/12 as this came in at 388,000 which was higher than expected. This news was mitigated somewhat by the index of leading indicators which for September was a relatively robust +0.6% versus the 0.2% expected and the Philadelphia Fed survey for October which came in at +5.7 versus the expectation for -0.1. All-in-all it was a strong week for U.S. economic data. 

The theme we are hearing from both companies we own and companies we do not is a consistent note of caution in terms of their outlook for the fourth quarter and heading into 2013. It has been a good climate for earnings but with economies in Europe in turmoil and slowing growth in China in particular, many companies are seeing that reflected in their results. In addition, with the recent strength of the U.S. dollar, for multinational companies the currency translation has taken a chunk out of their top-line growth. Technology companies in particular are seeing cautious spending as well ahead of the looming fiscal cliff here in the U.S. We highlight the results from our holdings that released their results this week below. We have many more companies to report in the next couple of weeks so we will be busy!
SGK Blog--Update October 12, 2012 The Way We Were
Do you remember where you were on October 9, 2007?  In the movie theater watching The Rock as he powered The Game Plan to the top spot at the U.S. box office?  At home waiting for Gil Grissom and crew to solve the latest mystery for TV’s #1 rated show CSI:?  If you were following the stock market, you were popping champagne bottles as the Dow Jones Industrial Average closed at an all-time high of 14,164.  The S&P 500 also closed at its record high that day: 1565.  It is instructive to talk a stroll down memory lane to see where we were then and where we are now…

Back then, the housing market was just showing some cracks, but nothing really to worry about.  Existing single family home median prices were $204,800 in October, 2007, a slight dip from the $219,600 median reached in the same month a year prior.  In fact, mortgage rates were likely to improve as the Federal Reserve had just begun cutting its benchmark Fed fund rate to 4.75%.  By the end of the next month, it would be even lower at 4.50%.  Real GDP was humming along at a 3.0% annualized pace in the third quarter.   There was a new cell phone on the market with a quirky name—the iPhone—which was less than four months old and involved using your finger on what was called a “touch screen”.  Its manufacturer, Apple Inc., was trading under $170 per share.

Fast forward to 2012 and the world has changed.  We have suffered (and continue to suffer on some fronts) through the worst financial crisis since the Great Depression.  Existing single family home median prices go for about $188,000 now which is a welcome relief from the lows from the mid $150,000’s just two years ago.  Mortgage rates now hover around the 3.5% range for a 30-year fixed rate after the Federal Reserve went “shock and awe” on its benchmark rate which is now near 0%.  Real GDP for the second quarter of 2012 was revised down to 1.3%.  And today we are on the fifth generation of iPhones, and Apple is the most valuable company in the world.  Any guesses for what 2017 will hold?

October has been quite notable in financial history.  The 9th is also the 10-year anniversary of the low point of the bursting of the tech bubble.  On 10/09/02, the S&P 500 bottomed at 777 before gaining over 100% over the next five years.  It was only four years ago that Warren Buffett authored his “Buy America, I Am” op-ed article in the New York Times encouraging investors to “be fearful when others are greedy, and be greedy when others are fearful.”  Since that letter was published on October 16, 2008, the S&P has gained 69% through last Friday’s close.  Tomorrow also marks the 4-year anniversary of the infamous meeting between then-Treasury Secretary Hank Paulson and the heads of 6 major U.S. banks.  There he gave them an offer they couldn’t refuse.  Literally.  Nearly four hours later, they walked out with Paulson’s commitment of $125 billion of taxpayer money via preferred equity stakes.  Today half of those CEO’s are no longer in the same roles with those firms.

Indeed, a lot has occurred since the turn of the century in the financial world.  Stock exchanges are dominated by rapid fire trading houses.  The euro, still young currency-wise at 13 years old, faces a weekly threat to its very existence.  And political gridlock threatens to push the U.S. over the “fiscal cliff” when the clock strikes midnight on New Year’s Eve.  Yet, were are still within single digits of reaching and exceeding the record levels set five years ago.  Cash levels on corporate balance sheets total in the trillions of dollars and though the unemployment rate remains stubbornly high, it pales in comparison to developed Europe and the U.S. remains the envy of the world on many fronts including technology and health care research.  Sometimes a trip down memory lane reveals some skeletons in the closet which should remain hidden, but sometimes it shows the rewards of patience and a focus on the many fundamental, bottoms-up reasons why we are close to achieving record results in our equity markets.    

SGK Blog--Update October 5, 2012 Economy Adds 114,000 New Jobs in September; Unemployment Rate Dips to 7.8%

As we witnessed relative calm this week in terms of headline news out of Europe, traders attention has shifted to the outlook for corporate earnings.  Expectations for the third quarter have been contracting.  Analysts’ on average are expecting a decline of 1.7% year-over-year which would be the lowest rate of growth since the third quarter of 2009.  Half of the ten sectors as broken out by Standard & Poor’s are expecting a decline while nine out of ten sectors have seen estimates lowered recently for the current quarter.  This is a reflection of where we are at the in business cycle and also slowing economic growth and uncertainty with respect to the looming fiscal cliff here in the U.S. as we approach 2013.  We have had a few notable warnings from companies such as Caterpillar, Fed-Ex and most recently Norfolk Southern and these companies are important indicators of the state of the economy.  The flip side is we have had solid earnings delivered by two of the companies within our portfolio, Accenture last week and General Mills prior to that.  So we expect to see individual stocks to trade in a pattern reflective of their earnings results and also, very importantly, based on their outlook for earnings in 2013.  So stay tuned!

With that said, we did have important news out on the economy this week.  We started out on a relatively strong note as the Institute of Supply Management (ISM) released their gauge of activity in the manufacturing sector based on their polling of purchasing managers and it surprised to the upside for September coming in at 51.5 vs. the expectation for 49.7.  A number above 50 indicates expansion in the economy while a number below signals contraction.  This was quickly followed by a robust reading on the service sector as the ISM Services gauge came in at 55.1 versus the 53 expected.  The services sector accounts for about 70% of U.S. gross domestic product (GDP) so this is not a figure to ignore.  Initial weekly jobless claims for the week ending 9/29/2012 came in at 367,000 which was basically in-line with expectations.  This set us up for a monthly jobs report from the Labor Department released Friday in which the numbers were good, but certainly not awe inspiring.

In the month of September, according to the Labor Department, the U.S. economy created 114,000 new jobs, which was slightly below expectations.  There were numbers in the report that were positive though as the unemployment rate dipped to 7.8%, which caught economists’ off-guard as the expectation was for it to remain at the 8.1% level.  Also, the figures for July and August in terms of job creation were revised upwards and average hourly earnings climbed more than forecast.  July figures for new job creation were revised up to 181,000 from the previously reported 141,000 while August figures were revised to a gain of 142,000 from the previously reported 96,000 gain.  Average hourly earnings grew 0.3% versus the expectation for an increase of 0.2%.  As a result of the report, Treasury yields rose and stock futures climbed as traders bet an improving job market will give workers the wherewithal to boost their spending, helping cushion the economy from a global slowdown.  There are items within this report that both Presidential candidates can use to support their platform, it is likely a net positive for the incumbent with the headline number coming down and the likely positive market reaction – that combination may provide some temporary reprieve from the criticism that not enough progress is being made.

How to explain the unemployment rate coming down after relatively lackluster job growth for the month?  For that we need to get into the detail on the employment report and again we see positive signs.  The total number of jobs employed grew by 873,000 which was the highest one month increase in 29 years.  The total of unemployed people fell by 456,000.  The labor force participation rate, which reflects those working as well as those looking for work, edged higher to 63.6% but remains at 30 year lows.  The total labor force grew by 418,000 which would account for the relatively modest net level of job growth for the month.  The level of part-time workers reported a big gain as it grew 582,000.  We view this as being positive as increases in part-time workers or the hiring of temporary workers can be a precursor to more permanent hiring.  The U-6 number, one which Romney will likely cite and which accounts for the underemployed and those who have given up looking for jobs, held unfortunately stubbornly steady at 14.7%.  As we indicated, there are items in the report for both candidates to point to in terms of supporting their positions, but when you net it all out this was a positive report for the U.S. economy.

SGK Blog--Update September 28, 2012 Homeland
Things may not be what they appear to be.  That is the premise of this year’s Emmy for a dramatic series, Showtime’s Homeland.  Is a similar deception going on in the U.S. economy?  Final data for second quarter GDP was released this week which showed the economy expanded at a 1.3% annual rate.  This was lower than the prior estimate of 1.7% thanks to lower consumption spending and lower exports.  Final sales, which excludes the effects of inventory stocking or de-stocking, came in at 1.7%, a decline from first quarter’s 2.4% growth.  Orders for non-defense capital equipment excluding airplanes—items expected to last at least three years in households and businesses like washing machines, autos and printing presses—rose 1.1% in August after two straight months of declines.   When aircraft are included, the figure plunged 13%, the most since January 2009.

Most global trade takes place over water.  The Port of Los Angeles is the largest in North America handling nearly 8 million TEUs (twenty-foot equivalent units, a standardized maritime industry metric) in 2011.  Through August total loaded containers are down 6.2% compared to the same period last year while total empty containers are up 11.3%.  Inttra, a firm that runs logistical services for shippers, says holiday-season volume is tracking only about 90% of last year.  We have already heard the warnings from FedEx and Caterpillar which said it is forecasting moderate and “anemic” global growth through 2015.  Today the Chicago purchasing managers index fell to 49.7 instead of the 52.5 expected.  A level below 50.0 indicates contraction and this was the first such sign in three years.

Glimmers of hope have shown in the housing sector.  This is not a surprise given the exceptionally low mortgage rates and supply which was available from foreclosed homes.  Now that that supply is drying up as these troubled properties come off the books of banks, household formation is remaining solid so that demand is facing lower supply leading to a bump in prices.  Nevertheless, prices remain about 30% below peak levels and we are entering the slowest time of the year for housing transactions.  Real estate has also been aided by the employment situation.  Weekly applications for jobless benefits fell 26,000 to 359,000 in the week ended September 22.  That was below the 375,000 expected by economists in a Bloomberg survey.  Yet there are over 5 million continuing to collect jobless benefits or collecting emergency and extended payments.

These ill winds are obscured by the fact that the stock market is doing very well.  We are at multi-year highs in the major averages and profit margins are near record levels in many industries.  Outside of the few notable profit warnings in the transportation industry, most of the news from corporate America is good including record sales for Apple’s latest iPhone and the once shaky financial sector is doing well as evidenced by the government’s desire to reduce their presence in financial crisis poster child AIG.  And this main street/Wall St. dichotomy is not just here.  The Stoxx Europe 600 index is up over 11% year-to-date with bourses in Germany, Belgium and Switzerland leading the charge.  Yes, Spain is not doing well year-to-date but even the Greek Athens Composite is up high-single digits through the end of September.

There is no simple answer but some educated guesses can be made.  Markets are very influenced by the price of money and with central banks around the world pumping liquidity into their markets, it is having a profound effect on the bourses.  Plus, with each round of quantitative easing, the resulting positive effects on the economy at large get less impactful.  Political issues like the dreaded “fiscal cliff” are unlikely to be solved in the next month so they continue to weigh on the decisions of both businesses and governments as 2013 budget planning takes place.  This uncertainty, however, is simply being drowned out by lots and lots of cash.  The money has to go somewhere and it is going into stocks.

SGK Blog--Update September 21, 2012 Equity Markets Remain Calm Ahead of Earnings

As we await third quarter earnings results, stock and bond markets were fairly quiet this week as traders absorbed actions recently taken by central banks globally and their implications.  This week Japan followed moves by our Federal Reserve and Europe’s central bank by easing monetary policy through increasing the size of their asset purchases to 80 trillion yen ($1 trillion) from 70 trillion yen and extending the program six months until the end of 2013.  This is designed to help keep the value of the yen in check in an attempt to stimulate their export sector.  These central bank actions have created a domino effect globally and central banks in countries like Brazil and Turkey are having to take steps to keep easy money from flooding into their markets and driving up their currencies.  This can create animosity towards developed countries as it makes developing countries currencies more volatile and it can make their inflation targets more difficult to achieve. 

Reports continued to come in from around the globe and all signs point to a slowing global economy.  A Chinese manufacturing survey pointed to an 11th month of contraction and Japan’s exports fell in August.  A separate report showed euro-area services and manufacturing output fell to a 39-month low in September.  In the U.S., Labor Department figures showed weekly jobless claims decreased by 3,000 in the week ended Sept. 15 to 382,000.  But that was above the median forecast of 375,000 projected by 49 economists surveyed by Bloomberg.  The index of U.S. leading economic indicators fell in August, led by a decline in new orders for manufacturing.  The Conference Board’s gauge of the outlook for the next three to six months decreased 0.1 percent after a revised 0.5 percent increase in July, the New York-based group reported today.  Economists projected the gauge would fall by 0.1 percent, according to the median estimate in a Bloomberg survey.  The Federal Reserve Bank of Philadelphia’s general economic index increased to minus 1.9 in September from minus 7.1 the previous month.  Economists forecast the gauge would improve to minus 4.5, according to the median estimate.  A reading of zero is the dividing point between contraction and expansion in the area covering eastern Pennsylvania, southern New Jersey and Delaware.  Our manufacturing and export sectors have helped sustain our growth here in the U.S. but with global growth slowing down these figures are concerning.

On a positive note, consumers here in the U.S. do pay close attention to the value of their homes and there is no question in our minds that the Federal Reserve is targeting the housing sector in an attempt to stimulate housing prices and activity through their actions.  It is almost impossible to determine the impact of Fed actions in their efforts to suppress interest rates but needless to say rates remain very low.  Low rates definitely stimulate activity in the housing sector and that was reflected in the data we received this week.  All data reflects activity in the month of August and housing starts came in at 750,000, building permits 803,000 and existing home sales came in at 4.82 million.  These are all figures that are relatively robust and either met or exceeded economists’ expectations.  If we are able to create additional job growth here in the U.S. then this will also help stimulate activity, both building and sales, in the housing sector and it is an important contributor to U.S. gross domestic product.

SGK Blog--Update September 14, 2012 A Simple Plan

The Federal Reserve issued a two page press release and a five page summary of their economic projections that can be summed up in two words: “Trust us.”  Chairman Bernanke and the rest of the Open Market Committee firmly believe that through an increase in the price of assets, corporations will invest more and individuals will feel more wealthy leading to better employment and more spending.  In the quarterly question and answer session that followed the Federal Open Market Committee’s two-day meeting, Bernanke reiterated many times that there is no “panacea” and monetary policy must work with fiscal policy in order to get the economy growing closer to its upper potential.  Though there has been payroll growth over the past six months, the committee is obviously not satisfied with its trajectory and question its sustainability. 

The Federal Reserve has worked hard to build and maintain its credibility.  It has built enough goodwill over the years—even with their implicit and explicit involvement in the creation of the internet and real estate bubbles—that markets will trust its judgment.  However, it just seems that the latest announcement sounds like they have run out of ideas.  The latest plan, affectionately called quantitative easing 3 or QE3, involves buying $40 billion each month of agency mortgage-backed securities.  In addition, the Fed will also continue Operation Twist under which short-term bonds are sold to buy longer-term bonds.  Together that will provide $85 billion of bond purchases per month through the end of the year.  Of that amount that is not funded by the sale of short-term bonds, the Fed will be printing money thereby expanding its already bloated $2.8 trillion balance sheet.  The Fed is also going to keep its benchmark Fed funds rate target near zero until at least mid-2015, beyond the previous range of late 2014.  Taken together, the Fed is telling the public at large that they will continue to print money until they don’t need to.

That is not comforting.  Though the equity markets shot higher on Thursday after this announcement, often unintended consequences have a way of destroying simple plans.  The signs of desperation do not get much clearer than this part of their statement: “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases (emphasis added), and employ its other policy tools as appropriate…”  Even after the economy strengthens, whenever that is, a “highly accommodative stance of monetary policy will remain appropriate for a considerable time.” It seems like the Fed will buy anything they can get their hands on and will stop only when growth is robust.  In other words, “Keep trusting us.”

The European community got its own dose of adrenaline this week.  Germany’s highest court said on Wednesday that the creation of the European Stability Mechanism (ESM) did not violate the German constitution.  Therefore, the ESM can come into force as planned with €500 billion of permanent firepower.  The first meeting of the ESM board is likely to happen in early October with the goal of having it operational by early next year.  The German court however did say that there must not be any increase in Germany’s share of the ESM (€190 billion) without the express consent of the German parliament.  Also, the court did not make any decision on whether sovereign bond purchases on the secondary market by the European Central Bank would infringe upon the ESM treaty.  A final legal verdict on that and the Fiscal Pact (whereby euro-zone members would coordinate budgetary decisions) would be coming in December.  Stay tuned.  Yields on Spanish and Italian bonds narrowed compared to benchmarks as this decision, though expected, was still viewed as positive by the fixed income markets.  Unlike the Fed domestically, the euro-zone community has been quite reluctant to open the spigot on providing cash to prevent financial turmoil.  This and further fiscal coordination is exactly what the euro-zone needs.

In our opinion, QE3 may not be what the U.S. economy needs.  After expressing his deep concern about the employment situation at Jackson Hole, Bernanke and the committee had to do something.  Since their only policy is monetary, it was going to involve buying something.  Could they have extended Operation Twist?  Increased it?  Maybe.  Could they have lowered their rate on funds deposited at the Fed to spur banks to actually lend out that money instead of having it sit in vaults? The problem with “QE Infinity” is that in its effort to convey a whatever-it-takes attitude, it opens the door to uncertainty.  What is “substantial improvement in unemployment”?  Monthly public payroll growth of 125,000?  200,000?  80,000?  Unemployment of 7.5%? 7.0%  Bernanke said they would not keep buying until full employment was reached, and we assume that is around the low-6% range based on previous comments.  But that still leaves a lot of wiggle room for the market to interpret.  Yes, QE3 is likely to help on the margin…in the near term.  It may push some people to pull the trigger on a housing purchase or refinancing.  It may incentivize a firm to break ground on a new factory to employ a few thousand new people.  The Fed has big, blunt tools for affecting people on the margin but not much else.  Most people are neither buying nor selling their house, but for those on the margin, this may provide a spark.  However, the marginal cost is a balance sheet that will explode to over $3 trillion and the worst enemy of savers is inflation which may not happen in the next year or two but what about 5 years down the road?  Or 10 years?  Bernanke and the Fed are confident they have “the tools” to deal with inflation whenever it arrives but isn’t this the same confidence in “the tools” which are currently not sparking the real economy?

SGK Blog--Update September 7, 2012 Global Economies Slow as Markets Take Queue From Central Banks 

As further hints of a global economic slowdown came to light this week, the European Central Bank (ECB) offered a plan by which they will support sovereign debt prices and therefore control yields through “sterilized” bond buying.  ECB chief Mario Draghi said the “euro is irreversible,” and dubbed the program “Outright Monetary Transactions” or OMT for short.  It will focus on the secondary sovereign bond market with purchases of one-three year bonds and Draghi said it was necessary to deal with “severe distortions” in the bond market.  “Governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality.”  So the point is, if a country needs the support it will be provided through an unlimited bond buying program.  But countries have to agree to the terms.  This seems fair and reasonable.  Spain seems to be the first ready to step up to such a program, but they are awaiting what the conditions will be in order to accept the ECB’s firepower.  The markets loved the news, but as we have pointed out for the last three years, love can turn to hate once all the details are laid bare.  We will see.

We had a weaker than expected manufacturing number here in the U.S. as the ISM Index (Institute of Supply Management – basically a purchasing managers index) came in below expectations at 49.6 versus the expectation for 50.  A number below 50 signals contraction in the economy – so although it is only one month – August – it is a worrisome number.  Other fiscally prudent countries witnessed weaker than expected manufacturing reports this week including Australia, Canada and Norway.  Each of these country’s economies rely to a certain degree on the export of natural resources, so again it hints at a general global slowdown.  The currencies of all three nations weakened relative to the U.S. dollar and the euro, the latter being boosted by the announcement from the ECB. All eyes remain focused on September 12 as Germany’s Constitutional Court is set to rule on the legality of the European Stability Mechanism, the euro region’s permanent bailout fund.  The ECB will likely provide great detail regarding their bond buying program after the German court rules.

U.S. worker productivity increased sharply in the second quarter as companies continue to squeeze more out of their existing labor force.  Labor costs remain in check as second quarter unit labor costs here in the U.S. rose just 1.5%, basically in line with expectations.  This is positive for corporate earnings but does not provide much of a boost for the general economy as workers wages would need to rise as unemployment tracks down and companies hire more.  Given the uncertainty surrounding the “fiscal cliff” which in part hinges on the outcome of the general election, we are not likely to see much progress on that front until we have some definitive resolution on our nation’s fiscal path.  Equity markets have been very resilient in the face of this heightened uncertainty.   Equity indices received a boost in Thursday trading as the details of Draghi’s news conference came out and with surprisingly resilient U.S. data that come out that day.  The ADP report indicated that 201,000 new private sector jobs had been created in August versus the 143,000 expected and initial weekly jobless claims ending 9/1/2012 came in at 365,000 versus the expectation for 373,000.  Also, after the disappointing manufacturing ISM figure on Tuesday, the ISM Services Index came in at 53.7, better than the expected 52.4.

On Friday, the government reported that payrolls rose 96,000 in August which was below the Bloomberg consensus of a gain of 130,000.  Also, revisions to previous months subtracted a total of 41,000 positions from June and July.  The unemployment rate fell to 8.1% from 8.3% as 368,000 people left the labor force.  Private payrolls, which exclude government agencies, rose 103,000 last month versus the expectation of 142,000.  The unemployment rate has exceeded 8% since February 2009 and with the presidential election only 60 days away, it has become the key point many voters are concentrating on.  Four more years of Obama may mean more growth but it could be this grinding, herky jerky pattern that is clearly wearing thin on the patience of those looking for work and it heightens Fed chairman Bernanke’s fears that the longer someone remains unemployed, the more that person’s skills erode to the point that they may just not be employable at all.  A move to Romney brings with it the promise of 12 million new jobs in his first four years according to his campaign.  We find that to be an utter fantasy as no four-year president has done something like that since 1939.  The only one who came close was Clinton when 10.9 million jobs were created under his first term and 10.3 million under his second.  The main source of Romney’s job engine juggernaut is tax cuts which has never been proven to create jobs.  In fact both Reagan and Clinton raised taxes (Clinton cut capital gains taxes during his second term) and both created jobs during their presidencies.  As we have said in the past, please do not focus on what the politicians say and especially not on campaign promises.  And, we will be proactive right here and now with the inevitable question we get on even numbered years, “What will the markets do when _____ wins in November?”  It really doesn’t matter.  The Fed chairman (and European central bank president) is a much more important character to financial markets than any popularly elected president right now.  Mr. Market in the end is always right.

SGK Blog--Update August 31, 2012 Houdini
Harry Houdini is one of the more famous performers to grace the stage.  He was known as an illusionist, a magician and a stunt performer as well as an actor and film producer.  His most famous act was the Chinese Water Torture Cell where he was suspended upside down in a glass cabinet filled with water.  While holding his breath, he had to escape from handcuffs or straitjackets.  He emerged often gasping for breath to the roar of thousands of fans.  What does an early 20th-century magician have to do with 21st -century finance?  Today’s markets have thrust current Fed Chairman Ben Bernanke in the role of Mr. Houdini.  High unemployment.  Low savings rates. Sovereign debt issues in Europe.  If the task is near impossible…send in Bernanke.  This week, the markets watched intently like audiences did for Houdini in the torture cell.  For the previous two years, Bernanke dropped strong hints if not outlines as to how the Federal Reserve would combat whatever ailed the economy during his speech at the Federal Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyoming.  Whether it was quantitative easing or “Operation Twist”, there was always a plan to deal with the latest challenge.  Will he escape? Will he run out of oxygen?  How does he do it???

In today’s remarks, the chairman gave a brief history of monetary policy in 2007 and 2008 and how the Fed’s balance sheet tools were used to influence financial conditions.  He concludes: “While there is substantial evidence that the Federal Reserve’s asset purchases have lowered longer-term yields and eased broader financial conditions, obtaining precise estimates of the effects of these operations on the broader economy is inherently difficult.”   In other words, the Fed’s actions have helped the financial situation but there is no way to tell how much they helped because doing nothing was not an option.  Nonetheless, in his opinion, “the economic situation is obviously far from satisfactory.”  He is most disappointed in the lack of growth in the labor market, and it is here which he makes some very important points.

He states that the “unemployment rate remains more than 2 percentage points above what most FOMC (Federal Open Market Committee) participants see as its longer-run normal value…labor force utilization remains at very low levels.”  Thus, we know that with national unemployment at 8.3% as of July, the “magic number” for satisfying one of its mandates of full employment is around the low-6% level.  The last time the monthly unemployment figure was below 6% was July 2008 so this is a figure which we will not reach anytime soon.  More importantly, he concludes that “although the recent recession was unusually deep, I see little evidence of substantial structural change in recent years.”  That is, the very framework of how the economy operates is fine and something can be done about it.  This is a critical point and has been a source of debate within the Fed.  If the long-term growth trajectory of the economy is not 3% but really 2%, the effect is a difference of trillions of dollars.  According to Bernanke, the employment situation and the economy are being held back by “headwinds” not structural inefficiencies.  An improving but still uneven residential housing market, shrinking federal and state and local spending and “uncertainty about developments in Europe” are the three main issues.

He concludes his remarks with the same policy statement from earlier press releases: “the Federal Reserve will provide additional policy accommodations as needed to promote stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”  We interpret this to mean that the Fed has its finger on the “QE” button if such a mechanism exists.  He and the rest of the Fed have not seen enough data to see strong and sustainable economic growth, and, since they believe they can help, are ready to provide more cash.  Bernanke is convinced that the Fed’s balance sheet actions have not damaged either Treasury, mortgage or money markets from operating normally.  There is no surge in inflationary expectations.  In his words, “The costs of nontraditional policies, when considered carefully, appear manageable.” 

Both Houdini and Bernanke have audiences to please.  The public wants to be amazed.  Houdini’s fans want him to conjure something out of nothing.  Bernanke’s fans want the same thing, however he cannot do that and he knows it.  If nothing else, Bernanke is a realist and, being a scholar with extensive knowledge of the Great Depression, understands that the real trick is to have true demand for goods and services be self-sustaining.  He and the FOMC are doing their best to create an environment where that can happen.  Unfortunately, since deleveraging is a long and painful process, until then, we will all be in that torture cell holding our collective breath. 

SGK Blog--Update August 24, 2012   FOMC Favors Easing Soon If There is No Sustained Pickup in Economic Growth 

The minutes from the July 31-August 1 Federal Open Markets Committee (FOMC) indicate that makers feel additional monetary stimulus will be needed soon unless the economy shows signs of a durable pickup in activity.  “Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of economic recovery,” according to the record of the minutes released Wednesday afternoon.  With a jobless rate that has been stubbornly stuck above 8% since February 2009, Chairman Ben Bernanke will have an opportunity to clarify his views in an August 31st speech at a forum for central bankers in Jackson Hole, Wyoming.  That was where he signaled a second round of bond buying by the Fed in 2010.  Additional stimulus would likely take the form of a new large scale asset purchase program aimed at either Treasuries or mortgage-backed securities.  The next meeting of the FOMC will take place on September 12-13 so stay tuned!

Data here in the U.S. once again showed mixed signals as sales of existing homes increased in July from an eight month low adding to signs that U.S. housing may pick up in the second half of the year.  Purchases of previously owned homes, which is tabulated when a contract closes, increase 2.3% to a 4.47 million annual rate according to figures from the National Association of Realtors.  This was just slightly below economists’ forecasts for 4.55 million.  Conversely, demand for capital goods dropped in July by the most in eight months. The Commerce Department reported that bookings excluding planes fell 0.4%. Total orders actually rose 4.2% thanks to a 54% gain in the demand for civilian aircraft. Since plane orders are often inconsistent from month-to-month, they are often excluded which is why the market took a dim view of the report and a warning that investment in items such as computers, engines and communications equipment was likely to fall further. 

The situation in Europe remains very complex.  It will once again boil down to what will Germany do?  An expansion of Greece’s $213.4 billion bailout that was agreed to this spring faces adamant opposition in Chancellor’s Angela Merkel’s center-right coalition in Germany’s parliament, the Bundestag.  Her junior coalition partners are especially against lending Greece more money, threatening to leave her either without a governing majority – or without a plausible way to cover Athens funding gap.  Greece could run out of cash by October (again) unless European authorities and the International Monetary Fund (IMF) release its next slices of international aid.  The IMF however requires the bailout math for the coming years to add up.  Even though Greece accounts for less than 2% of the euro-area economy, its debt crisis remains at the forefront because its exit from the currency zone would prove that euro membership is reversible – and this would be damaging to investor confidence.  A key upcoming date to keep an eye on is September 12 as Germany’s constitutional court is due to rule on whether the euro zone can launch its permanent bailout fund.  So once again – stay tuned!

SGK Blog--Update August 17, 2012 Summer's Almost Gone

As we approach the end of August, the flow of news from companies begins to wane as executives squeeze in a few more days of summer vacation before a busy September begins.  So the markets concentrate on economic headlines.  This week we saw jobless claims climbing slightly.  They rose by 2,000 to 366,000 in the week ended August 11 according to the Labor Department.  The less volatile four-week moving average dropped to 363,750, the lowest level since March 31.  Below is a graph of this metric. (Graph not available online)

Clearly more than a third of a million new claims for unemployment on a weekly basis is high—especially if you are running for re-election in November.  However, as one can see from the chart, it has been trending down, not sharply but in a steady pattern over the past two years.  If we see numbers closer to 325,000-350,000 then monthly payroll growth of 100,000+ like we saw in July is likely to continue.  Nothing about this recovery has been business as usual so that is not a given.

A strong(er) employment situation feeds into other aspects of the economy as we saw with better than expected retail sales.  According to the Commerce Department, retail sales in the U.S. in Jul rose 0.8%, the biggest gain since February and the first rise in four months.  It follows on the heels of a 0.7% decrease in June which fed fears of a broader slowdown during the heart of the summer months.  This is a sign that consumers have not gone into hiding even with the national unemployment rate above 8%.  Spending at clothing stores rose 0.8%, up 0.7% at general merchandise stores while health and personal care sales increased by 1.1%.  Even with these gains, prices remain subdued.  July consumer prices were flat while figures excluding food and energy were up only 0.1% .  Thus, core CPI was up 2.1% over the past 12 months while overall CPI was up 1.4% over that time period, the smallest year-over-year increase since November 2010 according to the Labor Department.  We may see more food-cost inflation if a worst-in-a-generation drought in the country’s heartland push up the cost of goods like corn and soybeans which in turn would raise the cost of cattle and other livestock which rely on these nutrients.

The so-so economic environment domestically still beats what is happening overseas.  The euro zone saw second quarter GDP fall 0.2%.  That small decline was helped by the fact that northern countries like Germany are still growing—by 0.3% in the three months ended in June.  However, the ironic fact remains that 40% of all German exports are shipped to euro zone countries so eventually something has to change—either Germany slows or the rest of the euro zone accelerates.  With the Italian economy contracting by 0.7% and Spanish GDP lower by 0.4% it will likely by the former instead of the latter.  The worry is not just in Europe.  Japan reported an advance GDP number for their second quarter of only 1.4% annualized growth, much lower than the 5.5% figure in the first quarter (which did benefit from easier comparisons to 2011 due to the earthquake/tsunami).  The International Monetary Fund lowered its global growth forecast in July to 3.9% for 2013 from the 4.1% estimate in April.  Even though European markets got a bump higher on Friday when Germany chancellor Merkel endorsed sovereign debt bond buying, she is powerless to rule on the legality of such an issue.  The German constitutional court will rule on the euro zone’s permanent rescue fund on September 12.  So, as the days slowly but surely get shorter and the daytime temps drop a bit, investors are left to contemplate what the fall months have in store.  Stay tuned.

SGK Blog--Update August 10, 2012 Are Earnings Expectations Realistic? 

Although the stock market has been relatively strong so far this year, this past quarter was not stellar in terms of earnings growth year-over-year and it may be signaling we are in for a rough road ahead. With about 85% of S&P 500 companies reporting so far, 51% have exceeded net profit expectations with about 40% beating on revenues. These numbers are not really too bad but these are backward looking figures. What is more worrisome is that more than 50% of companies in the broad index have lowered their estimates for the third quarter while only 21% have raised guidance. This should not come as a shock given the global economy is continuing to show signs of slowing and we have the looming fiscal cliff here in the United States as we approach year-end. It makes sense for companies to issue conservative projections, but none-the-less it is a sign that it will really be important to pay close attention to the differences between how companies manage through this stage of the cycle. In general, stock market analysts at the big banks and brokerage firms tend to be a little slow on the uptake.  Their projections today still call for annualized growth in earnings for the fourth quarter of 11% and for 12% growth in 2013. In our view, these results are simply unachievable for the broader market. It is not that stocks are terribly overvalued at the moment, but we really need to see additional growth in revenues, or “top-line” growth as we in the business refer to it as, and it is difficult to see where that will come from in a number of industries given the current global economic environment.  

The data out on the U.S. economy this week was not extensive and the results were mixed. Politicians are focused on jobs and for the week ending 8/4/2012 initial weekly jobless claims came in at 361,000 which was better than the forecast of 375,000. Figures for second quarter worker productivity exceeded expectations coming in at 1.6% but this was overshadowed by Q2 unit labor costs which rose considerably more than expected at a 1.7% rate. This latter figure is not great from a stock market standpoint because it can hint at inflation and a potential erosion of corporate profit margins. One quarter however is not enough to indicate a trend. There was not much else out in terms of U.S. data so we turn to England for a gloomy economic outlook. (At least the Olympics have been great!) The Bank of England said on Wednesday that Britain’s economy will barely grow this year and that it may have taken a bigger hit from the euro zone debt crisis than previously thought. The BoE as it is referred to (England’s central bank) resumed its asset buying last month, launching a four-month 50 billion pound ($78 billion) program with newly created money to keep a lid on borrowing costs and pump more cash into the economy. The issue of course always remains is there anybody out there willing to borrow the money to invest in their business?! Statistics have shown that Britain’s recession has deepened with little sign of a hope-for-bounce in activity in July despite the Olympic games they are hosting. “We are navigating rough waters, and storm clouds continue to roll in from the Euro area,” Bank of England Governor Mervyn King told a news conference while presenting their latest forecasts. Not exactly an upbeat message! Unfortunately it is a reflection of the current state of global economic affairs. Stocks moving higher on the hope of more central bank stimulus is not a healthy catalyst – it is far better to have more robust demand.
SGK Blog--Update August 3, 2012 Waiting for Superman
After a two-day meeting in Washington, the Federal Open Market Committee decided to do…nothing.  The committee said “economic activity decelerated somewhat over the first half of the year” which was in contrast to a prior description which said “the economy has been expanding moderately.”  The Fed has said since January that it intends to keep short-term interest rates at “exceptionally low levels” at least through 2014.  That was a disappointment to some who wanted that extended into 2015 or maybe indefinitely.  There were no changes to the interest rate on deposits left at the Fed by money center banks and no hints of more quantitative easing (i.e., QE3) besides saying the committee “will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”  The market’s initial reaction was muted given that two other big events were still to come: the European Central Bank meeting on Thursday and the employment report at week’s end.

If the Fed’s two day meeting was disappointing, then the ECB’s meeting can be viewed as dismal.  We watched and listened to ECB President Draghi via their website (here is the link in case you are interested: http://www.ecb.int/press/tvservices/webcast/html/index.en.html) and with each statement uttered, we saw the markets tick lower and lower.  He did say that the ECB would consider open market operations, which the market would love, to bring down yields on sovereign debt from countries like Italy and Spain.  However, once again, he was short on timing and details of such operations.  It was just last week in London when he stated that the ECB would do “whatever it takes” to save the euro and during his news conference he reiterated that it would be “pointless to short the euro” because it will survive against any market vigilantes.  That bold talk was replaced this week with a process by which various councils will examine which additional measures may be necessary to create “the fundamental conditions for such risk premia (of the bonds) to disappear.”  Bond purchases, if there any, would be concentrated on the shorter-term securities, implemented in conjunction with one of the euro-zone’s bailout funds and would only be triggered if a country requested the aid and agreed to conditions attached to the financial support.  It still remains to be seen whether any bonds purchased would have superior status over current holders meaning the ECB would be paid first if there was an eventual default.  So many question marks is not what the market wanted to hear.  The euro swung wildly during his remarks, trading between a high of $1.2406 and as low as $1.2198.  Thus neither Bernanke nor Draghi put on the cape and tights and was able to jump tall buildings in a single bound.  No government official at the moment seems to be able to save the economy from itself or hasten the deleveraging process which has dragged down global growth.  Therefore, with two important events down, there was one left to come: the monthly payroll figure and unemployment report.

And that report did not disappoint.  Nonfarm payrolls increased to 163,000 in July following a revised 64,000 gain in June.  That blew away the estimate for a gain of 100,000 according to a Bloomberg News survey.  Unemployment rose to 8.3% from 8.2%, but that is not necessarily “bad” news.  When job seekers believe there are more opportunities, they are more active in the labor pool.  Even though they may not be successful this month, it is better than having a discouraged worker sitting at home.  Private payrolls, which exclude government agencies, rose to 172,000 after a revised gain of 73,000 in June.  The estimate for private payrolls in July was only 110,000 according to that survey.  Approximately 100,000 new jobs per month are required to keep the jobless rate steady while about 150,000-200,000 are needed to lower unemployment according to various economists.  This is the first 100,000+ reading we have had in awhile so it is not going to make a dent in the 5 million individuals who have lost their jobs as a result of the 18-month recession that ended in June 2009.  However, it may also quiet the rumblings from the market that the Fed do something to help “juice” the economy.  Even though the latest GDP rating was tepid, if job growth will pick up (and that still remains a big IF), then the need for extra quantitative or other special stimulus would wane.  We will see.

SGK Blog--Update July 27, 2012 The Rain in Spain
It’s been a whole three or four weeks since we talked about Europe, so we felt it was fitting to borrow a few lines from “My Fair Lady” and focus on the problem of the “semana”.  This week, Spain’s two-, five- and 10-year bond yields all hit euro-era highs.  With all three levels near 7%, that is considered the “tipping point” for when a country needs to petition the European Central Bank (ECB) for a bailout.  Ireland, Portugal and Greece all hit that special level before they looked for help.  Last week, Spain’s Valencia region was going to seek help from the central government to refinance its debt.  Reports have also circulated that six more regions would are set to request aid from the Spanish government.  In response to these fears, Spain instituted a rule change which has an immaculate record of not working in previous efforts—banning short selling.  Short selling is the process whereby investors borrow shares from their broker or another institution and sell them in the open market.  The hope is to buy the shares back at a lower price—the old adage “buy low, sell high” but in reverse order.  The problem is that investors have enough tools to short the market in other ways—via derivative products like puts or other strategies and securities that bet on a broad market decline.  Plus, the ban, which is in place until October 23rd in Spain, usually just builds up selling pressure which erupts once the ban is over.  So instead of letting the market be the market, politicians intrude and institute artificial devices which skew a true economic clearing.

Can Spain be bailed out?  According to an analysis by Deutsche bank, Spain is likely to issue €240 billion of long-term debt (not short-term debt meaning less than two years) over the next three years.  The European Financial Stability Facility (EFSF) and  European Stability Mechanism (ESM) theoretically totals €940 billion and could cover this amount and also Italy’s issuances (which Deutsche bank calculates as €470 billion over that time period).  However, theory and reality are sometimes two different things.  The credit rating of the EFSF was downgraded in January and Germany’s Constitutional Court said that it would not be able to rule on the legality of Germany’s participation in the ESM until the fall.  And less we forget, there is the matter of Greece.  The recent vote was essentially a vote to remain in the euro zone.  The reward is that they will be subject to austerity programs until 2020.  Of course, the Greek people are not happy about that so the markets are prepared for more protests and more wavering by whatever politicians are put in charge.  This week, Moody’s Investors Service gave Germany a negative sovereign credit outlook.  This carries an implied threat of a downgrade within the next two years.  Suddenly, €940 billion doesn’t seem like so much especially when Europe’s core financial foundation is under attack.  Our best guess is that Spain will likely need a bailout.  Will it come from the ECB or International Monetary Fund?  Will it involve the ESM regardless of its legality in Germany?  We are not sure, but the path of least resistance is to ask for a rescue.  It may come with a lot of strings attached, but at this point, there are very few alternatives.

On Thursday, comments by ECB president Mario Draghi sent stocks higher across the globe.  He said, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.  And believe me, it will be enough.”  Rates on European debt fell, and equity markets including the U.S. spiked higher.  Our memory may be a little fuzzy, but wasn’t this the very same Mario Draghi who said that the worst of the crisis seemed to be over in January?  Politicians…bless their hearts.  The issue remains that the ECB can indeed save the euro, but only when push comes to shove.  Germany will not allow it to be a lender of last resort because it knows that relieving the pressure from countries that have received bailout funds would be a certain recipe for disaster.  Jens Weidmann, president of the German Bundesbank has said repeatedly that large purchases of government bonds are a violation of a ban on using the ECB to finance governments.  So, at this point we are more skeptical of such statements.       

Domestically, we received the preliminary figures for U.S. second quarter real GDP growth which grew at a 1.5% annual rate after a revised 2% gain in the first quarter.  The Bloomberg News median forecast was for a rise of 1.4% with a range of +0.7% to +1.9%.  Household consumption rose 1.5% during the quarter, down from a 2.4% gain during the first three months of the year.  Again, it was slightly higher than the 1.3% median forecast, but with nearly 70% of the economy driven by personal consumption expenditures, having it slow so meaningfully is not good news.  Government expenditures are dropping as well.  State and local government spending fell 2.1% in the quarter, the 11th consecutive quarterly decline.   With the next Fed meeting scheduled for next week, all eyes will be on the committee to see if they take immediate action to this latest news.

SGK Blog--Update July 20, 2012 That Old Black Magic

This week Ben Bernanke spoke before Congress detailing the outlook for the U.S. economy, and the speech was not exactly a pick-me-upper.  According to the chairman, “The U.S. economy has continued to recover, but economic activity appears to have decelerated somewhat during the first half of this year.”  He commented that business investment had also slowed and saw more weakness ahead.  Concerning the jobs environment, he stated that “given that growth is projected to be not much above the rate needed to absorb new entrants to the labor force, the reduction in the unemployment rate seems likely to be frustratingly slow.”  He was cautiously positive about housing commenting that the market has shown improvement and expects headwinds to fade over time.  He highlighted two items which were the main sources of risk to the Fed’s outlook: euro-zone problems and the U.S. fiscal situation.

The Fed is in “close communication with our European counterparts” according to Bernanke.  He went on to say: “Although the politics are complex, we believe that the European authorities have both strong incentives and sufficient resources to resolve the crisis.”  To say the politics over there are complex is a bit of an understatement given that the Old Country conflicts often go back centuries.  With Spanish bond yields piercing 7% for 10-year paper and lackluster demand for their latest public debt auctions, the situation does not look good.  Investors on the continent are flocking to German and U.K. paper which they view as a safe haven, pushing up bond prices and lowering yields to previously unheard of levels.  Each summit buys a little more time before inevitably traders place another target in the crosshairs.

The so-called fiscal cliff is only a few months away and nobody seems to be doing much about it.  Given that it is an election year, neither political party wants to be seen as the “bad guy” with voters heading to the voting booths in November.  Regardless of the outcome, there is precious little time to deal with a combination of expiring tax breaks and mandatory budget cuts that could possible lead to a 4%+ reduction in GDP according to an estimate from J.P. Morgan strategists.  The term “fiscal cliff” was coined by the current Fed chairman.  This week he stated: “…fiscal decisions should take into account the fragility of the recovery.  That recovery could be endangered by the confluence of tax increases and spending reductions that will take effect early next year if no legislative action is taken.”  The key is getting everyone in the same room that will hold key policy-making roles, but that is not going to happen until after the election which leaves a hectic two month period to look forward to before all these changes take effect at year-end. (Actually, the AMT patch expired at the beginning of 2012 but will not affect tax payers until 2013 unless Congress comes up with a change before the end of the year.)   This uncertainty will weigh on the markets in the coming months.  With the Federal Reserve holding a regularly scheduled meeting at month-end, all eyes will be on the Fed governors to see how they will respond to the softening of the economy. 

SGK Blog--Update July 13, 2012 Earnings Season Starts with a Thud
Enough about Europe – how about second quarter corporate earnings?!   Unfortunately Alcoa is always the first major company here in the U.S. to report and they receive an undue amount of attention as a result.  Naturally they delivered their usual mediocre performance.  In terms of the bigger picture, analysts now expect S&P 500 companies to generate $25.21 in earnings per share this quarter, and this estimate is down from the $25.89 level where it was at the beginning of the quarter.  After 10 straight quarters of profit gains, analysts are forecasting a drop in year-over-year second quarter earnings of 1.8%.  Company pre-announcements have been the worst since the fourth quarter of 2008 as profit warnings from companies have outpaced upward revisions by a ratio of 4-1.  To a certain degree this is not terribly surprising and some of this is baked into current equity prices.  The events taking place in Europe and slowing growth in both China and the U.S. is not new news and valuations on securities are in the mid-range of historical levels on average in terms of a forward looking price earnings ratio.  We expect however that the fact that most European economies are in a recession without a quick end in sight will begin to show up this quarter in corporate earnings and company outlooks.  The pending fiscal cliff here in the U.S. is not helping the confidence of executives at major corporations either, and folks are just not holding their breath that anything constructive will get done in Washington until sometime next year, well after the election results are in. 

As we have mentioned previously, currencies tend to fluctuate and the effects long-term tend to wash out over several quarters of earnings, but the reality this quarter is that the dollar has been strong relative to the euro and other currencies as the safety of U.S. Treasuries has been sought by investors all over the world.  Gold seems to have lost its luster as well – as we have warned before the price of gold can be heavily influenced by hedge funds which tend to be notoriously fickle investors in the precious metal anyway, making it frequently a guessing game when investing in the commodity.  We understand why corn prices have moved 30% higher in a short time frame – there is a heat-wave & drought negatively impacting a good portion of the corn producing states in the U.S. throwing the supply/demand balance out of whack.  Gold is frequently not a commodity that always responds to supply/demand issues and when it was trading at $1900 an ounce it was related to central bank stimulus being applied and obviously a degree of speculation.  The point being, the U.S. dollar has been in demand and this will negatively impact the earnings of big global U.S. companies here in the near term. 

Disappointing traders this week was the release of the FOMC’s minutes from their last meeting.  While several members acknowledged that more action may need to be taken to spur growth in the U.S. economy should it weaken, there was nothing specific in the minutes nor a timetable for a course of action.  They lowered their growth forecasts after seeing the labor market weaken and consumer spending soften and they indicated they do not expect to see the unemployment rate to fall much further this year.  This of course does not bode well for President Obama’s reelection hopes with unemployment hovering ominously above the 8% level.  Bernanke indicated he was open to another round of bond purchases if the job market does not improve. 

First time applications for jobless benefits actually declined sharply by 26,000 in the week ending July 7th to 350,000 but the sharp drop can be attributed in part to the volatility of applications during the annual auto-plant retooling period.  Automakers are keeping more plants than normal open during this time of year to fulfill demand and replenish inventories.  For this reason, the figure did not move markets higher as a Labor Department spokesman said that last week’s distortion is likely to unwind over the next few weeks.  The producer price index remained relatively stable for the month of June at +0.1% with the core rate, excluding the volatile food and energy segments, coming in at +0.2%, exactly in-line with expectations.  Friday’s release of the University of Michigan’s consumer sentiment survey for early July did little to calm markets concerns as it came in at 72 vs. the expectation for 73.5.  As usual, the opposite of what one would normally expect occurred as equity indices moved higher after the release and bonds dropped on speculation that additional stimulus from central banks would be pending and that China will take additional steps to stimulate their economy.

SGK Blog--Update July 6, 2012 The Heat is On
Nonfarm payrolls increased 80,000 in June after a 77,000 revised increase in May according to the Labor Department.  The forecast was for a 100,000 increase so the overall number was disappointing.  Excluding government agencies, private employment increased 84,000 which was weakest in 10 months.  This puts the heat on President Obama as the election is not that far away and history shows that a declining economy is not good for an incumbent candidate.  The unemployment rate stayed steady at 8.2% last month, much higher than the 6.8% when Obama won the election in November 2008.  Federal Reserve projections do not anticipate a sub-7% level until 2014 at the earliest, and no sitting president except for Ronald Reagan won re-election with an unemployment rate above 6%.  Reagan won a second term in 1984 with 7.2% unemployment after that rate had fallen three percentage points in the previous year and a half.  One bright spot was that previous data was revised higher including private payrolls for May which went from +82,000 to +106,000.  Another positive was average hourly earnings rose to $23.50 from $23.44 in the prior month.  Even so, economists and investors alike are wondering when the economy will begin to show more than just incremental growth. 

Central banks around the world are trying their best to ignite growth in their respective jurisdictions.  The People’s Bank of China made its second rate cut in less than a month.  The European Central Bank lowered its key rate to 0.75%, its lowest target ever, and dropped its deposit rate to zero.  They are trying to animate the €791 billion that banks have deposited with it.  With 0% interest, the hope is that banks actually take those funds and start to lend them which would fuel growth.  The Bank of England increased its total gilt purchases to £375 billion.  They, like the U.S. Fed, are trying to use open market operations in the bond space to lower rates.  However, with a U.K. 10-year yield near 1.6% and a U.S. 10-year Treasury also around 1.6%, it is difficult to see what benefit more purchases will do in either case.  Here is a phrase we have not used in a while but still remains apt: deleveraging is a long and difficult process.  Yes, we are still feeling the after-effects of the crisis of 2008-2009 as we enter the second half of 2012.  Here is the tale of the tape for real global GDP growth: 2004 +4.9%, 2005 +4.7%, 2006 +5.3%, 2007 +5.2%.  A lot of that growth was fueled by cheap money and the bills have been coming due.

SGK Blog--Update June 29, 2012 Germany Rebuffs EU Roadmap to Fiscal & Bank Union Then Eases Up at Summit - Where to Now?

Early in the week, the German Deputy Foreign Minister Michael Link told reporters in Luxembourg week that the new EU proposals lean “toward various models for mutualizing debt, what comes up short is improved controls.” This pretty much sums up the European progress on their issues to this point. It is somewhat like Euro 2012 soccer in that it is Germany vs. pretty much the rest of Europe. While this analogy is not 100% accurate (on the debt debate Germany is joined with fiscally conservative countries such as Finland for example while the actual team to beat in the Euro 2012 is clearly Spain – despite the front page picture on the WSJ of Merkel standing and celebrating the German quarterfinal defeat of Greece! Not to mention the fact that Thursday Germany got knocked off its soccer peak by Italy!) Anyway, I digress! European Union officials, led by EU President Herman Van Rompuy, on Monday issued a 10-year road map centered on common banking supervision and deposit insurance and a “criteria-based and phased” moved toward joint debt issuance. It also suggested that the EU could impose upper limits on annual budgets and debt levels of nations that use the euro. This seems like a pretty good start in our view. They clearly need a longer term plan to appease markets. We would have to side with Germany on this one though and we completely empathize with their point of view. We have said it before, why would a German taxpayer – retirement age 65 – want to underwrite a French worker – retirement age 60 (Italy 59 & Greece 57)? It makes no sense for them to do so. As Maggie Thatcher once said, Socialism works great until you run out of other people’s money to spend! 

Clearly the issue for Germany centers around the area of controls. Germany, as the largest and most robust economy in Europe, would be the go-to country in terms of joint debt repayment. Why should Germany underwrite the poor controls and lack of will in addressing the problems in the Spanish banking sector? Spanish banks helped contribute to the real estate bubble in that country, they kept extending the terms of loans instead of doing the prudent things like appropriately writing off bad debt and raising capital at a more opportune time, and now they are having to beg for a significant capital infusion from the rest of Europe. Are the fiscally prudent countries like Finland and Germany happy about putting a capital infusion into Spanish banks? We would suspect they are not. This week the tiny country of Cypress asked the EU for a $10 billion bailout – primarily to bail out their banking sector which was heavily invested in Greek bonds – both corporate and sovereign. We clearly see that if they all want to keep the euro area functioning at all and maintain the euro as their central currency, then more integrated banking guarantees and joint debt issuance is inevitable. Despite pressure from France, Italy and Spain, it is clear to us this will be done on German terms if at all. And it will be a painful process to get to that point. Yields on French bonds rose dramatically this week as the reality faced by new President Francois Hollande sets in. Given we witnessed record yields on short-term debt issuance for both Italy and Spain this week at auction – the new French President is starting to get the picture that France is squarely in the cross-hairs in terms of being next in line. With a gaping public deficit and record level of debt, the leader of the euro-zone’s second largest economy recognizes that their economy is on the brink of recession and their banking sector has significant exposure to the debt of Italy, Spain and Greece. Hence the reason why Hollande is one of the strongest advocates of closer euro banking integration. As we said, he will not be the one driving the decision. 

At week’s end, the latest European summit did help appease markets and we witnessed a rally in equity prices as the so-called “risk-on” trade gained some traction. Expectations for the summit had been miserably low so this could in part be simply short covering and the rally in equities could be short-lived. On the positive side we did see an easing in both Spanish and Italian yields and the spread between German bunds and other nation’s bonds tightened – which is the direction we want to see things moving in. The summit produced a couple of significant items related to closer European integration and shared liability. The latest agreement, negotiated Thursday evening in the wee hours of Friday morning, will allow the European Financial Stability Fund (EFSF) and its successor the European Stability Mechanism (ESM) to lend directly to euro zone banks and, via the European Central Bank (ECB), to buy euro zone bonds in the primary and secondary markets. Additionally, a 120 billion euro growth pact provided via the European Investment Bank (EIB) was also announced with strong support from Germany. The key provision in the whole thing was the announcement that seniority was being waived on EFSF/ESM loans to recapitalize Spanish banks as this had been a key sticking point for markets. Why hold questionable debt at all if you are going to be bumped down the food chain in terms of seniority? Better to sell and ask questions later – which is exactly what had been going on. A single supervisory mechanism for banks in the euro zone is being considered by European leaders by year end. 

As always, their announcements sound good in theory but are sketchy on the details. It is an important step that support for banks can be provided through these established mechanisms without piling on debt at the sovereign level for a country like Spain. The point being, Spain’s public finances can be freed of some of the burden of recapitalizing its banking sector, and a new deal for Ireland may be in the works as well. It begs the question though – how much money is this all going to take as these mechanisms have limited resources? Also, it does not solve the fundamental problem in that borrowing more to help ease the burden of having too much debt in attempting to support uncompetitive economies is not a winning strategy long-term. At this point, any relief provided in terms of liquidity is always helpful. But they still have a long way to go with economies over there either in recession or teetering on the brink. So these steps are helpful, but do not solve the underlying problems. We will not argue with the strong move in equity trading Friday however – we’ll call it a relief rally! 

For the U.S. economy, it was a bit of a mixed bag this week. We song good numbers on housing which is a real focal point obviously.   Figures for new and pending home sales came in much stronger than expected for May, while the Case-Shiller 20 city housing price index showed improvement month-over-month in 19 of 20 cities, which was better than expected. Orders for durable goods and personal incomes came in slightly ahead of expectations while initial weekly jobless claims ending 6/23/12 and personal spending were slightly below expectations. Figures for Chicago area PMI and the Michigan sentiment index came out Friday below expectations but traders largely ignored these as they instead focused on the revelry our fine leaders in Europe managed to create. We will see how Merkel is greeted over the weekend when she returns home after seeming to have caved to Monti’s demands! Anyway, it will make for an exciting week next week so, as always, stay tuned!

SGK Blog--Update June 22, 2012 Twist and Shout

The Fed decided to extend through the end of the year the program entitled “Operation Twist” which strives to reduce long-term interest rates.  The Fed has two mandates: stables prices and full employment.  Given that the economic environment—both here and abroad—is categorized by a lack of demand, the problem of stable prices is virtually moot as inflation has not been an issue.  From time to time, a spike in oil prices or another commodity may garner some headline attention.  However, as Chairman Bernanke notes, such spikes are often temporary.  In fact, the price for a barrel of oil fell below $80 this week, the first time such a level has been broken in eight months.  U.S. crude inventories increased 2.86 million barrels to 387.3 million in total last week, the highest level since July 1990 according to the Energy Department.  Natural gas prices remain in a bear market as that commodity, too, has seen higher-than-average stockpiles due to a warmer winter and, so far, cooler summer.  The question posed by many traders and investors alike is: Do we need more twisting?

In some aspect, the purchase of an additional $267 billion of notes ranging from six to 30 years funded via the sale of bonds with maturities three years or less is helpful.  Rates on 10-year Treasury notes closed this week near all-time lows around 1.6%.  Some of the demand for this paper has been driven by a flight to safety in response to the fiscal issues in Europe.  Investors would still rather a receive a return of investment than seek a return on investment at this point.  Since the Fed launched its first quantitative easing steps in November of 2008, rates on the 10-year have fallen from 3.34% to today’s low levels.  Stocks have also rebounded sharply from the low levels of 2008 & early 2009.   However, each step the Fed makes seems to provide less bang for the buck.  QE2 launched in November 2010 offered another $600 billion in buying on top of the $1.75 trillion from QE1.  Yet by spring of 2011, the euphoria had worn off especially in light of debt ceiling battles on Capitol Hill and the threat of a U.S. debt downgrade (which happened in August 2011).  The beginning of Operation Twist was in September of 2011 and the equity markets went on a tear from the end of the calendar third quarter through the first quarter of 2012.  Yet again as we enter summer of 2012, that run is over and fears of a slowdown persist reflected in the major averages each falling over 2% on Thursday this week.

Matters in Europe went from scary to merely troubled after the elections in Greece over the weekend.  A conservative-led government took power on Wednesday when Antonis Samaras was sworn in as prime minister.  Samaras will head an alliance of his New Democracy party and the Socialist PASOK group.  Leftist opposition failed—narrowly—to win the election but they now have enough seats to have their voices heard and, with one in five Greeks jobless, they are sure to make their positions known.  Though the new government campaigned on staying in the euro zone, they did say they wanted to “renegotiate” the deal just agreed to this past spring.  Germany has said they are willing to listen to “adjustments” but will not re-write the agreement.  It will be no surprise to us if another crisis moment arises in Europe in the next few months.  The problem is that both Spain and Italy are seeing the cost of their debt rise which, with Greece still in the fold, puts insurmountable pressure upon the European Central Bank.  Next week, EU leaders will meet in Brussels to seek a “deeper economic and political union” according to reports.  We will believe it when we see it.

SGK Blog--Update June 15, 2012 Italy Moves Into Debt Crisis Crosshairs

The Spanish bank rescue announced the previous weekend generated about 15 minutes of enthusiasm in equity trading Monday morning before markets started to roll over and Treasury prices climbed with the all familiar flight to quality trade.  The $100 billion euro ($125 billion) rescue for Spain’s banks pushed Italy to the front line of Europe’s debt crisis as the yield on their 10 year bonds rose almost immediately about 20 basis points to 5.98% in trading Monday, sending their stock index down 2.79% on the day.  To put it in perspective, Italy has 2 trillion euros of debt, more as a share of its economy than any other developed nation other than Greece and Japan.  Their Treasury has to sell more than 35 billion euros of bonds and bills per month which is more than the annual output of each of the three smallest euro members, Cyprus, Estonia and Malta.  Even though Spain’s fundamentals are a lot direr than Italy’s, that has not stopped Italy suffering from Spanish contagion.  (And they played to a 1-1 draw in Euro 2012 soccer!) 

Italy is not exactly in the same situation as Spain.  For example, Italy is on track to bring its budget deficit within the European Union limit of 3% of gross domestic product this year and the country is already running a surplus before interest payments, which implies that its debt will soon peak at about 120% of GDP.  The jobless rate is less than half of Spain’s 24% and Italy did not suffer a real estate bust, leaving its banks relatively healthy by southern European standards.  The budget deficit was 3.9% of GDP last year or less than half of that of Spain.  The issue though is that it is Italy’s total debt load at more than 2 times that of Spain’s that gives investors pause, especially in a country where economic growth has lagged the EU average for more than a decade.  Italy, as the region’s third largest economy, is also set to contract 1.7% this year, compared to a 1.6% contraction in Spain, according to the Organization for Economic Cooperation and Development. 

The exodus of foreign buyers for Italian debt has left their Treasury more dependent on Italian banks, which in turn have been the biggest borrowers in the European Central Bank’s three-year lending operations.  Given the size of Italy’s overall debt-load, only the ECB has the firepower to rescue the country and yet deploying that ammunition – though buying back bonds or making more long-term loans – may prove unacceptable to Germany and its allies in northern Europe.  Italian Prime Minister Monti has done an excellent job in our view by implementing 20 billion euros in austerity measures, overhauling the pension system and revamping the country’s antiquated labor laws and service industries.  These efforts had shaved off more than 200 basis points of yield from their 10-year bond before the turmoil erupted again in Greece and now Spain.  Now we are witnessing the passage of some of his reforms bogging down in parliament as elected officials continue to demonstrate a higher regard for their own political skin instead of making the really tough decisions.  The situation remains very unsettled in Europe and we expect it will continue to be this way for the foreseeable future.  In the short-term, all eyes will be focused on Greece this weekend as citizens once again head to the polls to decide their fate with respect to staying in the euro zone.

In domestic economic news this week, May figures for retail sales showed a decline for the second month in a row.  Although the main figure of -0.2% was in line with expectations, the figure excluding autos (a less volatile measure month-to-month) came in at -0.4% versus the expectation for 0% and this dampened traders enthusiasm for equities in Wednesday trading.  The figures for inflation for the month of May for both consumer and producer price indices were pretty modest and basically in-line with expectations.  This of course provides room for the Federal Reserve to take action should they deem it necessary as inflationary expectations remain muted.  Weekly jobless claims for the week ending 6/9/2012 were disappointing as the figure came in at 386,000 compared to the expectation for 375,000.  Ordinarily this miss would trigger an equity market decline, but combined with rumors on Thursday of the potential for coordinated global central bank action in the event the Greek elections go the way of the anti-bailout/austerity forces the equity indices pushed higher in Thursday trading.  Industrial production and capacity utilization were slightly below expectations and the University of Michigan’s consumer sentiment index came in at 74.1 for the month of June versus the expectation for 77 demonstrating that folks here in the U.S. are paying attention to the issues going on in Europe as well and the potential impact on our pocketbooks.

Hold your breath, it will be an interesting trading day Monday!

SGK Blog--Update June 8, 2012 A Bridge Too Far
For those old enough to remember, the 1977 epic film starring James Caan, Michael Caine, Sean Connery, Gene Hackman, Laurence Olivier among others, told the story of Operation Market Garden.  It was set in the later stages of World War II and tells the story of one of the largest airborne assaults ever attempted to steal behind enemy lines and end the war quickly by capturing the Arnhem bridge in The Netherlands and outflank Axis defenses.  Spoiler alert….it failed.  What does it have to do with finance?  The markets got a huge jolt on Wednesday with the S&P and Dow Jones up over 2% each based on the belief that more quantitative easing was on the way.  More “free” money certainly means that the evil powers will be defeated and world peace is on the way.  QE3—the term used by those in the know about another round of financial easing—is not what the market needs.  Throwing a mountain of money at the problems facing the global economy is sure to come to the same conclusion as the Allied forces faced nearly 70 years ago.   The markets got a boost from QE1 and QE2 but here we are in June 2012 facing many of the same issues from three years ago confirming that whatever solutions have been devised have not worked.

The People’s Bank of China (PBOC), China’s central bank, will lower its benchmark one-year lending and deposit rates by 0.25 percentage point effective today.  That will bring the one-year benchmark lending rate down to 6.31% and the deposit rate to 3.25%.  In addition, the bank will allow deposit rates to float to 110% of the benchmark rate and the lending rate to fall to 80% of its benchmark.   This is the first cut in four years by the PBOC after two rate hikes in 2010 and three in 2011 to deal with rising inflation.  While the markets cheered the news, we are concerned with the parallels to the Arnhem bridge.  The Chinese government threw 4 trillion yuan ($630 billion) at the global slowdown between 2008 and 2009.  More liquidity was pumped into the system in 2010 through higher bank loans.  What’s the trigger this time?  There is falling consumer confidence and less general demand for loans.  Sound familiar?  Eventually, societies reach the point that economists refer to as “pushing on a string.”  That is, no matter how low the interest rate, or how much money is pumped in via quantitative easing, it does not stimulate demand.  For example, see Japan since the 1990’s.

Europe has somewhat similar problems.  No one is willing to lend them money and their central bank, the ECB, will not do so to countries such as Greece, Italy and Spain without guarantees of reforms.  We have often referred to a country’s indebtedness as a three-legged stool.  One leg is capital (assets that can be converted to money), another is liquidity (the daily inflow and outflow of money) and the third is confidence (third-party assessment of capital and liquidity).  Europe has plenty of capital but is facing a liquidity crisis because confidence is plunging or has plunged.  The ECB needs to step up and be that confidence-building third leg for the southern countries.  It has shown a willingness to step up with their long-term refinancing operations of earlier this year.  We have little doubt they have more firepower in reserve.  It has the right to demand certain trade-offs as a result of more easing, but the time is coming when they need to fish or cut bait.  Sometimes the solution is failure.  That is, a euro zone without Greece is salvageable and maybe by June 17th that will be the answer.  This weekend Spain is expected to seek bailout funds to save its banking system.  The next few weeks will be very interesting, and we’re not just talking about the European soccer championship.

It can be argued that the U.S. is on safer ground than either Europe or China at this point.  Markets gasped last week when job growth was meager at best.  This week we saw weekly initial unemployment claims fall by 12,000 to 377,000.  That was slightly below consensus even though the four-week moving average climbed higher by 1,750.  The monthly data is not as timely as the weekly information and is subject to more severe seasonal adjustments.  The monthly gain in payroll employment has averaged just 96,000 in March through May versus 252,000 in December through February.  With one of the warmest winters ever from coast to coast, it is not irrational to see how these numbers came to be.  If the winter months are massaged with upward seasonal adjustments, then moderate growth seems exceptional when construction projects continue unabated and travel plans are not disrupted for any reason.  Similarly, the usual spring revival gets squashed by downward seasonal tweaks making moderate growth seem dismal by comparison.  Just imagine sentiment if those average monthly gains were reversed and we were seeing strong six-digit gains heading into summer.  Is the economy humming along perfectly?  No.  But Institute of Supply Management data on both manufacturing and services continues to generate monthly readings above the 50.0 level which suggest growth not contraction.  Productivity numbers released this week declined—a sign that more workers are being added and those workers need time to become sufficient in their jobs.  Productivity usually rises when unemployment spikes because the workers that are left are usually the best and have the extra incentive to do well or face layoffs themselves.  Once the market peers through headline risk, we believe it will come to the same conclusion about the U.S. economy that we have held for some time: not robust but still moving in the right direction.

SGK Blog--Update June 1st, 2012 Weaker Than Expected Jobs Report and China PMI Pushes Stocks Lower & Bonds Higher

Payrolls climbed by 69,000 last month which was below even the most pessimistic forecast from economists after a revised 77,000 gain in April that was smaller than originally estimated. The median estimate called for an increase of 150,000 new jobs in May. There was not a lot to like in the Labor Department release Friday as the jobless rate in the U.S. rose to 8.2% from 8.1% while hours worked declined. The overall revisions to the data subtracted a total of 49,000 jobs to payrolls in March and April. These figures follow data released earlier Friday overseas pointing to slowing global economic growth. A measure of manufacturing in the 17-nation euro region fell to a three year low while measures of manufacturing in China, India, South Korea and Taiwan also weakened. These are countries that traditionally export goods so these economic reports are concerning and are indicators that issues making headlines in Europe are indeed impacting the global economy. It does not help that euro zone unemployment hit 11%, the highest level in March & April since they started tracking the statistics for the region back in 1995 according to a statement Friday from the European Union statistics office in Luxembourg. China has the second largest global economy next to the U.S. and their purchasing managers index dropped to 50.4 in May from 53.3 in April, which again was below the most pessimistic forecast from economists.  

There are solutions to the problems in Europe but they involve difficult choices. It is our view that Europe’s leaders can’t save their currency union without figuring out a way to salvage the region’s banks. We have written extensively about the lack of confidence in Europe’s banking sector and there is no country more appropriate to look at than Spain in terms of analyzing the links amongst the euro area’s banking, sovereign-debt and economic crises than Spain. Its banks are largely paralyzed amid concerns about heavy losses on real estate loans that, by various estimates, could require as much as 120 billion euros ($150 billion) in fresh capital to offset. Tight bank credit has in turn deepened the country’s economic slump increasing banks’ potential losses and fueling fears that bailout costs will overwhelm the Spanish government’s already stretched finances. The longer the situation lasts, the worse it gets. Nervous investors pushed Spain’s 10-year borrowing rate to over 6.7% this week, up from less than 5% in early March. The Spanish government’s response to the crisis has been inadequate to say the least. More than 100 billion euros in private money has fled Spain for other euro-area countries, an amount equal to about a 10th of the country’s annual economic output. Europe’s banks in aggregate have about 672 billion euros in claims on Spanish banks, government and companies, according to the Bank for International Settlements. Germany’s claims alone add up to about 186 billion euros or nearly half of German banks’ aggregate capital.  

There are a number of steps that can be taken to help restore confidence. First the euro area’s bailout funds should be allowed to provide capital directly to individual banks, a route now closed to the rescue funds. In return, there should be a measure of European control over how the money is used, burden-sharing amongst the banks’ creditors, the ejection of entrenched management and steps towards a unified banking authority with the power to take over failing banks anywhere in the euro area. A system similar to our FDIC insurance here in the U.S. backstopped by the entire European region would help restore confidence and prevent a further run on the banks in the weaker more indebted nations such as Spain and Italy. Europe needs a stronger bank recapitalization plan where the host country, along with support and representation from the European bailout funds, jointly accept responsibility for injecting capital into the banking system. This would be a key step in the move towards financial federalism and collectively backed euro bonds. The sooner they realize this is the only direction they can go, combined with a promise from the ECB to act as a lender of last resort, the greater the currency union’s chances of survival.  

We mentioned the employment report here in the U.S. which came out on Friday, there were other economic reports during the week which were rather uninspiring. Numbers on consumer confidence in May and pending home sales for April were weaker than expected and the figure for Chicago PMI  for May was disappointing. The Case-Shiller 20-city housing price index for March came in slightly better than expectations and both personal income and personal spending were positive for the month of April and roughly in line with expectations. As discussed, there was simply not much in the way of good economic data out globally for equity traders to hang their hats on, hence the flight to quality in the bond market on the week.

SGK Blog--Update May 25, 2012 Waiting for Godot
In Europe, it was another week, another summit.  Though this was deemed an informal event, all of Europe’s major players, including new French president, Francois Hollande, made an appearance at this latest EU summit.  In response to the worsening financial situation on that continent, an idea for euro bonds was floated.  According to Hollande, “I wasn’t alone in defending euro bonds.  Some countries were completely hostile…”  Germany’s Angela Merkel reiterated her country’s resistance stating “we need much stronger economic coordination in the euro zone.”  Former French president Sarkozy and Merkel seemed to have found a way to smooth out their differences over various summits and appeared to be working in a coordinated effort earlier this year.  However, now that a new president is in place as head of Europe’s No. 2 economy, these two do not seem to be on the same wavelength yet.  They better hurry up because time is short.

The main problem is that the global markets will be waiting until June 17th to find out what happens to Greece in the euro zone.  Anti-austerity party Syriza has pulled even with conservative New Democracy party in recent polls.  That date seems to be the line in the sand.  That has led to a spike bond yields for Spanish and Italian debt.  At this point, the markets have already begun pricing in a Greek exit.  Stalemates are broken only when someone blinks.  For the sake of the global economy, we hope it is not the rest of the euro zone but Greece.  Though no one, including us, knows exactly what would happen if those in power in Greece decide not to abide by the agreements of just two months ago.  We do believe it will not be another “Lehman moment” as many try to depict.  First, this slow slide into disaster has actually taken nearly three years to unfold.  When George Papandreou’s Socialists won a snap general election victory in 2009, it was revealed soon after that debt at 113% of GDP was far above the level advertised by the previous administration.  Since then it has been summit after summit of half-measures and band aids which as of May 2012 have really done little to remedy the situation.  Compare that to March 2009 when seemingly overnight Bear Stearns ceased to exist and needed Federal Reserve help to be merged into JP Morgan.  That panic “aha” moment was followed just six months later when no one came to save Lehman Brothers causing the global crisis reached a fever peak.  Second, the market is doing what markets do, they react.  What the anti-austerity crowd in Athens does not understand is that once they are kicked out of the euro-zone, the market will exact the very same concessions on the country that Germany and other euro-zone leaders are trying to do now, except it will not have the backing of their northern neighbors and be able to hide behind the euro.  Be more competitive.  Have more flexible labor markets including working longer hours and postponing retirement.  Impose and collect taxes efficiently.  The deficits are merely a reflection of these failures in the Greek economy.  The only thing re-introducing the drachma will do is give a real-time indicator how uninspiring Greece is.  The requirements for being a growing economy in the 21st century are not negotiable.  Third, the ECB has the firepower to save Europe.  We have seen but a taste of how the continental bank can help the situation through lowering interest rates, some bond purchases and bank loans.  When push comes to shove, we feel the ECB will make “helicopter Ben” look like Scrooge if the alternative is the end of the euro.  But this will only happen when they know without a doubt that none of this extra money will go to save Greece which is a bottomless pit and beyond saving absent reforms.  Thus, though we believe a Lehman 2: The Sequel, has a small probability at this point, it doesn’t mean there will not be some harrowing days in the markets as the situation unfolds.  In the meantime, we will all just wait.

On a more positive note, domestically, we are seeing more solid signs of a housing bottom.  Sales of existing homes, which represent the bulk of all housing transactions, increased 3.4% in April to a 4.62 million annual rate.  That was the best month since January and 10.5% better than the year before.  Moreover, this figure is seasonally adjusted by the National Association of Realtors.  The unadjusted number is 400,000 homes sold in April or 4.8 million on an annual basis.  Excluding 2010’s figures which were skewed by federal home-buyer tax credits, this was the strongest April since 2007.  The price of lumber is sometimes used as a housing proxy.  It is up 15% in the last three months and 41% higher than a year ago.  What is also key is that the median price of an existing home rose 10% to $177,400 in the biggest year-to-year gain since January 2006.  The sale of distressed housing can push up the volume of homes sold, but those are often moved at a discount.  The higher price is a sign that buyers are actually bidding up the price of homes maybe because they are more confident in their job prospects or feel that mortgage rates are not going much lower.  New home sales in April rose to a 343,000 annual rate, up 3.3% from a revised March.  The median price of a new home was up 4.9% to $235,700.  New home sales are recorded when the contract is signed as opposed to existing home sales which are cataloged when the transaction closes.  So, we are seeing momentum in both parts of the housing transaction process.  This combined with another week of slightly lower initial unemployment claims bodes well for sustained growth in the U.S. economy.  Nevertheless, when Hewlett Packard lays off 27,000 employees this week, it shows that not all is well in the labor markets and until hourly earnings show a meaningful increase, the U.S. consumer is still vulnerable to supply shocks (e.g., higher oil prices) and negative headlines (e.g., proposed tax increases).

SGK Blog--Update May 18, 2012 FOMC's Minutes Reflect Fed's Nervousness

Several Federal Reserve policy makers said a loss of momentum in growth or increased risks to their economic outlook could warrant additional action to keep the recovery going, according to the minutes of their last meeting.  The Fed is continuing its swap of $400 billion of short-term debt with long-term debt to lengthen the average maturity of its holdings and help lower the interest rate on Treasuries, a move dubbed Operation Twist.  With turmoil in Europe once again at the forefront of traders attention and with inflationary expectations muted here in the U.S., there has been little discussion about the fact that this operation is scheduled to end in June.  Rates on the U.S. Ten-year Treasury are hovering at historic lows of between 1.7%-1.8% because of concerns over the situation in Greece and the possibility of contagion over there and based on the mixed U.S. economic data we received this week.   

It appears that there will be new elections in Greece sometime in mid-June.  The current favorite candidate and quite possibly the country’s next prime minister, Alexis Tsipras, head of the Coalition of the Radical Left known as Syriza, has indicated that Europe must consider a more growth-oriented policy to arrest Greece’s spiraling recession and address what he has called a “humanitarian crisis” facing the country.   He stated on Thursday, “our first choice is to convince our European partners that, in their own interest, financing must not be stopped.”  So he has a point obviously, but the reality is traders don’t like it.  Even after their debt restructuring, Greek bond prices are reflecting a default and subsequent exit from the European monetary union.  This puts pressure on the European banking sector which was also very much in the news this week.  Greek citizens have been actively withdrawing euros from their bank deposit accounts within that country for understandable reasons.  So the banks there have tapped into emergency lending facilities offered by the European Central Bank as they have been shut out of standard financing interactions with the bank due to insufficient capital levels.  Also, this week there were rumors that there were significant withdrawals taking place at Bankia SA, the Spanish bank recently taken over by the government there.  These rumors, first circulated in a local newspaper, were subsequently denied by the Spanish finance minister.  The net result though is that Spanish yields have climbed, as have yields in Italy, and once again there is concern centered on the health of the banking sector in these countries right now.  Moody’s naturally rubbed salt into the wounds as they downgraded a number of Spanish banks this week, following on their downgrade of numerous Italian banks last week.

The data in the U.S. was mixed this week as we initially saw strong housing figures which provided some level of optimism on the day of the release.  Housing starts for April were 717,000 versus the expectation for 680,000 while building permits were just slightly lower than expected at 715,000 compared to the 730,000 expected.  Figures for industrial production and capacity utilization for April were better than expected at +1.1% and 79.2% respectively showing there is still health in our manufacturing and export sector here in the U.S.  Early in the week the figures for retail sales for April were slightly lower than  expected but this news was tempered by the fact that the figures for the consumer price index or CPI were in line with expectations and showed that inflation remains very tame.  Coinciding with the release of the FOMC’s minutes from their last meeting, this definitely caused much discussion around whether or not the Fed has additional room to move with respect to more easing to help stimulate the economy.  Tempering traders enthusiasm later in the week were the figures for initial weekly jobless claims, the Philadelphia Fed and the index of leading indicators which all were below expectations and this contributed to the general stock market pullback in Thursday trading and the rally in bonds ahead of the much hyped Facebook IPO on Friday.  

SGK Blog--Update May 11, 2012 Meet John Doe 
The people have spoken, and the markets do not like what they hear.  In France, Socialist Francois Hollande became President-elect Hollande when he beat President Sarkozy in a run-off election last Sunday.  Further south in Greece, the mainstream parties, New Democracy and Pasok, fell short of the 151 seats needed to form a ruling coalition in Athens.  The Coalition of the Radical Left, better known locally as Syriza, garnered 52 seats but their leader, Alexi Tsipras, rejected teaming up with the conservatives.  All the major bourses in Europe have traded lower this week, mainly as a result of these elections.  The main fear is that any previous agreements as they related to austerity programs would be renegotiated or possibly just ignored.  As one Syriza official said, “…the message from the electorate is clear.  They want a radical change to how this country is run, they want an end to the brutal austerity and we are ready to take on the challenge.”  Mr. Hollande did not get a clear mandate is his country’s elections with left-leaning groups lining up behind him mainly to prevent Sarkozy from being re-elected.  His party—which did win control of the Senate late last year—will not be able to lead unless his coalition also commands a majority in the National Assembly which is holding elections next month. 

We view this week’s events as not completely surprising.  Voter anger and grass roots movements have driven leaders from various European capitals lately and is the basis of last year’s Arab Spring.  The political process whether it is in Europe or even here stateside is often not pretty and true progress, if any, is often watered down by compromise.  These are all terms which markets hate because the markets hate uncertainty and politicians love to meet and talk and talk and talk.  So it is not out of whack for the markets to start heading lower while all this rhetoric is being worked out. 

The key question is what happens next.  Unfortunately, we have no crystal ball but we can make an educated guess.  It appears sooner or later that Greece is going to leave the euro zone.  The rest of Europe would be wise to let that happen before Greece’s problems drag down stronger countries.  Right now, European leaders are trying to buy time to strengthen those countries facing major issues like Spain and Italy because there is not enough firepower in their stability facilities to bailout either or both of those large countries.  For the most part, Greek debt has already been written down on the books of financial institutions (except the European Central Bank (ECB) which refused to take any losses in the debt swap), credit default swaps (insurance-like products) have been settled and psychologically many investors have already started preparing for the return of the drachma.  A total breakup of the euro zone seems unlikely because of the total chaos it would involve.  Plus, Germany is loath to return to the Deutsche mark simply because the strength of its economy would send that single currency powerfully higher and make a severe dent in the growth of their export-led economy.  Thus, it has to survive, but maybe without the Greek tragedy.

What does that mean for the markets?  No one knows for sure, but it seems apparent that Greece would suffer a great depression as they tried to export their way to growth with a devalued currency.  It will happen but it will take years to turn the corner.  The rest of Europe will survive, assuming they can use monies from the IMF and loans from the ECB to actually spur growth through better competitiveness.  If foreign investors see weak-link Greece jettisoned, they may view sovereign debt in a new light and provide the needed funding to refill euro zone coffers.  If politics prevails and this year and next is filled with summit after summit where half-measures get voted in, we can expect a major tipping point which would not be a good day for financial instruments.

SGK Blog--Update May 4, 2012 Traders Attention Shifts to Economic Data as Earnings Season Winds Down 

Traders were comfortable putting money into equities in early week trading based on manufacturing data that was not as bad as expected in China and the U.S. One of the big fears market participants have been citing is the concern over a rapid deceleration in growth in the world’s second largest economy. It appears a hard economic landing in China is not in store for us. Their PMI (purchasing manufacturers index) expanded at the fastest pace in a year, showing their manufacturing sector is resilient in the face of a slowdown in Europe. We must remember that the markets in recession in Europe (Greece, Spain, etc.) are not necessarily China’s largest export locations, although there were indications out last week that Britain has officially entered into double-dip recession territory. The U.S. and Germany for example (along with many Asian countries) are growing and both consumers and businesses in those significant markets are gaining confidence, thus creating demand for Chinese manufactured goods. Their PMI rose to 53.3 in April from 53.1 in March, a number above 50 signals economic expansion. The main issue is whether Premier Wen Jiabao will extend a two month pause in lowering banks’ required reserve ratios, as he seeks to reign in property and consumer prices without sending the economy into the so-called hard landing scenario. So there is some expectation that in fact the slowdown in growth we have recently been witnessing in their economy will bottom out this quarter. 

In the U.S., our ISM Index (Institute of Supply Management) came out at 54.8 for April, well above the expected 53, which was a pleasant surprise after the Chicago PMI had disappointed the day before. Growth in manufacturing appeared to have been slowing in the first three months of the year, raising concerns that the slowdown in Europe and China was starting to limit demand for U.S. exports. Manufacturing has actually been a bright-spot in the U.S. recovery so these figures appropriately garner a lot of attention when they come out. The group’s orders gauge climbed to its highest level in a year, while its production measure put in its best performance since March 2011 and its employment figure advanced to a 10 month high. Friday’s U.S. employment report put a damper on equity trading (bonds rallied) as the numbers were disappointing but not surprising given the weekly initial jobless claims data we had been receiving throughout the month of April. The unemployment rate dipped to 8.1% from the previous level of 8.2% but that was largely due to a decline in the labor participation rate. The actual number of total jobs created in the economy in the month of April was 115,000 versus the expectation of 162,000. Private payrolls increased 130,000 versus the expectation of 167,000 indicating that governments continue to shed jobs in a typical month as budgets remain squeezed.  

The disappointing data Friday, along with elections pending in both France and Greece caused equity traders to take a breather and choose not to head into the weekend with an overabundance of long positions.   
SGK Blog--Update April 27, 2012 Nothing New in the West
The Fed held its regularly scheduled open market committee meeting this week.  Outside of a few tweaks in the post-meeting statement, their views on the economy have not changed.  In its statement, it reiterated points previously made: “Labor market conditions have improved in recent months; the unemployment rate has declined but remains elevated.” They continued to stress the fact that, although increases in gasoline prices were notable, longer-term inflation “will run at or below the rate that it judges most consistent with its dual mandate.”  That mandate—stable prices and full employment—is best served in their opinion by keeping the target rate of fed funds near zero and continuing its program of extending the average maturity of its holdings in the so-called Operation Twist.  This involves swapping $400 billion of short-term debt with long-term debt.  The program was initiated last September and is expected to conclude at the end of June.

One has to read between the lines to see a slight hint at a change in the Fed’s stance.  As opposed to January, more Fed officials expect unemployment to fall lower this year than previously and for economic growth to pick up more.  In a post-meeting news conference, Chairman Bernanke said “It’s a little premature to declare victory.  Keeping interest rates low is still appropriate for our economy.”  More than half of the Fed officials (5 board governors and 12 regional Fed Bank presidents) saw the fed funds rate at 1% or higher by the end of 2014.  Might there be some dissension at the Fed?  Possibly, but 2014 is still over a year away and there will be many more meetings to debate policy in the interim.  The upward momentum in employment hit a speed bump recently when March’s payroll figures were released.  That could be a result of hiring being pulled into the early months of the year due to the unusually warm weather benefitting manufacturing and homebuilding payrolls.  The inflationary picture seems rather tame on the surface, yet the price of oil remains over $100 per barrel and tensions with Iran could produce a spike come summer.  Against this backdrop, Bernanke is determined to keep rates at exceptionally low levels.  One consequence could be that when rates do rise, they will rise very quickly.  And the market will likely sense that in advance of any official move.  Thus, there are still many challenges to face even as the U.S. seems to be mid-cycle in an economic recovery.

The latest GDP data will stir up debate as to how far in that mid-cycle we actually are.  In the first quarter, the U.S. economy expanded at a 2.2% annual rate according to the Commerce Department, lower than the 2.5% median forecast from Bloomberg News.  This GDP estimate is the first of three for the quarter, with more refined data to be released in May and June when additional information becomes available.  So there is the possibility that this number could be revised up…or down.  The headline figure is misleading.  The GDP figure was indeed restrained by a drop in government spending and slower growth in business investment.  However, household purchases, which comprise nearly 70% of GDP, was up 2.9% which exceeded the most optimistic projection.  That follows a 2.1% gain in the fourth quarter of last year which shows that the consumer is indeed becoming stronger.  Inventories contributed 0.6 percentage points to GDP growth after a 1.8 percentage points at the end of 2011.  This means that stockpiles rose from a $52.2 billion annual pace last quarter to a $69.5 billion annual pace in the first quarter.  Higher inventory builds decrease the rate of GDP growth, but it sets the stage for growth in the future as these goods have to be used eventually.  The final sales figure, which excludes inventories from the calculation, shows that GDP climbed at a 1.6% pace in the first quarter compared to a 1.1% gain in the final three months of 2011.  These are signs that the economy continues to grow at a slow, steady pace

SGK Blog--Update April 20, 2012 Earnings Help Markets Firm  

Strong corporate earnings dominated the relatively weak news we received on the U.S. economy this week. High profile companies such as Microsoft, Travelers and General Electric delivered results that exceeded analysts’ expectations and this helped send equity indices higher on the week. We report on the results of a number of our core holdings this week below and so far so good. Next week headlines will be dominated by additional earnings releases, along with the results of the first round of French elections and the meeting of the Federal Reserve’s FOMC (Federal Open Markets Committee) which sets interest rate policy. Traders will be looking for hints of a possible QE3 or further quantitative easing, which we do not expect at this time. The situation in Europe would have to deteriorate notably before the Fed would step in with further easing. They are already assisting central banks in Europe through open swap lines and other means of making U.S. dollars readily available. 

News on the U.S. economy was not all bad as we started the week with a better than expected retail sales figure for March, which at +0.8% compared to the expectation of +0.3%, shows the U.S. consumer is gaining confidence even though there is a lot to worry about with respect to this recovery. We had mixed results on the manufacturing sector in the month of March as industrial production, the Philadelphia Fed survey and the figure for empire manufacturing were below expectations while capacity utilization was slightly better than expected. Housing data was mixed for March as housing starts were well below expectations, existing home sales were slightly weaker than expected but building permits came in above expectations. Initial weekly jobless claims were 386,000 for the week ending 4/14/2012 which was above the forecast for 375,000 while the index of leading indicators remained strong coming in at +0.3% for March relative to the expectation for +0.2%. As we indicated, the data was decidedly mixed this week on the U.S. economy. 

The equity markets were helped in trading Friday by news that the G20 finance ministers, meeting in Washington Friday, announced they would support the European efforts by pledging an additional $430 billion in support for the International Monetary Fund’s (IMF) efforts to help stem the crisis in confidence. This news helped send European equity bourses higher on the day, although it did little to inspire confidence in those acquiring French and Spanish bonds at auction this week. Those bonds were issued at higher rates than previous auctions although all the offerings were oversubscribed which is positive news. The higher rates in France reflect concerns that the Socialist candidate remains well ahead in polling heading into elections next week. He has promised to institute a 75% tax rate on high income earners and to reinstitute the retirement age of 60 from the current 62, both regressive steps in our view. If he wins it will be a good time to start a business in Germany! Speaking of which, the German economy continues to fire on all cylinders as their unemployment rate remains substantially below ours at 5.5% and both consumer and business confidence figures released over the past two weeks have come in higher than expected. Germany is enjoying success exporting goods to Asian countries and their domestic consumer demand, traditionally considered a weakness of theirs, appears to be strengthening which is positive news indeed.
SGK Blog--Update April 13, 2012 Equity Markets Retreat as Spanish Bond Yields Rise 

Spanish banks borrowing costs from the European Central Bank almost doubled in March from February to 316.3 billion euros ($415.9 billion) as the question whether Spanish banks need to be recapitalized hangs over the sector like the sword of Damocles. Worries about the country’s housing sector and a recent spike in government bond yields have rattled investors’ nerves over the past two weeks and Tuesday, Spanish central bank Governor Miguel Angel Fernandez Ordonez said “if the economy worsens more than expected, it will be necessary to continue increasing and improving capital as necessary in order to have solid entities.” The Governor did not specify which Spanish banks would need to raise capital from investors thus compounding the uncertainty. We fall back to the lack of rigor and disclosure that has characterized the European approach to stress testing their banks relative to the U.S. The U.S. process was rigorous and tough and the results were well publicized. The Europeans took a “they’re fine, trust us” approach which clearly has just not cut it. Existing investors in Spanish banks are finding that when the bank they own is being acquired, their equity becomes either worthless or is worth considerably less than they expected. This is not just the case in Spain, this week when new shares were issued to raise capital Wednesday by Portugal’s Banco Espirito Santo, they were issued at a 66% discount to Tuesday’s closing share price. Ouch! Italy’s main labor unions took to the streets of Rome Friday to protest Prime Minister Mario Monti’s pension system overhaul and the ECB is contemplating kick-starting their bond buying program again, which puts us squarely back to where we were two years ago with respect to European sovereign debt concerns. With Spain and Italy in the crosshairs this time, the stakes are considerably higher. 

Compounding investor concerns in Friday trading, China’s growth slowed more than forecast last quarter to the least in almost three years. Gross domestic product in the world’s second biggest economy expanded 8.1% from a year earlier after an 8.9% gain in the fourth quarter, according to the always reliable (dripping sarcasm) National Bureau of Statistics. The flip side of this is the unexpected surge in March in new yuan loans which shows the ruling Communist Party is trying to avoid a deeper growth slide amid a once in a decade power transfer to the younger leaders. Pickups in industrial production and retail sales reported Friday somewhat limit concerns that the world recovery is losing steam after job gains in the U.S. lagged forecasts and Europe’s sovereign debt crisis threatens to worsen. China has lowered banks’ reserve requirement ratios twice since November to boost liquidity and spur loan growth. The ratio is currently 20.5% for large lenders and this rate may be lowered again this quarter. They are reluctant to lower interest rates due to concerns over inflation in that country.  

In the U.S. the numbers for both the producer price index and the consumer price index were basically in-line with expectations showing inflation remains in check. This does give the Federal Reserve some flexibility to take action in the event the economic numbers start to trend in the wrong direction. Weekly jobless claims for the week ending 4/7/2012 came in at 380,000, worse than the expectation of 355,000, although there was some distortion due to seasonality. The rally in Thursday equity trading was in part prompted by this negative figure and comments by Vice-Chair of the Federal Reserve Janet Yellen indicating the Fed remains in an accommodative stance. She really didn’t say anything particularly new or enlightening and we argue below that there is not a clear case for further easing at this point, but the market tends to feed off of that type of speculation like an addiction. We will be officially in the thick of first quarter earnings releases next week and comments from executives on their outlook for the economy will be particularly interesting at this time.

SGK Blog--Update April 5, 2012 Hot 'n Cold
At the beginning of last week, Federal Reserve Chairman Bernanke made comments at a speech to the National Association of Business Economists which the market interpreted as bullish for stocks.  Employment was growing but due to less layoffs and not robust hiring was a key take away from the speech.  This week, minutes from the March 13th Federal Open Market Committee meeting seemed to get across a different message.  Only a couple members thought additional stimulus would be needed if the economy losses momentum or inflation remains too low for too long.  This contrasted with a much broader group of governors who thought that was a possibility at the last meeting in January.  They left forward guidance unchanged at the meeting.  That is, they still intend to leave short-term interest rates near zero until 2014.  But, the market has become hooked on the drug called easy money and withdrawal symptoms are starting to appear. 

A key indicator of how the Fed will react is the employment picture.  With the equity markets closed, we will not have the latest payroll or unemployment figure before this update is distributed.  We did get the weekly initial unemployment claims figure which dropped to the lowest level in four years.  In the week ended March 31, initial benefits fell 6,000 to 357,000 which was almost in line with the median forecast of 43 economists in a Bloomberg News survey.  The less-volatile four week moving average fell from 366,000 to 361,750.  This data serves as a leading indicator and is a more timely data point than the monthly data which is often revised a couple of times a few months later.  Median expectations for March’s payroll numbers for tomorrow are for a gain of 200,000 versus February’s 227,000.  The unemployment rate is expected to remain the same at 8.3%.  

SGK Blog--Update March 30, 2012 Judge Dredd
Here is the synopsis of the 1995 Danny Cannon directed film titled ”Judge Dredd”:

Judge Dredd depicts a nightmarish future in which overcrowded cities are terrorized by brutal gun battles and policed by "Judges," law officers who act as judge, jury, and executioner. Sylvester Stallone stars as Judge Dredd, a punishing enforcer with an unswerving dedication to law and order.”

If you saw the movie, it was 96 minutes of your life that you will never get back and can file under “waste of time.”  As unlikely as this dystopian future USA appears, the scenes on the steps of the Supreme Court this week might cause one to pause.  The “We love Obama Care” signs juxtaposed against the “Tea Party Patriot” banners provided an interesting contrast.  People camped out overnight in order to get the few public tickets available matching the frenzy of the launch of any Apple i-product.  All in the name of law and order.  Truth be told, the stakes have rarely been higher.  Plessy v. Ferguson, Brown v. Board of Education, Miranda v. Arizona, United States v. Nixon all can claim the title of landmark cases and to this day affect our daily lives.  Add Department of Health and Human Services v. Florida to the list.

The significance of the case comes from the fact that the outcome will not only affect every American but also could upend years of planning by businesses and state and local governments.  Many companies took millions of dollars of write-offs when the law was enacted in 2010 claiming it was an unusual and special event.  What happens to the balance sheet now?  Do these charges get reversed?  What happens if only the individual mandate to buy insurance is removed but the federal-state Medicaid expansion is not?  And, can someone please check to see if Justice Clarence Thomas is deaf—his six year streak of not asking a single question during oral arguments continues.   We will talk more about the effect this case could have on one of our holdings below in the company events section.

Many of the facets of the Patient Protection and Affordable Care Act, the formal name of the health-care law, do not come into being until 2014.  Thus the amount of “undoing” will be less than two years from now.  Nevertheless, it will not only shape health care in this country for generations to come but also calls into question the reach of federal power.  The founding fathers purposefully created the checks on the balance of power so we do not see here what we have seen in Greece, Italy, Egypt and Libya among other regimes under pressure.  Not to say that our system is perfect, but however the outcome in June for the latest landmark case, we probably will not see Stallone reading the final decision on the steps of the D.C. anytime soon.

In domestic economic news, there was mixed data this week.  Orders for durable goods (those expected to last longer than three years in service) rose 2.2% which was less than projected.  Excluding transportation equipment, orders rose 1.6% which was in-line with a Bloomberg News survey.  These numbers are important because for the first time in generations, growth in GDP is being mainly fueled by business investment rather than the consumer.  Though the final reading of GDP growth in the fourth quarter of 2011 was a respectable 3.0%, the world’s largest economy grew by only 1.7% for all of 2011, down from 3.0% in 2010.  Corporate spending on equipment and software rose at a 7.5% annual rate in the fourth quarter, revised upwards from a preliminary figure of 4.8% last month.  It climbed at a 16% pace in the third quarter.  Meanwhile, consumer spending rose only at a 2.1% annual pace with a small increase in spending on services which makes up the bulk of our economy.  Yes, consumer spending is a much bigger portion of GDP than investment, but its growth has been anemic as households have tried to recover from the 2008-2009 financial crisis.  Company spending has made up the slack once the economy started growing again in late 2009, but it has not been enough to lead to more robust growth.  Today, the Commerce Department monthly indicator said spending rose by 0.8% in February which is a good sign that the consumer is healing, but with incomes rising only 0.2% during that month there is not a lot of ammunition to work with. 

On the positive news front, claims for unemployment benefits fell to the lowest level since April 2008 according to the Labor Department .  Federal Reserve Chairman Bernanke said on Monday that the improvement in the labor market may not be sustained.  He emphasized in a speech to the National Association of Business Economics: “A significant portion of the improvement in the labor market has reflected a decline in layoffs rather than an increase in hiring.”  The market interpreted that to mean that the Fed’s commitment to low rates through 2014 is stronger than was being reflected in the interest rate futures market.  Clearly, with so many inflationary signals reflecting little to no upward pressure, Bernanke is determined to get the labor market going again with ultra-low interest rates.  Only time will tell if this policy is sound, but the equity markets liked the move pushing higher that day.  By the end of the week, there were about as many down days as up days suggesting that maybe some steam has left the engine which has driven the market to multi-year highs recently.  

SGK Blog--Update March 23, 2012 Markets Retreat on Weaker Than Expected Data out of China and Europe 

Two economic news items from overseas caused markets to take pause this week – one generated from China and the other from Europe – and both were related to signs that manufacturing was slowing on both those continents. Anytime a piece of economic news comes out of China these days it gets heavily scrutinized by traders and economists. Global economic growth is somewhat fragile right now and during the last recession stimulus applied by the Chinese government was one of the few sources of positive news during the height of the turmoil back then. These days a lot is dependent on confidence and the trend with respect to the news coming from the U.S. economy has been positive. Given global markets and economies are so intertwined and co-dependent, a recession in Europe would impact growth in China and the spillover effect would be to dampen revenues and profits for U.S. companies. 

A preliminary measure of Chinese manufacturing fell to 48.1 for the month of March and that is the lowest reading on the purchasing managers’ index since November and it compares with a final reading of 49.6 in February – wrong direction! A result below 50 indicates a contraction. Euro-area services and manufacturing output contracted more than expected in March as well. The composite index they use to measure both industries dropped to 48.7 from 49.3 in February and economists had forecast an actual gain to 49.6 – again wrong direction! While these numbers will fluctuate obviously on a monthly basis – the combination of these figures coming out consecutively on the same day sent equities lower on the news. Somewhat surprisingly, bond prices did not move as sharply higher as expected indicating that the recent rate move higher may have legs and certainly may be here to stay for a while. This does make bond prices more attractive but the negative consequence is that mortgage rates have risen not insignificantly in the past week and a half. 

Domestically, we had a lot of data out on the housing market which continues to send mixed signals. Key metrics such as inventories are less than half of what they were post financial crisis and that is good news.  This week housing starts and both new and existing home sales were weaker than expected while building permits were better than expected. All this data was for the month of February and we are quickly approaching the Spring selling season so economists (and realtors) are hoping for a healthy environment this year. Initial weekly jobless claims for the week ending 3/17/2012 were close to a 4 year low at 348,000 and this was a bright spot in the data this week. The index of leading indicators came in at +0.7% which was slightly better than economists’ forecasts. Next week we have key data coming out on consumer confidence and manufacturing along with personal incomes and spending so we will be following this closely. In April we will be closely following corporate earnings releases to get a sense of how companies view 2012 in terms of the financial health of their operations. As always, we will be keeping you abreast of important developments through this weekly format.

SGK Blog--Update March 16, 2012 Fever Pitch
The Federal Reserve Open Market Committee conducted its one-day policy meeting this past Tuesday.  As usual, they released a statement after the meeting expressing their outlook on interest rates.  The tone of the statement was moderately positive which helped fuel this week’s stock market rally.  They stated, “The Committee expects moderate economic growth over coming quarters and consequently anticipates that the unemployment rate will decline gradually…”  They did not want to appear too pleased stating “Strains in global financial markets have eased, though they continue to pose significant downside risks to the economic outlook.”  There was no change to its desire to keep short term interest rates near zero into late 2014.  Also, there was no announcement launching another bond-buying program.  Instead the target rate for the federal funds rate remained at 0%-0.25% and the current program to extend the average maturity of its holdings of securities (by selling short-term bonds and buying long-term bonds) continues until summer as planned. 

The source of the Fed’s optimism is the data flow which is showing that the U.S. economy is back on its feet.  February retail sales according to the Commerce  Department was the highest in five months.  The 1.1% advance was higher than January’s 0.6% increase as sales rose in 11 of 13 categories.  Sales increased 1.6% at auto dealers which can be choppy from month to month.  Excluding auto sales, retail sales still rose a robust 0.9%, higher than the median forecast of 0.7% according to a Bloomberg survey.  The consumer price index rose 0.4% in February according to the Labor Department, matching a median forecast of economists.  A large increase in the price of gasoline accounted for about 80% of this increase.  According to the Fed, fuel cost increases like this will be temporary and the futures markets do not anticipate stronger inflation down the road.  Gas prices often get a lot of headlines as they should with 240 million vehicles on the road.  However, there are alternatives to driving and fuel efficiency makes today’s cars much more pocketbook-friendly than the vehicles from even 10 years ago.  Excluding food and energy, core prices rose only 0.1% last month, less than expected.  In the last twelve months, this core price increase has been 2.2%, which is slower than the annualized rate of GDP growth according to the latest data.  In other words, prices outside of gasoline have been tame and consumers have used this to fuel retail sales as we reported earlier.  The Thomson Reuters/ University of Michigan consumer sentiment indicator fell to 74.3 in data released Friday.  This drop was unexpected but probably shouldn’t be a total surprise given the higher energy costs.  Nevertheless, with a winter which basically never arrived in much of the East Coast, household heating costs were much lower than the past few years.

SGK Blog--Update March 9, 2012 Economy Gains 227,000 Jobs in February; Greek Debt Swap Calms Markets 

There were no real surprises in February’s jobs report released today and for equity and fixed income markets no surprises has a calming effect on traders (and the computer algorithms although we grant they do not have feelings!) 227,000 new jobs were created in the month of February, which was above the average economists’ forecast of 206,000. The private sector created 233,000 new jobs demonstrating once again that this is the engine of growth in the economy during this recovery. The jobless rate stayed the same at 8.3% unemployment due to additional people being classified as job seekers. Average hourly earnings increased only 0.1% and the average workweek stayed the same at 34.5 hours. Reaction in the bond market (and equity markets) was interesting to watch. Just prior to the release of the data we saw a sell-off in Treasuries and a spike in the equity futures in case the number came out much stronger than expected. Some analysts had been anticipating this. When the numbers came out basically as expected, markets immediately reversed course and the overall reaction on the day was fairly muted. In our view this is in part due to the strength of the stock market rally since the lows of August 8th last year. The stock market, as measured by the S&P 500, has risen over 21% since that date and that is a strong move in a relatively short time frame. While notoriously hard to predict in the short term, the consensus is that we are due for a temporary reprieve or a more abrupt pullback.  

It is an interesting part of the business cycle. Since the severe recession of late 2008, early 2009 we have seen a sharp year-over-year recovery in corporate earnings. The stock market is reflecting a healthy environment right now and with the temporary reprieve on the Greek bond crisis, equity prices are reflecting that recovery in earnings and the improvement we have seen over the past six months in the U.S. economic data, as evidenced by today’s employment report. The bottoms up analysts’ consensus forecast for growth in earnings on the S&P 500 is for +3-4% for 2012. So it raises the issue of why would we pay 13-14 times earnings (multiple of earnings based on current level of the S&P 500) for earnings that are expected to grow at only 3-4%? The answer is we want to be somewhat cautious here and definitely selective in our investment choices. As reinforcement of this principal, according to data released this week, productivity grew at only 0.9% in the fourth quarter of last year while unit labor costs rose at a 2.8% rate. This implies that companies that have squeezed workers to maximize productivity to this point in the cycle are now having to pay them more. The next step in the process is hiring and we are starting to witness the pace of hiring picking up in the broader economy. Typically labor is the highest cost component in the income statement for most companies and having to bring in new workers – while great for the overall economy – does result in margin compression which in turn impacts the bottom line. So we want to make sure we are selecting companies with top line growth and tight cost controls in order to ensure that their profits are indeed growing if we are paying a higher multiple for those expected earnings. This is why we spend so much of our time analyzing the earnings reports for each of our holdings as they come out each quarter. 

Greece managed to push through the largest sovereign debt restructuring in history this week as private investors have agreed (at least most of them) to forgive more than $100 billion euros ($132 billion) of debt. This paves the way for the second Greek bailout and Euro-region finance ministers agreed Friday on a conference call that the swap meant Greece had met the terms to proceed with the 130 billion euro rescue package designed to prevent a collapse of the Greek economy. So ministers freed up 35.5 billion euros this week with a decision on the balance to be made at their formal meeting on March 12 in Brussels. It literally is the seemingly never-ending saga. Investors with 95.7% of Greece’s privately held bonds will participate in the swap after so-called collective action clauses are triggered, this is based on the fact that the voluntary participation rate ended up being a stronger than expected 85.8%. While all this sounds good on paper and clearly is a real positive, we must keep in mind that it is a process that does not solve the underlying issues in Europe with respect to economies that are simply uncompetitive. It takes the risk of an outright collapse or disorderly default off of the table right now, but the reality is the Greek economy is currently in a state of severe recession and the average person on the street in Greece is not feeling much different about their prospects than they did yesterday.

SGK Blog--Update March 2, 2012 Deja Vu All Over Again
Haven’t we been here before?  Yes, on April 25, 2007 the Dow Jones Industrial Average crossed the 13000 level for the first time on its way to an all-time high of 14164 on October 9th of that year.  This week, traders pushed that average back above that level.  We are all aware of what happened between that spring day in 2007 and this first week of March nearly five years later—the lowlight of which was a March 9, 2009 low of 6547.  A lot of things seem to be going right which is fueling this recent surge.

On the domestic front, according to the Commerce Department, consumer incomes rose 0.3% in the month of January while consumer spending climbed 0.2%.  Those numbers were below the median estimate of economists surveyed by Bloomberg News.  Given that these figures were from January, the mood of consumers was probably not as confident as now which may be one reason why spending was lower.  The Thomson/Reuters/University of Michigan measure of consumer sentiment rose in February for the sixth consecutive monthly gain and the longest advance since 1997.  Plus, in January the employment picture was improving but still in flux following the holiday shopping season which is why incomes may have come in below consensus.  Speaking of employment, applications for jobless benefits continued to fall.  In the week ended February 25, they fell 2,000 to 351,000 matching a four-year low according to the Labor Department.

A revision to gross domestic product (GDP) meant that the economy grew at an annualized 3% rate in the fourth quarter of 2011 according to the Commerce Department.  That was an increase from the 2.8% originally estimated.  There will be one more revision before final numbers are announced.  Consumer spending rose at an annual rate of 2.1%.  Business inventories also rose by $54.3 billion which reversed a trend of inventory liquidation the prior two quarters.  Many economists expect a first quarter 2012 growth rate between 1.8% and 2.4%.  The slowdown relates to lower durable goods orders and the fact that the inventory which has built up needs to be drawn down.  Fed Chairman Bernanke gave his required semi-annual testimony to Congress this week.  He mentioned “positive developments” in the labor market but still considers it “far from normal.”  He made no mention of additional options to boost growth as opposed to last July when he outlined steps that the Federal Open Market Committee put in place at its August and September meetings.  Nevertheless, even recent signs of domestic economic strength has not changed his view that low rates are needed to keep the expansion going especially with the a subdued outlook for inflation.

Overseas, it was an eventful week for finance ministers.  The European Central Bank conducted its second long-term refinancing operation (LTRO) on Wednesday where it distributed €529.5 billion in 1% three-year loans to 800 banks.  The first LTRO last December was for €489 billion dispensed to 523 banks.  So, we are seeing higher handouts and more participation.  Is that good?  In the short-term, probably.  In the long-term, probably not.  As we wrote last week, European Central Bank (ECB) president Draghi has calmed a market that looked destined to crumble late last year.  It was actually a page out of former Treasury Secretary Paulson’s book.  The origin of the now infamous Troubled Asset Relief Program (TARP) was for Congress to raise enough funds to buy all the troubled mortgages from teetering banks.  Knowing that $10 trillion in funds was not coming, Paulson and the Treasury did the next best thing and took the $700 billion and established stakes in the banks themselves thus providing needed capital and liquidity at a time when there was no other source.  Similarly, Draghi does not want to walk into the minefield of buying European sovereign debt directly (even though he has done so on a limited basis) and does not have the firepower to do so without completely turning on the ECB printing press.  So, he decided to tweak the refinancing operation.  He lowered the rates to 1% which is less than what the banks could get on their own and extended the maturity from one year to three to ease any short-term pressures.  Also, by expanding the type of collateral accepted, it enabled more than just large banks to participate.

However, there could problems down the road.  These are loans which means that one day they have to be repaid.  If the banks don’t have €1 trillion lying around now, what is to say they will in 2015?  As we have pointed out, the key is to buy time.  Still, these loans have no strings attached.  Meaning the banks can take the money and do whatever they want—invest in other banks, buy higher-yielding sovereign debt and play the carry trade game, place a hard money bet at the craps tables in Vegas, anything.  No one is forcing them to do what banks are supposed to do—make loans to help support growth.  And with Madrid now relaxing fiscal targets and France talking about lowering the retirement age (again!!), these moves will not help make the euro zone more competitive.  Just something to keep an eye on.

What is more pressing could be next week’s Greek sovereign debt swap deadline.  S&P declared Greece to be in a state of “selective default” due to the restructuring of its debt whereby the ECB took no losses but everyone else has to take a steep face value haircut.  According to the International Swaps and Derivatives Associations’ Determinations Committee, credit-default swaps (CDS) on Greece’s debt had not been triggered due to this event.  Why not?  Because nothing has happened yet.  That is, euro zone finance ministers agreed to swap ECB Greek debt for no-loss bonds and others have until March 8th to voluntarily accept a deal involving a haircut and €30 billion of “sweetner” bonds from the European Financial Stability Facility (EFSF).  If not enough private volunteers agree to the swap, then collective-action clauses (CACs) will be triggered forcing them to do so.  That event, based upon previous CDS contracts, would trigger payouts but it is still no guarantee this time around.   It is a little complex and legalese is not our expertise, but suffice it to say it could still end up being a tremendous mess come next Thursday.  Maybe in response, German higher-ups this week showed a newfound possibility of combining the temporary EFSF €250 billion fund with the permanent €500 billion European Stability Mechanism.  They are against a permanent increase, but they do see the value of buying time here in the near-term.

SGK Blog--Update February 24, 2012 Why Have Markets Stabilized You Ask?
So let’s get straight to our headline question this week…  why have markets - both equity and credit – stabilized and traders become more confident given all the headline risks we read about daily?  Sure the economic data here in the U.S. has been trending in the right direction – upwards – as we have been keeping you abreast of.  Building on that, there was not a lot of data out this week but the data that did come out looked good.  Weekly jobless claims ending 2/28/12 were 351,000 which was below the estimates.  Existing home sales came in at 4.57 million which is a relatively robust number.  Granted a good portion of that is because foreclosure activity is picking back up again after the lull, but as we have said we need to continue the process of working through that inventory in order for a recovery to take hold.  Fourth quarter 2011 earnings, on average, came in ahead of expectations here in the U.S. as margins remain strong and most companies (Hewlett Packard a notable exception) have experienced year-over-year revenue growth.  But the main reason for the stability is the return of a measure of confidence with respect to the situation in Europe.  That is not to say that risks in that continent do not remain elevated, as most countries over there are either in or on the verge of a recession.  We also have the always fun election cycle process which can be adventurous and raises the specter of unpredictability regarding the enforcement of established agreements.  So we will expand on what we feel is the real reason that markets have stabilized and traders are more confident than they were just 4 months ago.

After months of endless hand-wringing, innumerable talks, and considerable pain, it seems the eurozone has actually been saved - quietly but effectively.  The savior is Mario Draghi, the new head of the European Central Bank (ECB), an institution that had been seen as powerless and obscure until now. For much of the last couple years, it had taken a backseat amid the crisis around it. Its original mandate was almost solely to keep inflation low and stable. But now, under Draghi, it has become Europe's deus ex machina.  Last December, the ECB did the equivalent of printing nearly 500 billion euros worth of cash. Essentially, the central bank lent money to more than 500 European banks at just 1% interest.  What was the effect?  Look at the chart below.  It shows what we call "bond yields" - the rate of interest governments pay to raise money from bonds.

Both Italy and Spain's rates have fallen sharply in the last three months - so they pay less to borrow money. That means they can get their financial houses in order without as much pain.  At a more micro level, Barclays estimates that the cheap source of cash from the ECB will boost the earnings of eurozone banks by 4% this year. That's going to trickle into the rest of the economy, but most importantly it means that a run on Europe's banks - the great fear – is now highly unlikely.  Remember the moment in "It's a Wonderful Life" when everyone runs to the bank to get their money out and Bailey Savings and Loan just doesn't have enough cash during the Great Depression.  Well, thanks to the ECB, banks will now have access to plenty of cash.  The ECB is now said to be preparing another auction worth a trillion dollars this month.  You can expect that to further de-clog the financial systems.

To put this into perspective, over the last two years Europe's governments have painstakingly put together a "stability fund" to convince markets that they are serious.  Well, the ECB just conjured up three times the money - almost out of thin air.  The magic of its work is in the perception of what it does.  It doesn't want to directly bail out any one country - that sets a dangerous precedent.  And yet by demonstrating its ability to inject liquidity into the system, it has convinced investors that it is the ultimate lender of last resort.  This is – by the way – what Jeff Gordon in our office had been calling for in his now famous e-mail from last year.  (See SGK’s marketing packet for reference!)  Now this does not fix Europe's longer term problems. Greece is basically going through the early stage process of defaulting on its longer term obligations – call it whatever you want.  Also, European banks are not necessarily lending out all that cash to help businesses – they are storing a lot of it actually back at the ECB – which is not really a recipe for long-term economic success.  But there is unlikely to be a Lehman-like crisis.  It's also bought crucial time for Europe's leaders to make structural changes to their economies and move towards growth.  (And, no, we don't think inflation is a likely consequence - with unemployment at record highs in Europe, how can wages go up in that circumstance?)  The irony is that the ECB's activism is not a new theory of what a central bank can do, and with all due respect to the Tea Party and Ron Paul, this is exactly what our Central Bank did back in 2008 during the height of the financial crisis to avoid the second Great Depression.

Of course, not all the credit can go to Mr. Mario.  Jeff here in the office had been personally making phone calls to ECB President Mario Draghi and obviously all that hard work on his part finally paid off.  Seriously though, good riddance Jean-Claude Trichet!  If you have been following our weekly over the years, we have been counting down the days until he was gone by scratching lines on the wall in John’s office.  Who would have thought, given the country’s current fiscal state, that an Italian banker would be welcomed with such open arms?  Well so far so good!  Viva Italia!!  Trichet had a lengthy history of sounding off after interest rate meetings (he liked to hear himself talk) and then completely reversing course a week later when the markets made him “eat crow.”  For clarification for our non-U.S. clients, here is the definition of “eating crow” from Wikipedia (what did we do before Wikipedia – does anyone remember?):  “Eating crow is a U.S. colloquial idiom,[1] meaning humiliation by admitting wrongness or having been proved wrong after taking a strong position.[2”  By the way, there is a picture of Jean-Claude beside the definition in Wikipedia.  We jest of course!  On a serious note, Mr. Draghi is doing an excellent job so far after taking over in the midst of a serious crisis of confidence.  Frequently what is not said makes a more powerful statement than what is said.  Interestingly he kept very silent after the latest agreement was reached with Greece despite demands for some type of statement.  Yet in our view the actions taken by the ECB speak far more loudly than any statement Mr. Draghi could have made.  He has walked a fine line between protecting the bank’s interests and avoiding total disaster and during this process his balance and acumen have been steady as a rock and spot on in our opinion.

SGK Blog--Update February 17, 2012 Don't Stop Believing
After a brief Jeremy Lin-like head fake during the middle of the week, the major averages continued to march higher spurred by more positive economic data.  New claims for unemployment benefits fell 13,000 to 348,000 according to the Labor Department.  That is the lowest level since March 2008 which pre-dates the Bear Sterns crisis.  Economists polled by Reuters had forecast claims of 365,000 after last week’s revised 361,000 figure.  There is no “magic number” but the 350,000 level is sometimes associated with sustained strength in the labor market.  With job gains exceeded 200,000 for the last two months and unemployment falling to a three-year low of 8.3%, a strong case can be made that the economy is humming along nicely.  Nevertheless, continuing claims of unemployment still remain around 3.50 million, and a total of 7.68 million people were claiming some form of state or federal unemployment benefits nationally.  With the Fed recently discussing a revival of its bond-buying program, more still needs to be done to keep the economy growing especially with a population of over 313 million.

On the inflation front, things also look good.  Producer prices excluding food and energy, the so-called core rate, was up 0.4% in the month of January thanks primarily to drug prices.  That was higher than the 0.2% rise expected by economists in a Bloomberg survey.  Wholesale energy costs fell 0.5% and food prices fell 0.3% reflecting declining costs for dairy goods.  The overall index rose 0.1%.  The Labor Department also reported its consumer price index this week.  It was higher by 0.2% overall in January following no change in December.  Its core rate also rose 0.2% and has been up 2.3% in the past 12 months.  All of these subdued numbers reinforce the belief that the Federal Reserve is likely not going to change its tune at any upcoming policy meeting.  Keeping rates low is not leading to inflation for the consumer or producers, and the job market is showing real signs of strength for the first time in a number of years.  We are not sold on the fact that rates will remain low into 2014 as the Fed’s latest official estimates state, but the rest of 2012 seems pretty safe at this point.

The European Central Bank (ECB) is swapping its Greek bonds for new ones of an identical structure and nominal value this week to make sure that it will not be forced to take losses in any debt restructuring.  This is being done to ensure that about €100 billion of Greek debt is voluntarily swapped by the private sector at a 50% haircut.  If not enough private owners agree to a voluntary exchange, a collective action cause, or CAC, would be enforced resulting in involuntary losses.  That would essentially doom the euro zone because the ECB would never be allowed in the future to buy any government debt because it would essentially be throwing money out the window if losses were forced upon it.  It has already bought bonds of Spain, Portugal and Italy totaling about €220 billion.  These new bonds the ECB receives would be exempt from any CACs.  This brings up a variation of the Animal Farm statement—all bondholders are equal, but the ECB is more equal than others.  Is the creation of a two-tier market possible and might it discourage future private investment?  Definitely.  Plus, the introduction of CACs would not itself trigger payouts on credit-default swap insurance contracts, but using them does according to the rules of the International Swaps & Derivatives Association.  On Monday, EU finance ministers are scheduled to meet to approve the €130 billion package which will keep the Greek government operating and help pay off a €14.5 billion debt maturity due March 20.  An EU leaders summit (yes, another one) is planned for March 1-2.  Greece obtained its first €110 billion loan package in May 2010.  Loans on that deal have been lowered from around 5% to 4% in March 2011.  Still the latest package is crucial for the country to keep functioning and that is ahead of elections scheduled in the spring where anti-austerity leaders may be voted in virtually assuring no further funds from the ECB, International Monetary Fund or private investors.

SGK Blog--Update February 10, 2012 Greece Once Again Captures the Attention of Traders  

The saga continues in Europe, with attention focused on Greece at the moment. On Friday alone, the Greek deputy foreign minister resigned over proposed austerity measures, Greek labor unions went on strike for the second time in a week and the situation became as muddled as it has ever been. The Greek finance minister returned to Athens as well after failing to reach an agreement with his euro-zone counterparts at an emergency meeting. Euro zone finance ministers cited the failure to reach previous budget-cutting targets and doubts Greek party leaders will stick to their commitments after elections due as soon as April. The Greek parliament is due to vote on the measures this weekend and euro-region ministers are set to meet again on February 15th. Greece faces a 14.5 billion euro bond payment on March 20th so time is short to come to an agreement. As we pointed out at the end of last year in our year-end summary, these issues are not going away any time soon and even if an agreement is reached in time on the next bailout payment, this will be an ongoing issue for the foreseeable future. 

The infamous word of the week is “contagion.” We have used this term before and it refers to the possibility, or some would argue the likelihood, that once attention shifts from Greece to Portugal, then Spain & Italy, the problems become much more profound. Yields on Portugal government bonds are at unsustainable levels, and while the yields on Italian and Spanish government bonds have come in quite a bit due to the European Central Bank flooding the credit markets with liquidity last year, the risks remain at elevated levels. So while equity markets got off to a good start this year based on no news coming out of Europe, healthy corporate earnings and continued signs of a recovering economy here in the U.S., as we also stated at the end of last year, we expect volatility to continue here in 2012. If Europe were to tilt into a more severe recessionary condition it would drag the global economy down with it. The fact that Europe has too many banks and financial institutions with uncertain capital cushions remains a very real concern and during periods of stress investors & traders confidence can be fleeting, thereby compounding the situation. While we certainly hope Europe muddles through its difficulties in an orderly fashion, hope is not an investment strategy which is why we have been aggressively trimming highly appreciated securities in our clients portfolios in the past two months with the goal of maintaining a prudent balance. 

The news out of the U.S. on the economy was really overshadowed by events in Europe and there was not much information out anyway. Consumer credit expanded in the month of December to a level of $19.3 billion which was twice the expectation, a sign that the U.S. consumer was more confident using their credits cards during the Holiday shopping period. Weekly initial jobless claims fell to 358,000 for the week ended 2/4/2012, well below expectations, which continues the trend of the data here in the U.S. showing slow but steady improvement in the job market. The University of Michigan’s consumer sentiment survey for February came in at 72.5 which was weaker than expected and, combined with the U.S. trade balance data being a little worse than expected, it helped dampen traders enthusiasm for equities in Friday trading while sending high quality bond prices higher.
SGK Blog--Update February 3, 2012 Vertigo
Today’s impressive employment numbers has pushed the major indices to new heights.  The Nasdaq Composite is at an 11-year high and the Dow is near a four-year high.  Clearly a fear of heights is not something investors are worried about at the moment.  Expectations of the payroll number ranged from 95,000 to 225,000 according to a Bloomberg survey.  The actual number, a 243,000 increase, was above the highest end of this range and much better than the median 140,000 figure.  The unemployment rate fell to 8.3%, the lowest since February 2009 when the country was still in the grips of the financial crisis meltdown.  The increase in employment was broad-based: manufacturing, construction, accounting firms and retailers among others were industries benefitting.  Private payrolls, which exclude government agencies, saw a 257,000 increase in January after a revised gain of 220,000 in December.  Average hourly earnings rose 0.2% while the average work week held steady.

Seeing such strong figures for employment is good news.  We have been reporting signs of growth in various pockets of the economy since late last fall and now we are seeing a follow-through on the job front.  The key to turning around the residential mortgage market is a better employment picture so things look promising.  Of course, there remain millions out of work or underemployed so, as Fed Chairman Bernanke commented yesterday, “We still have a long way to go before the labor market can be said to be operating normally.”

Further indicators of strength were apparent in other data released earlier this week.  On Monday, personal income rose 0.5% in December which was an improvement on the prior month’s 0.1% rise.  Core prices as measured by personal consumption expenditures were up only 0.2%, a quite modest figure.  The ISM Index which tracks manufacturing health was released on Wednesday.  It showed a 54.1 level.  Anything above 50.0 is interpreted to mean growth in manufacturing, and it was an improvement from December’s 53.1 figure.  The ISM Services data point which tracks service industries was a very strong 56.8 in January compared to 53.0 in December.  Auto sales released this week also showed signs of not only strength but acceleration.  January’s data was up 11% compared to a year ago and the fastest pace in nearly four years.  Nissan, Chrysler, VW and Honda each announced U.S. expansions that would add nearly 2,000 jobs over the next year.  Ford Motor said it would 7,000 jobs in the U.S. in this year alone.

Even Europe received some positive news with the euro-zone purchasing manager’s index rising to 50.4 in January from 48.3 in December thereby crossing into the growth area (above 50.0).  Germany’s main stock index was up 1.7%, France up 1.5% and Spain up 1.0%.  Earlier this week, representatives from many euro-zone nation’s agreed to abide by the outline established at their December summit.  That is, annual deficits as a percent of GDP were to be minimal (less than 0.5%) and general government debt was to be no more than 60% of GDP.  Anything outside of these limits would be met with sanctions as imposed by the European Court of Justice.  Of course, during extraordinary economic events (like a recession) there would be some flexibility.  The markets like to hear more fiscal harmony among the euro-zone countries, but there still remains a lot of doubt.  The reason why Europe has calmed in the first month of the year is due to the European Central Bank’s 3-year 1% loans it is extending to banks in the region.  Another round is due to be offered later this month.  Though the immediate liquidity pressure has been eased, the long-term question of labor flexibility and global competitiveness remains a long ways off.

SGK Blog--Update January 27, 2012 Fed To Hold Rates Steady Through Late 2014 

In a slight policy adjustment, the Federal Reserve’s Open Market Committee (FOMC) indicated they expect to keep the Fed Funds rate at the current level of between 0% and 0.25% at least through late 2014. According to the Committee, due to relatively low inflation expectations and continued challenges on the economic front, particularly related to international pressures and continued strains in the housing market, they expect to maintain a “highly accommodative” stance for monetary policy. They are going to continue to extend the average maturity of their holdings within their portfolio and to reinvest principal repayments on their mortgage-backed securities and Treasuries. While they technically did not add stimulus to the economy with these actions, the impact on markets was pretty immediate. Interest rates declined across the board, particularly the ten-year rate as it is widely known this is one of the Fed’s targets, and other asset prices such as gold, equities and oil climbed. There is an old saying, “don’t fight the Fed!” and we wholeheartedly agree with that logic! 

On the economic front, the number of Americans signing contracts to buy previously owned homes in December held near a 19 month high although it declined slightly more than expected. The index of pending home sales decreased 3.5% last month after climbing a combined 18% in October and November. Ben Bernanke, Chairman of the Federal Reserve, has cited the continued decline in home values as a key drag on the economy and this prompted President Obama to announce a plan aimed at reducing monthly mortgage payments during his State of the Union address. The combination of lower unemployment, higher consumer confidence coupled with record low interest rates have helped stimulate some buying on the housing front. We will have to await the details on the President’s plan. Later in the week the figure for new home sales came out and that was slightly below expectations as well for the month of December. 

In other U.S. economic news, initial weekly jobless claims remained at the expected level coming in at 377,000 for the week ending 1/21/12. The figure for leading indicators was positive for December at +0.4% but was below the expected +0.7%. Orders for durable goods, a pretty good indicator of future manufacturing opportunities as these are goods built to last more than three years (obviously does not include our smart phones!), was +3% for December, nicely above the consensus estimate from economists of +2%. Excluding autos (which can be volatile) it was an even more impressive beat coming in at +2.1% versus the expectation of +0.7%. A wet blanket was thrown on equity trading Friday as the estimate for fourth quarter gross domestic product for the U.S. came out at +2.8% and the expectation was for a figure of +3%. That sent foreign equity markets lower and our stock futures down before markets open here in the U.S. Many foreign traders had been looking to a robust figure here in the U.S. as we know that growth in the EU has slowed to a virtual standstill. So traders are tuned to the fact that growth in global commerce has to come from somewhere and the focus is on the U.S. and China – the two largest economies in the world. Even the gauge of consumer sentiment released by the University of Michigan which came out at a pretty good level of 75 versus the expectation of 74.2 failed to brighten the mood of traders Friday. As a result, equities sold off while bonds were pretty much flat on the day. 

The combination of the President’s housing plan and the Fed’s statement helped bolster markets in Wednesday trading after a shaky start to the week based on the Europeans inability to come to an agreement with Greek bondholders. Sometimes it is like watching a really bad soap opera. EU officials and the IMF are indicating that more must be done in terms of supporting the banking sector and in terms of private bondholders taking a bigger haircut on the bonds and accepting lower interest rates on new bonds. Of course the existing private bondholders don’t really want to do that (hadn’t that decision already been made? It’s hard to keep track!) Actually the decision on the size of the haircut had essentially been dictated to bondholders by Merkel and Sarkosy but now they are fighting over the level of the interest rates. Add to that the fact that the European Central Bank, now that they hold a fair bit of Greek debt, does not want to take a haircut or accept lower interest rates and the situation has once again gotten complicated. We’ll call it a three-ring circus actually, although decision making within a three-ring circus probably progresses more smoothly than it has within the EU. Actually, the following is a nice, concise summary of the current state of the situation in Greece/Europe – borrowed from the Wall Street Journal… 


Is the worst of the euro-zone bond-market crisis over? It's tempting to think so: Italian 10-year yields are under 6%, their lowest since October, while Spanish yields are well under 5%, a level not seen in over a year. January's bond auctions have seen heavy demand. And despite soaring Portuguese bond yields, there is not a hint of contagion.

The European Central Bank's December offer of unlimited three-year loans to banks has been key in easing tensions, helping to stave off a fire sale of assets and reducing the risk of a bank failure. A second loan will be granted in February. Economic data have surprised positively. And investors clearly became too negative in the fourth quarter. With Italy and Spain still key components of government bond indexes, previously cautious investors are boosting their underweight positions. Dutch pension funds, big sellers of Italy last year, have been buying in January, says one market participant.

Importantly, Italian and Spanish yields have fallen steadily despite concerns about Greece's debt restructuring and an imploding Portuguese bond market, where five-year yields now stand at 19%. The absence of contagion is illustrated by Ireland's success in swapping two-year for three-year bonds this week at a relatively low yield. Crucially, the governments of Mario Monti in Rome and Mariano Rajoy in Madrid are pushing ahead with ambitious structural reforms.

Risks clearly remain. While it appears in all sides' interest to conclude a Greek restructuring deal, the process could yet fall apart, causing a messy default and reviving euro break-up fears. Friday's euro-zone money supply data for December show a credit crunch may only narrowly have been averted, with bank lending to the private sector plummeting and deposits falling. Austerity is also biting: Spanish unemployment is nearly 23%. Ratings downgrades could yet affect appetite for Italian debt. And puzzlingly, German yields remain extremely low despite signs of risk appetite, suggesting some investors remain very cautious.

These risks probably mean the crisis is dormant, not over. But dormant is vastly preferable to the acute stress seen in late 2011. The longer the improvement continues, the better the chance it is durable.

SGK Blog--Update January 20, 2012 The Turning Point

This week, there were more positive signs of sustainable economic growth…at least here in the U.S.  For the week ended January 14, initial jobless claims fell by 50,000 to 352,000.  That is the lowest level since April 2008.  The Bloomberg News median forecast was for a figure closer to 384,000.  Regardless of turmoil overseas, U.S. companies are slowing the pace of firings.  Because this weekly indicator is seen as a forward indicator, it is likely that if this trend continues, we will see a quite positive monthly payroll report in the beginning of February.  The four-week average of claims, a less volatile measure, fell to 379,000 from 382,500 the week prior.  And the number of people continuing to receive jobless benefits fell by 215,000 in the week ended January 7 to 3.43 million.  All was not bright, however, as those who have used up their traditional benefits and are now collecting emergency and extended payments rose around 105,000 to 3.56 million in the week ended December 31.  Nevertheless, we seem to be solidly below that psychological 400,000 initial weekly figure which we wavered around for month after month.

There has been really no change in the general level of prices even with this uptick in good news on employment.  Producer or wholesale prices fell 0.1% in the month of December compared to November.  Economists had predicted a 0.1% gain.  Excluding the volatile food and energy components, the index rose 0.3%.  For all of 2011, the core index rose 3%, the most since 2008.  Consumer prices were unchanged in December according to the Labor Department.  That was below the 0.1% median forecast according to Bloomberg News.  Its core rate rose 0.1%, in line with expectations.  For the twelve months ending in December, the core consumer price index 2.2%, the most since 2007.  Even though the annual figures are high, the monthly figures remain quite low which is given the Federal Reserve ammunition to continue to pump liquidity into the economy without fear of stoking inflationary fears.

Housing starts dropped 4.1% to a 657,000 annual rate last month according to the Commerce Department.  The median forecast was for a 680,000 annual rate.  Starts fell in three of four regions last month led by a 41% decrease in the Northeast.  We are nearly five years removed from the housing peak (depending upon which survey is used) and prices have still not firmed.  This is thanks to the “shadow inventory” of homes that are in foreclosure or in the process of foreclosure and are weighing on the bids from prospective buyers.  It is hard to tell if 2012 will mark the definitive bottom in the process, but because we have seen less and less supply from homebuilders, that will help quicken the process. 

SGK Blog--Update January 13, 2012 Why Europe Will Remain a Headwind in 2012  

In our view, the sovereign debt issues enveloping Europe hold important lessons for the United States. As we wrote at the end of 2011, one of the issues facing markets and investors in 2012 is the fact that developed nations will have to roll over approximately $7 trillion in sovereign debt. The United States, similar to Germany, benefits from extraordinarily low refinancing costs as both countries are considered safe havens in times of turmoil because of the strength of their respective economies. At the same time, the U.S. owes over $15 trillion and that figure is climbing every day. As we have indicated, that high level of debt restricts our flexibility and our capability of effectively dealing with future economic shocks without causing significant global market disruptions. When our Federal Reserve prints money it creates imbalances in other countries – especially those countries that run surpluses and who are attempting to abide by free market principles such as Brazil for example. It leads to rapid currency appreciation in other countries and when currencies are in turn manipulated it can lead to rapid inflation. It also makes the U.S. hugely unpopular in other countries – we are trying to maintain stability and promote growth in our country to the potential detriment of those in others. 

How is our situation analogous to events in Europe? We read with interest this week two articles highlighted in Bloomberg related to issues in Europe that are not even front page news these days. The first topic related to how the government in Spain may be forced to guarantee or even bail-out indebted regions within their own country. The focus so far has been on the sovereign debt of Spain itself but let us look at what kind of financial shape some of the regions within Spain are in. Catalonia, Valencia, Andalusia and Madrid, regions which combined account for 60% of Spain’s economy, are currently shut out of capital markets as they brace to repay 9 billion euros ($11.5 billion) to lenders this year. So this is debt these areas have run up aside from the debt of Spain itself. As a result of this, regional shortfalls have driven Spain’s deficit to 8% of GDP, breaching the 6% it pledged to keep within to the EU. So once again they are having to examine another round of increased taxes and decreased spending, which will not help bring down Spain’s 20%+ unemployment rate. The second and perhaps more concerning article related to Europe’s $39 trillion future pension obligations. This amounts to about 5 times the level of total outstanding debt. As we do in the U.S., Europe faces issues associated with an aging population and this is compounded by falling birthrates and rising life expectancies. The actual $39.3 trillion of projected future obligations to their existing populations is based on a very credible study by a German institution that was commissioned by the European Central Bank and this represents an absolutely unsustainable number. Translation – they are in for more pain in Europe for several more years and there is no easy way out.  

What lessons can we learn from this here in the U.S.? In our view we need to address several issues at once and the sooner we get started the better. While the situation is not completely analogous – we do not have over 20% unemployment in this country thankfully – there are several issues which are concerning. Future Social Security and Medicare liabilities reflect demographic shifts in our country and these liabilities in their present form are not sustainable long-term. It is estimated that based on current projections – which are notoriously usually wrong anyway – that these programs alone will cost the Treasury over $5 trillion per year by 2020. We mentioned the level of debt at the national level but what about at the state level? Let’s take California for example. At the state level it is estimated that total reimbursements and current debt amount to about $40 billion. Add to that general obligation borrowing for schools, roads, etc. and that brings to total to $77 billion or about $2362 per person on a debt per capita basis. By the way, that is second worst in the country as New York wins (loses?) that category at $3,135 per capita while the best in the country is Texas at $520 per person. The real kicker on all of this is that unfunded pension liabilities for retirees & pensioners in California currently stand at $96 billion. The problem with this latter figure is that the official calculations on this estimate assume that pension assets will grow at a faster rate than they actually have in the past century. If you assume the assets grow at the exact same rate then the actual unfunded liability in California is more like $256 billion! Do you see where we are going with this? Overall, it is not a pretty picture and the issue of unfunded liabilities is the can that politicians perpetually kick down the road. It is time to do something about it now lest we end up in a situation like Spain at some point. 

This week we did receive data on the U.S. economy reminding us how much we are not like Spain! J The preliminary University of Michigan consumer sentiment survey for the month of January came in at a robust 74 versus the expectation for 71.2, showing Americans are still confident after the Holiday shopping period. This was also evidenced by the fact that consumer credit for the month of November rose to $20.4 billion from the previous month’s figure of $6 billion, an indication consumers were comfortable taking on more debt during the Holiday shopping period. On the downside, retail sales were inexplicably weaker than expected in the month of December and initial weekly jobless claims for the week ending 1/7/12 rose to a higher than expected 399,000 as retailers appear to have let added workers go after the Holiday shopping period ended. Data in the U.S. was trumped somewhat by additional data from overseas, in particular the news coming out of the globe’s second largest economy – China.  

In a weird way, (what the market acting strangely & unpredictably?! Shocking!) the weaker than expected figure from China sent stocks higher in Tuesday trading because traders interpreted that as increasing the possibility that the central bank in China will ease up on reserve requirements for banks to help boost growth. Their central bank had been increasing reserve ratios in an attempt to control real estate inflation in that country and this strategy was resulting in upward pressure on the yuan and slowing export growth. Exports to Europe have obviously also been under pressure given the turmoil over there based on the fact they are on the brink of recession. China is now playing such an important role in global markets as they have become the second largest economy in the world. Add to that they are one of the few large economies that sustained growth during the recession of 2008/2009 and they have a significant surplus compared to the abysmal state of our government’s finances here in the U.S. So the weaker number coming out of China made us all happy because stocks went up – go figure! Oh and the rumor is that due to the slightly weaker Chinese economy the prices on high quality Bourdeaux wines may come down now in the second half of the year and there really is no down side to that in our opinion! J
SGK Blog--Update January 6, 2012 Bonanza
December’s payroll figures paired with an unexpected drop in the unemployment rate gave investors some positive economic news on the first week of trading in the New Year.  U.S. employers added 200,000 jobs following a 100,000 revised figure for November.  The median projection in a Bloomberg News survey was for a December gain of 155,000.  The unemployment rate fell to 8.5%, the lowest since February 2009.  Also important was the fact that average hourly earnings rose 0.2% and the average work week increased to 34.4 hours.  Those are key signs because it implies employers are likely to continue to seek out new workers in order to keep up productivity.  Private hiring, which excludes government agencies, rose 212,000 last month after a revised gain of 120,000 in November.  That figure was also above the median expectation of 178,000.  These numbers are not a complete surprise given the positive data in the weekly initial unemployment claims data.  In the week ended December 31, applications fell 15,000 to 372,000.   The four week average fell to 373,250, the lowest since June 2008.

For all of 2011, employers added 1.64 million workers, the best year of hiring since 2006.  In 2010, a comparatively smaller 940,000 payrolls were created.  Still, those numbers pale in comparison to the 8.75 million jobs lost during the recession that ended in June 2009.  The labor participation rate held at 64% which is still on the low side compared with recent periods.  Retail trade payrolls climbed by over 27,000 in December while even construction companies added 17,000 during a usually down month because of weather-related issues.

With the tide turning to the positive, the Federal Reserve is about on what may be considered its boldest move yet in terms of public communication.  Beginning with its next policy meeting on January 25, the Fed will release interest-rate projections several years out.  As part of the Summary of Economic Projections (SEP) which are updated four times a year, all 17 members of the Fed’s Open Market Committee will anonymously show the range of rate forecasts.  This is not unprecedented as Sweden, Norway and New Zealand already release interest-rate projections.  However, none of those countries boasts a $13 trillion economy or the world’s reserve currency. 

What makes this such a risk is that by being more exacting in their forecasts, they leave themselves open to questioning on many fronts and that strikes at the heart of their power: credibility and independence.  The Fed’s press release stated: “Participants generally agreed that issuing such a statement could be helpful in enhancing the transparency and accountability of monetary policy…to promote the goals specified in its statutory mandate in the face of significant economic disturbances.”  However, when the drivers of that economy from a financial point-of-view are revealed to be way off base, how will investors react?  How do you hold an independent body like the Fed accountable?  Will the public see the forecast as a promise rather than a prediction?  These are all high-minded questions which are great to debate in the halls of Congress or around the dinner table.  The market, however, is ruthless and if it smells trouble, the result will not be pretty.  Imagine what would happen if traders believed the Fed was completely off base with its predictions?  Investors have much more faith in fellow businesspeople than politicians.  So who would come to calm the markets then?  How much pressure do you think the forecast outlier is going to get when the predictions are released and, what if that outlier turns out to be right?  To be clear, we are believers in more transparency but there is also a point where openness often invites criticism.  The bottom line is that it will be interesting to see how the markets view this latest glasnost effort from Bernanke and crew and if our old friend of government initiatives—unintended consequences—makes an appearance.

SGK Blog--Update December 30, 2011 Markets Volatile on Last Trading Week of Year on News From Overseas - Happy New Year!  

We would like to take this opportunity to wish all of our clients a Happy New Year and we look forward to a challenging but prosperous 2012! As we said last week, we want to thank each and every one of you for your kind support and for making this one of our best years in terms of business growth and relative portfolio performance. 

As a recap on the week, trading volumes were light as was news on the U.S. economy. Information we did receive on the U.S. economy generally had a positive tone. Tuesday’s report on consumer confidence from the Conference Board was sharply higher than expected coming in at 64.5 for the month of December vs. the expectation of 58 demonstrating that Americans were definitely in a Holiday shopping mood this Christmas! While weekly initial jobless claims at 381,000 for the week ending 12/24/11 were slightly higher than the expectation for 368,000, the key four-week moving average dropped to 375,000 which is the lowest level it has been since June 2008 according to the Labor Department. Housing indicators were somewhat mixed this week as the Case-Shiller 20 city Index for October showed a 3.4% decline from the previous year which was lower than expected but the figure for November pending home sales was up 7.3% relative to the expectation of 0.6% so this was quite a strong figure. Finally the last data point on the U.S. economy we received this year was a good one as the Chicago Purchasing Managers Index, or Chicago PMI for short, for the month of December came in at a relatively robust 62.5 versus the expectation for 60.1. All-in-all a pretty good week and as we have said in our recent weeklies, we are generally pointing in the right direction here in the U.S. Slowly but surely the economy is gaining traction. 

So we have to look overseas for some of the contributing factors for this week’s volatility. Once again Italy was making headlines as traders, those that actually were at work this week, were nervous as Italy auctioned off new debt securities to replace maturing ones. In fact there were quite a number of auctions for Italian securities this week and the results were mixed. Early in the week they auctioned 9 billion euros in treasury bills at a yield of 3.251%. While that sounds like a very high rate for treasury bills, very short term securities, it is about half the level in terms of yield they paid at the last auction on November 25th. Subsequent to that Nov. 25th auction the European Central Bank has expanded their balance sheet to a new record 2.73 trillion euros ($3.55 trillion) after implementing their policy of extending euro-area banks unlimited funds for three years. This was a critical step in easing pressure in the credit markets over there and as we wrote shortly after they announced this step, you could practically hear the woosh of the pressure being released in the market like a valve that had been opened up. Subsequent to the auction of the short maturity securities, the Italian government auctioned 2.5 billion euros of securities due in 2014 at a rate of 5.62% down from 7.89% at the previous auction, 2.5 billion euros of its 5% bond maturing in 2022 (ten year) at a yield of 6.98% compared with the 7.56% they paid at their Nov. 29th auction and a number of other issuances. As we said, although yields were down the total issuance of 7.02 billion euros fell short of their goal of raising 8.5 billion euros. What will make 2012 an interesting, and we expect volatile year, will be the fact that Italy, with the world’s fourth largest debt load, will have to raise 450 billion euros at auction. Great (slight tone of sarcasm) – that means we, like a number of other traders and registered investment advisors, will be paying very close attention to Italian government securities auctions next year. Let’s just call that one more important indicator to add to the list we follow closely looking forward. By the way, the Italians pay about 3 times what the Germans pay to issue 10 year debt and their economy is not close at all to measuring up to the German economy in terms of productivity. Something to keep a very close eye on in 2012 for sure! 

Is it conceivable that once again international markets and economies will become the focal point of traders attention in 2012? We believe that will potentially be the case. Another part of the globe we will be paying close attention to will be China. They have become an economic superpower whose scope and influence moves markets globally. On a worrisome note, we received a data point this week showing that Chinese manufacturing contracted for a second consecutive month in December as Europe’s debt crisis cut export demand. One of their purchasing managers indices came in at 48.7 for December from 47.7 in November and a number below 50 indicates contraction. Last month we reported that Chinese officials cut reserve ratio requirements for banks for the first time since 2008 and there is speculation they may cut the ratio again in January. China is the world’s second biggest economy so any hint of a slowdown in that country has the potential to weigh on markets in the new year.  

We here at SGK are approaching 2012 with a sense of cautious optimism. We ordinarily do our best to avoid redundancy in our weekly updates, and we always appreciate your commentary and feedback on our reports. Given it was two days before Christmas when we sent it out last week our gut feeling is that readership may have been a wee bit on the light side! Sooooo here we are one day before New Year’s Eve and we are quite certain that reading our weekly is right up there on your priority list this evening! With all that said, we are going to repeat the last paragraph from our update last week to once again express our appreciation to each of our clients in case you happened to have missed it. We believe we are very well positioned in our client portfolios heading into 2012. It is notoriously difficult to predict where major averages will finish at the end of 2012. After all who would have predicted at the start of 2011, with all the negative attention stemming from the now infamous Meredith Whitney study, that high quality municipal bonds would have been one of the best performing market benchmark indices for the year. Our emphasis remains on maintaining balance in our clients’ portfolios and focusing on high quality securities, while maintaining a well diversified portfolio structure. We have very specific views on interest rate direction and equity sector weightings/opportunities in our clients’ portfolios and we are happy to discuss our positioning and our goals for your portfolio heading into the New Year. Please feel free to call us to discuss as we always enjoy talking about this with you. Your portfolio structure is a reflection of our viewpoint for 2012 and beyond. There is no better testament to the strength of our conviction and our process (and confidence in our people J ) than a referral from a client to a family member or an associate and we received a record number of referrals this year from our clients. So thank you very much for your business and please have a safe, joyous and prosperous New Year!  

SGK Blog--Update December 23, 2011 Markets Drift Higher on No News from Europe - Merry Christmas! 

While we can’t entirely attribute this week’s listless movement higher in equity prices entirely to the lack of market moving news out of Europe, it certainly was a contributing factor. After a relatively brutal year for European traders, even one of the better markets over there Germany is down approximately 16% year-to-date, many of them have simply gone home for the Holidays as they say! It is notoriously difficult to gauge market direction this time of year due to thin trading. However, after volatile trading conditions over the past six months, this week’s relative calm was a refreshing change! We would like to take this opportunity to wish all of our clients a hearty Merry Christmas and we look forward to a happy and prosperous New Year with you. We want to thank each and every one of you for your kind support and for making this one of our best years in terms of business growth and relative portfolio performance. 

Equity indices here in the U.S. were propelled higher this week on the strength of the data on the U.S. economy. The week started out strong based on the housing data we received in Tuesday trading. New housing starts for the month of November came in at a higher clip than any economist had forecast. So housing starts for November were 685,000 versus the expectation for 627,000 and building permits for the same month were 681,000 versus the expectation of 633,000. The housing sector has been a focal point during this recovery as it is one of the areas that led to the severe recession we had in the 2008-2009 period. It was not all rosy this week as the figure for existing home sales for November was actually weaker than expected. On a positive note, the figure for initial weekly jobless claims ending 12/17/11 once again defied the odds and was 364,000 relative to the expectation for 380,000. This follows last week’s better than expected number of 368,000 as we reported. The jobs picture is the other area that is receiving a very high level of attention during this recovery as we have been mired in a state of high unemployment. These back-to-back figures are an indication that we should see a decline in the unemployment rate for the month of December when those figures are released the first week of January. The rest of the news released this week was mixed but equity traders seemed to shake off the bad news and focus on the good. What can be said about that? Everyone loves a Santa Claus rally! It just has a nice ring or jingle to it! So while third quarter GDP was revised downward and both personal income and personal spending figures for November were weaker than expected, traders focused their attention on the strong figures for durable goods orders, the above expectations measure of leading indicators and the really strong figure for December released by the University of Michigan on consumer sentiment. The rally this week was helped because these latter figures are better indicators of future growth whereas the GDP figure was old news at this point. Either that or traders were simply in a jolly good mood! 

We believe we are very well positioned in our client portfolios heading into 2012. It is notoriously difficult to predict where major averages will finish at the end of 2012. After all who would have predicted at the start of 2011, with all the negative attention stemming from the now infamous Meredith Whitney study, that high quality municipal bonds would have been one of the best performing market benchmark indices for the year. Our emphasis remains on maintaining balance in our clients’ portfolios and focusing on high quality securities, while maintaining a well diversified portfolio structure. We have very specific views on interest rate direction and equity sector weightings/opportunities in our clients’ portfolios and we are happy to discuss our positioning and our goals for your portfolio heading into the New Year. Please feel free to call us to discuss as we always enjoy talking about this with you as your portfolio structure is a reflection of our viewpoint for 2012 and beyond. There is no better testament to the strength of our conviction and our process (and confidence in our people J ) than a referral from a client to a family member or an associate and we received a record number of referrals this year from our clients. So thank you very much for your business and please have a safe and joyous Holiday!  

SGK Blog--Update December 16, 2011 It's Beginning to Look a Lot Like Christmas

With only eight shopping days left before Christmas, the markets got more pieces of good news from economic releases.  Initial unemployment claims dropped by 19,000 to 366,000 in the week ended December 10, the fewest since May 2008.  The median forecast as compiled by Bloomberg News was 390,000 so this was a pleasant surprise.  The four-week moving average dropped to 387,750 from 394,250 previously.  Since the monthly payroll figure is more of a lagging indicator, when that number is released on January 6th, it is likely to show a further reduction in the national unemployment rate which currently stands at 8.6%.  The biggest issue we have highlighted is whether the gains we see in the employment picture were sustainable.  It is still too early to call a permanent turn for the better yet, but signs are looking more positive than they were even a few months ago.

Producer and consumer prices continue to show little gains, which is a positive.  Wholesale prices for November, excluding the more volatile food and energy factors, rose 0.1%, less than the consensus 0.2% increase forecasted.  Overall, the producer price index rose 0.3% thanks to a 1% advance in food expenses and a 0.1% rise in energy costs.  Consumer prices were unchanged in November following a 0.1% decline in October.  Its core rate (excluding food and energy costs) rose 0.2%, reflecting higher medical care and clothing costs.  Year-over-year, the core CPI rose 2.2% from November of last year.  The overall CPI rose 3.4% for the past twelve months, the smallest increase since April.  Approximately 60% of the CPI covers prices consumers pay for services. 

In its last regularly scheduled Federal Open Market Committee meeting for the year on Tuesday, the Federal Reserve decided to keep the status quo on interest rates.  In its press release, the Fed stated: “The Committee continues to expect a moderate pace of economic growth over coming quarters…”  They added that they still believe unemployment is too high versus its mandate of “maximum employment” but believe inflation and inflation expectations will be at or below levels they believe are consistent with its other mandate of “price stability.”  As a result, these conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”  Low interest rates are not a new holiday present, but the markets still enjoy low rates as another gift under the tree.  The next meeting date for the Fed will be January 24th and 25th

In Europe, a week after country leaders released another grand deal, signs of strain were already apparent.  Besides a few struggles with new auctions in Spain, some legislatures in the euro zone said they would have problems passing the new conditions which call for greater fiscal uniformity.  It is this solidarity which the continent desperately needs.  The market is coming to realize that there is no silver bullet as long as the European Central Bank (ECB) refuses to step up as the lender of last resort in the sovereign marketplace.  The worry stems from the fact that banks continue to see pressure in the near-term lending market even after many safeguards have been extended through swaps with the ECB and Federal Reserve among other central banks.  Given that many banks will have to raise billions of euros by mid-year 2012 in order to meet capital requirements, this situation is sure to come to a decisive head sometime early next year.

SGK Blog--Update December 9, 2011 Let's Make a Deal
With the eyes of the financial world watching, European Union leaders announced a deal on Friday which they hope will lead to a more unified Europe and save the euro from disappearing.  Without going through every single detail, we will try to highlight the most relevant parts and what affect it is likely to have on the markets.

Member states would face automatic sanctions if the budget deficit rose above 3% of GDP, unless a majority of euro-zone nations overturn this rule (for example, in the case of a major recession or depression).  Debt-to-GDP would be capped at 60% and countries would have to write into law a commitment to reduce it if that ratio was currently higher.  Countries will have to broadcast how much debt they plan to issue through bond sales on a regular schedule.  The European Court of Justice is charged with making sure all member states adhere to these rules or else face immediate repercussions including automatic monetary penalties.

The euro zone and other willing EU states will give up to €200 billion to the International Monetary Fund to help rescue troubled nations.  The permanent bailout fund, the European Stability Mechanism (ESM), will replace the current rescue fund (the European Financial Stability Facility, EFSF), one year ahead of schedule in July 2012.  The ESM has paid-in capital meaning countries will contribute funds to it like placing a deposit at a bank.  The money will be there and available.  The EFSF was an emergency fund which would only be used as needed and, as such, would request funding only as needed which created delays.  Moreover, only 85% of holders in the ESM would need approval to disburse funds which prevents smaller or disorganized nations from slowing down the process.

On Thursday, the European Central Bank cut its benchmark rate by 0.25 percentage points to 1% thereby completely reversing the rate hikes which happened earlier in the year.  ECB President Mario Draghi also announced three-year unlimited loans for banks and the ECB’s willingness to accept a greater variety of collateral for these loans.  Also, the ECB cut its reserve ratio (the percent of assets which must be held at the ECB for every bank operating in Europe) to 1% of deposits from 2%.  This takes pressure off the banks after the European Banking Authority said European banks would need to raise €114.7 billion in new capital by next June.  The shortfalls are spread across more than 30 banks in 12 countries.  Spain and Italy had the biggest deficiencies with Spanish banks needing €26.2 billion and Italian banks needing €15.4 billion.  Even Germany was not immune with the banking authority requesting a capital raise of €13.1 billion.  This exercise applied theoretical losses to banks’ sovereign debt portfolios and differs from the “stress tests” of last summer which examined a more widespread deteriorating economic environment.      

Who’s in?  The 17 countries that use the euro are all in.  The U.K. gave a clear “no” to the deal because it did not include certain safeguards for its financial center from regulation.  Nine non-euro states said they would consult their parliaments which might mean putting the deal to a referendum in certain countries.  What does this mean?  This is an intergovernmental agreement which has less teeth than a new European-wide treaty.  A treaty would require all 27 euro zone countries to get legislative approval which would probably take until months if not a year.  Time they do not have. 

What does all this mean?  In the short run, the actions by the ECB helped prevent further bank panic.  It was essentially the ECB stepping up and saying it would be the lender of last resort.  Just as U.S. stress tests gave U.S. banks the needed quantitative targets and needed time to get their houses in order, these moves do the same for European banks.

But what about governmental debt?  Herein lies the problem.  The ECB has repeatedly stated that it is bound by European Treaty to buy sovereign debt unless it is with the purpose of implementing monetary policy.  That enables them to nibble in the debt markets but not jump in with both feet.  Using the IMF (e.g., lend money to IMF who in turn lends it to troubled nations) is also not going to happen under Draghi.  He has stated that is the job of the EFSF and eventually ESM to be buyers.  Even with the extra €200 billion commitment, it is not enough.  Eventually, they will run out of bullets because time is not on their side.  The ECB projects euro zone growth of -0.4% to +1.0% in 2012 and only 0.3% and 2.3% in 2013.  In the meantime, Italian and Spanish governments will need hundreds of billions of euros to be raised via auction in order to remain functioning.  If the consensus was back-to-back growth of 3%-4% in Europe over the next two years then it might be possible to actually grow out of the recession and not have the burden of this debt be so large.  But that is quite unlikely especially with all the austerity plans in place.  Therefore, the markets will continue to pressure bond yields because no one wants to hold this debt because there is no growth. 

More fiscal coordination is a good first step but we are loathe to declare victory.  With the global spotlight shining brightly, politicians always smile.  When it comes time to make decisions in front of one’s own legislature in the name of balanced budgets that might lose votes in an election, the mood will change.  They have already provided a “backdoor” for themselves saying that the deficit and debt-to-GDP ratios can be suspended in times of financial stress—just when discipline is needed the most.  We still maintain that the ECB holds the key because it can fire its bazooka by printing an unlimited amount of euros.  Why not kill them with kindness?  That is, have the ECB be the lender of last resort for all government bonds immediately.  Then, when the covenants are breached, refuse to buy that country’s debt thereby essentially tossing them out of the monetary union.  In other words, make space for everyone in the lifeboat and then throw member states out who refuse to row.  Until that happens, we believe Europe will be just “muddling through” for years to come.

SGK Blog--Update December 2, 2011 Markets Rally on Coordinated Central Bank Action 

Traders pushed major global stock market indices higher this week and sold Treasuries based on coordinated actions by central banks and generally very positive economic performance here in the United States. Six central banks acted together to make additional funds available to banks to help ease strains from Europe’s debt crisis. The central banks of the U.S., the euro region, Canada, the U.K., Japan and Switzerland agreed to cut the cost of providing dollar funding via swap arrangements and agreed to make other currencies available as needed. In what appeared to also be a coordinated and timely effort, the People’s Bank of China indicated they were cutting the reserve requirement ratio for banks by 0.5% from previous levels. Euribar rates, the rate at which European banks lend to each other in the interbank market, had reached highs we had not seen since the financial crisis of 2008. So this amounted to a coordinated effort on the part of the central banks to provide liquidity to banks – primarily European banks – to ease what was developing into a precipitous crisis situation. Traditional short-term funding options, which banks in Europe tend to rely heavily on, had been drying up and the last thing needed right now when the European Union (EU) is teetering on the verge of a recession is a full-blown liquidity crisis. The impact in pre-market trading Wednesday was immediate. If you listened closely enough to your trading computer screen that morning you could almost hear the pressure being relieved – like a valve being opened! So, for example, an important measure such as the three-month cross-currency basis swap, the rate banks pay to convert euro payments into dollars, dropped to 134 basis points below the euro interbank offered rate after it had earlier in the morning reached a three-year high of 163. European finance ministers continue to develop programs as well to lend support to markets, such as the recent guarantee of as much as 30% of new bond sales from troubled governments to enhance the bailout fund, but the action by the central banks was the main driver this week as it provided immediate relief to markets experiencing the most stress.

Turning to our domestic economy, the U.S. employment report released Friday turned out to offer some relatively pleasant surprises. While the government continues to shed jobs, 20,000 in the month of November, and the gain in the unemployment rate was in part due to a shrinkage in the labor force, overall in our estimation the report contained more positive news than negative. Here is a nice, detailed summary of the data by Ian Shepherdson at High Frequency Economics:

“The private payroll numbers show all the gain in services, with broad gains. Retail is up 50K, and business services, including temps, up 22K. Temp hiring tends to lead permanent hiring, and the recent pace of temp job gains is consistent with permanent job growth accelerating to about 200K per month. Elsewhere, another small gain in aggregate hours worked is welcome; three-month annualized gain in hours is now 2.2%, best since June. Wage growth still very subdued, though, with no sign of any pick-up; y/y at just 1.8%. Overall this is a decent report in the context of an economy growing modestly but there are clear signs in the household employment and temp numbers to suggest better times ahead. Note too that the NFIB small business employment components, released ahead of the full survey on Dec 13, show net hiring intentions at their best level since Sep 08, just before the Lehman bust. Something good is stirring in the U.S. economy.

Other data released this week tends to support our view that the trend, while slow and choppy at times, is heading in the right direction for the U.S. economy. The number from the Conference Board on consumer confidence really blew out expectations coming in at 56 versus the expected 42.5. The figure for Chicago PMI was a solid 62.6 versus the expectation for 57.5 while the ISM index was 52.7 compared to the expectation of 51. Combined with the pending home sales figure which came in at +10.4% (October figure) versus the 0.1% expectation and the construction spending figure of +0.8% versus the expected +0.3%, it shaped up to be a very strong week for key data points. Right now confidence both in markets and global economies is crucial, and actions by the central banks and the strength of the data on the U.S. economy drove stocks and interest rates higher for the week.  

SGK Blog--Update November 23, 2011 Markets Roiled Again 
With only three trading days before the holiday season begins, markets already were dealing with lighter than normal volume.  In such an environment, the effect of any bad news is going to be multiplied.  This week, we saw exactly this happen.  Let us begin with a review of the overseas situation.

Recession signals are mounting in the euro zone, in fact they are probably already there.  Following last week’s 0.2% growth figures for the union, today saw the composite purchasing managers index rise to 47.2 from 46.5.  Though an increase, this broad measure of business activity indicates expansion at readings above 50.0 and contraction below that level.  Additionally, industrial orders plunged 6.4% in September from the previous month.  This series of data is volatile so next month’s reading could reverse to the upside.  Nevertheless, it is an ominous sign and with austerity packages in place in Greece, Ireland, Portugal, Spain and Italy there are not too many other countries left to grow.  Maybe Slovenia will punch above its weight and save the euro.  We kind of doubt it though.

The most troubling news came out of Frankfurt where a German government-bond auction failed to raise the required amount of funds.  They were only able to sell €3.644 of the €6 billion in 10-year bunds on auction.  The average yield was 1.98% and observers called it the worst result in recent memory.  We believe this is a sign that investors are slowly beginning to demand more from Germany viewing it as the lender of last resort for Europe given that the European Central Bank has steadfastly refused to take that role.  Germany is not willingly volunteering, but it is widely expected that if the current crisis afflicting the continent cannot be solved through “grand summits” then Germany will be the country that has to bear the burden of failure.  This comes one day after Spain was forced to pay a euro-era record 5.11% yield on three-month treasury bills at auction.  This is higher than what Greece paid at its last three-month auction a week ago!  According to Barclays Capital, euro zone governments excluding Ireland, Greece and Portugal will need to borrow approximately €800 billion in 2012 to repay maturing debts and fund operations.  This will be impossible if yields continue to skyrocket as they have in the past few weeks.  And now that “cracks” are showing in the previous solid German market, the pressure to do something becomes even greater.  The markets are always forward-looking and it does not see a bright future.

The news was not all good on the domestic front either this week.  Gross domestic product climbed at a 2.0% annual rate for the second quarter versus the 2.5% prior estimate.  This is an increase from the second quarter’s 1.3% rate, but still not very robust.  Consumer spending was little changed, growing at 2.3% versus the 2.4% initial estimate.  Inventories were the biggest swing factor.  They were reduced at a $8.5 billion annual rate, subtracting 1.6 percentage points from growth, compared with a 1.1 percentage point previous estimate.  Fewer inventories means the fourth quarter should see some restocking and a boost to GDP.  But that will only provide about a 0.8 percentage point increase according to economists at JP Morgan Chase.  Today the Labor Department reported weekly applications for unemployment aid rose 2,000 to a seasonally adjusted 393,000.  The less volatile four-week average fell to 394,250 which was the eighth drop in the past nine weeks.  Nonetheless, this figure needs to stay below 375,000 on a consistent basis to push down the unemployment rate given such factors as immigration and Baby Boomers retiring later. 

The headline event of the week was the latest Congressional failure to agree on a plan for balancing the budget or at least making a dent in the deficit.  This time the failure did not have the consequences of previous stalemates—the near-shutdown of the government in March or the debt ceiling crisis in August.  Without such pressures, the six Democrats and six Republicans, in our opinion, decided to put party in front of country and never came to any agreement.  As a result, across-the-board spending cuts totaling $1.2 trillion will take effect on January 2, 2013 and will be spread out evenly over the next nine years in the absence of any further legislation.  About $200 billion will be interest savings and $1 billion will be cuts with 50% from the defense budget and 50% from non-defense (entitlement programs like Medicaid and Social Security are exempt).  Actually, that is not really bad news.  One can argue the Pentagon needs a little more efficiency and there is probably more than $500 billion of waste elsewhere on Capitol Hill.

Unfortunately, with no supercommittee agreement, there was no legislation to attach proposals for items that are expiring much sooner.  In early 2011, employee payroll taxes were reduced from 6.2% to 4.2%.  That reduction is set to expire on January 1, 2012.  Government payouts for unemployment insurance will also cease on that date with no extension.  Also, business R&D credits, individual deduction for state and local sales taxes, the deduction for college tuition and the IRA charitable rollover will also expire.  The Alternative Minimum Tax (AMT) “patch” will also expire thus exposing nearly 30 million Americans to a much higher tax bracket.  However, this provision expires at the end of the 2011 tax year meaning it will not actually hit households until they file their 2012 tax returns (in April 2013) so at least Congress has some time to address that.  Those are the issues that have to be faced by a bitterly divided Congress in the next month before they depart on their “deserved” holiday recess.  Not to mention the 500 lb. elephant in the corner of the room is the expiration of the Bush-era tax cuts (lower tax brackets, 15% capital gains and dividends and estate taxes among other issues) that will expire in December 2012.  Who knows who will control Congress or 1500 Pennsylvania Avenue at that time?

Consumer spending rose only 0.1% in October after a 0.7% gain in September.  This was below the 0.3% increase economists had predicted.  With incomes rising 0.4%, Americans decided to increase savings.  Unfortunately, with the retail Black Friday shopping season kicking off in two days, it is the worst time of the year for the consumer to become frugal.  Businesses also showed their Scrooge-side with bookings for durable goods falling 0.7% after a 1.5% decrease the prior month.  Excluding orders for transportation, that figure rose.  Nonetheless, it is becoming increasingly difficult to see where U.S. growth going forward is going to come from.  Consumers are facing 9% unemployment and the possibility of more taxes if Congress cannot get its act together.  Businesses are still not embracing risk even in an environment of extremely low interest rates.  This can be seen in the declining durable goods orders or the fact that mergers & acquisitions are few and far between though many industries (e.g., banking) are ripe for consolidation.  Exports to Europe are not a huge part of U.S. GDP (1.3%) so a worsening of the euro zone is not a direct negative but the psychological consequences and indirect effect on our banks are another story.  Plus, net exports are usually a negative contributor to GDP anyways as our imports have outweighed exports since the early 1980s.  And the last component of GDP—government spending—is firmly in the cross hairs for reduction to help solve the budget crisis.  It is little wonder that first quarter 2012 GDP expectations are for only 0.5% annualized growth and a return to double-dip fears.

SGK Blog--Update November 18, 2011 Europe's Problems Solved?  Hardly! 

We were guardedly optimistic the other week when it appeared European leaders had rallied to force Greece to adopt reforms and for Greek bondholders to take a 50% haircut on their holdings. It had the makings of a solution, or at least it was a step in the right direction. We remind ourselves however that Jeff here in our office gave components of the plan a solid D+, arguing of the need for the European Central Bank (ECB) to wield the “Bazooka” to alleviate the pressure on credit markets over there. As bond yields for virtually every European Country increased this week on concerns over the potential for contagion, the pressure is mounting on the ECB to act as the lender of last resort to European governments, a role it has so far refused. Germany opposes this step as well. Their arguments, while valid, we believe are really a moot point because sooner or later action on the part of the ECB will be inevitable. The ECB’s argument is that it’s primary or rather only mandate is to fight inflation and bailing out European governments by printing unlimited euros is a risk to both future inflation and their own balance sheet. Germany’s argument is that unlimited bond buying would lead to severe inflation, of the magnitude that scarred Germany in the 1920’s. Both the ECB and Germany would argue that unlimited bond buying would not provide the incentives for the Southern countries to really seriously tackle fiscal reform. The reality is these economies are just not competitive by global standards. The value of the euro is a reflection of the strength of the German economy today. The yield differential between 10 year German government bonds and French government bonds hit an all time Euro era high this week so Germany is truly standing alone at the top of the pack. While the arguments put forth are valid, the problem with their logic, and why we are saying that they will be forced into a situation where the ECB’s tune will have to change, is because the Euro region is on the brink of tilting back into recession. GDP growth across those countries, including Germany, was just +0.2% for the third quarter. So as the region slides into recession, the ECB will be forced to act more forcibly and without question marks or hedging about their strategy or goals. After all, this would not be unique as similar action was taken in 2008 during the heat of the financial crisis in coordination with our Federal Reserve and other central banks across the globe.  

Data on the U.S. economy was surprisingly quite strong for the week. We say surprisingly not because of the general trend, which has been moving in an upward sloping direction for a few weeks as we have been reporting, but rather because of just how good many of the numbers actually were. U.S. retail sales grew at 0.5% for the month of October and 0.6% excluding autos which handily beat the 0.2% expectation. Apparently a whole bunch of people were holding out and are now buying the latest iPhone as sales of electronic goods were very strong! Figures for industrial production, capacity utilization and empire manufacturing all came in well above expectations. Both the producer price index and the consumer price index figures were either flat to negative which was better than expected and could possibly provide our Federal Reserve with a little leeway should they determine it necessary to step in and take further quantitative measures in an attempt to stimulate the economy. Our concern with this latter point is the potential to create imbalances in the economy which can actually be a drag on growth. For example, devaluing our currency can be a mixed blessing. While it can help stimulate exports, we already witnessed oil move above $100 per barrel this week which increases input costs for many companies, not to mention the higher cost to the consumer at the pump. Oil is priced in dollars so oil is sensitive to movements in our currency and also the general outlook for global economic growth. Housing data was also better than expected based on data for both housing starts and building permits. Initial weekly jobless claims for the week ending 11/12/11 came in at 388,000 which was considerably better than the estimate for 398,000. Finally, the index of leading indicators, actually a pretty good measure of future direction, came in at +0.9% versus the expectation of +0.3% when released Friday. Overall, despite all the doom and gloom we read about on almost a daily basis, the U.S. economy is trucking along at a pretty decent clip. 

SGK Blog--Update November 11, 2011 Markets Get Some Signs of Hope

The Italian Senate approved a bill on Friday which paved the way for a decisive vote by the lower house on Saturday which is likely to approve the budget measure. At that point, Italian Prime Minister Silvio Berlusconi would step down. The markets were encouraged by this state of affairs at week’s end compared to the uncertainty and fear that dominated Wednesday’s trading. Investors were focused on the yield on Italian bonds which pierced 7% for 10-year issues at midweek.

Why is Italy suddenly the focus when all the headlines until now were centered on Greece? The European Central Bank (ECB) and other European heads tried to state the case that Greece was an isolated, unique event. They saw that it was a mistake to let them in the European Monetary Union (EMU), and now they were paying the price. Otherwise, the rest of the EMU was fine. Well, the market did not buy that story and now they were letting their feet do the talking so to speak by selling Italian debt. With €1.9 trillion in government debt, Italy accounts for about one quarter of all euro-zone public debt. That is about five times the size of Greece’s public debt. If they could not pay their debts, the European Financial Stability Facility (EFSF) would not be big enough—levered or unlevered—to deal with a collapse.

At 120% of debt to GDP Italy is not as dire as Greece. And its budget deficit as a percent of GDP is actually less than the United States. But if bond yields stayed above 7%, that would be unsustainable over time. When Ireland and Portugal saw their debt yields rise above that amount, it only took a number of weeks before they turned to the ECB for a bailout. Thus, Italy, in the short term, is not virtually doomed unlike Greece. We emphasize short term because new Prime Ministers and budget amendments merely are band aids. As we have argued before, the problem with Italy and much of Europe (outside of Germany and arguably France) is that it is non-competitive. Yes, Italian sports cars are cool but they are way outside of the price range of the average or even affluent buyer. Mercedes Benz and BMW are competitive and sell globally very well. Italian wines are good tasting, but they do not corner the market on alcohol of that type. This a long-term problem which will need long-term solutions. We are not great fans of the economist and professor Nouriel Roubini, but his article published in the Financial Times this week is right on the money when he stated: “Even a restructuring of the debt…will not restore growth and competitiveness…if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies.” This is why every Grand Summit the Europeans hold has a short burst of euphoria followed by cracks in the dam. This will happen again and again and again for years and years until some real hard choices are made. Making the ECB the lender of last resort and starting to meld the fiscal and labor policies of the EMU countries is absolutely crucial for surviving this crisis and laying the groundwork for a more competitive Europe. Whether the political will is there is another question.

On the domestic front, the U.S. got some positive economic data points this week. Consumer sentiment surveys were above expectation. That is good news, but we still prefer to judge consumers on what they actually do than what they say. With the holiday shopping season set to kickoff in two weeks, that will be a crucial test of the strength and confidence of consumers. Initial jobless claims fell by 10,000 to 390,000 in the week ended November 5. That is the lowest level in seven months and below the 397,000 expectation of 46 economists in a Bloomberg survey. The four-week average which smoothes out weekly ups and downs fell to 400,000 from 405,250 the previous week. The number of people continuing to receive jobless benefits fell by 92,000 in the week ended October 29 to 3.62 million. The number of people who have used up their traditional benefits and are now collecting emergency and extended payments rose to 3.53 million. The job front will continue to be a key component of any type of sustainable economic growth.

SGK Blog--Update November 4, 2011 Traders Attention Riveted on Developments in Europe

Once again most the world’s investment focus was centered on Europe.  Greek Prime Minister Papandreou dropped a bombshell on the markets early in the week when he suggested that last week’s Grand Summit agreement be put to a popular vote in his country.  After receiving what we guess was a “stern talking to” by other European leaders and representatives of the European Central Bank (ECB) and International Monetary Fund, he played the other hand he had left.  He reached out to the opposition party and tried to make a deal.  A referendum would have decided the fate of Greece as a member of the European Monetary Union (EMU).  If the public supported the austerity measures which still left Greece with debt at 120% of GDP ten years from now, then they would get the latest bailout funds and avert imminent disaster.  If it was not supported, Greece would not receive any funds, would have to declare bankruptcy and begin laying the very, very messy groundwork for leaving the EMU.  No politician wants the finger pointed solely at them, so Papandreou’s main rival, Antonis Samaras of the New Democracy party, reversed course and said Greece must implement the bailout plan, which he had previously vociferously denounced.  But the drama is not done.  Papandreou faces a no confidence vote today which could see him removed from office anyways.  The vote is scheduled to take place at 6:00PM ET, so we will not be reporting on the result, but it will weigh heavily on next week’s trading. 

What are the rest of the world’s leaders doing while this drama unfolds?  At the Group of 20 industrial and developing countries meeting in Cannes, they look to not only strengthen countries like Italy and Spain which are facing pressures of their own but also help boost the global economy which is never really achieved separation from the global crisis of 2008-2009.  China is reluctant to help: “The solution to the bloc’s debt problems depends on Europe,” said Chinese President Hu Jintao.  The ECB, which can print an unlimited amount of euros and backstop any sovereign debt declines, continues to refuse to be the lender of last resort.  New president Mario Draghi, all of three days in that position, announced a surprise quarter-point rate cut to 1.25% from 1.50% in the key benchmark rate.  That rate was increased to 1.50% as recently as July which means the ECB is coming to grips with the fact that growth is slowing and this might help stem the tide.  What is our take?  More bunk.  There is actually more euro zone inflation now than during the summer which makes the move somewhat contradictory to the sole mandate of the ECB—fighting inflation.  The move is mostly symbolic—what does a 0.25% rate cut mean in the face of value added taxes rising double digits?  The ECB needs to step up and buy bonds like they were going out of style instead of ruling out that action except on a very limited basis.  Plus, we continue to argue the fact stated clearly in this “Heard on the Street” column in The Wall St. Journal: “As long as that remains the case, it simply gives investors in Italian and Spanish government bonds an exit, not a reason to enter.  Over time, that leads to higher ECB holdings of bonds and fewer private investors.”  We admire Draghi and his colleagues high-mindedness and desire to stay above the fray, but as Mike Tyson once said, “Everyone has a plan ‘till they get punched in the mouth.”  It’s time for the ECB to start swinging back. 

Meanwhile the U.S. Federal Reserve had to face the fact that their own economic projections given in June were too robust.  Instead of real GDP growth of 3.3%-3.7% in 2012, now the outlook is for 2.5%-2.9%.  Unemployment was predicted to fall to 7.8%-8.2% next year, but now that range is 8.5%-8.7%.  At this week’s meeting, the Fed governors kept their benchmark rate unchanged near zero percent.  Also unlike the ECB, Fed Chairman Bernanke stated during his new conference: “We’re prepared to do more and we have the tools to do more.”  One can read that as a sign that another round of quantitative easing—QE3—may be on the way.  We think that will depend for the most part on the two issues which has weighed on the market most heavily this fall—the European debt situation and China’s growth trajectory.  If Europe can “muddle through” their situation, then 2.5%+ GDP growth next year seems possible.  However, the U.S. economy cannot take a wounded Europe AND a “hard landing” in China.  What worries us the most is that fixed-asset bubbles (i.e., real estate) nearly always lead to hard landings because housing is such an important factor in any society.  Damaging fissures can take years to appear so this is most likely a late 2012/2013 problem, but it cannot be ignored.  China, unlike the U.S., has massive currency reserves so it might be able to cushion the blow while the U.S. was forced to bloat the balance sheet of the Fed in response to our bubble popping.  We are clearly still in the early innings of the deleveraging crisis.   

U.S. economic news this week was pretty good. Friday’s payroll report showed that the economy created 80,000 new jobs in October with the private sector creating new jobs while government jobs continue to decline. This is consistent with recent trends. While not robust growth, on the positive side, the previous two months figures were adjusted up by 100,000 and the unemployment rate notched down to 9%. Figures for the long term unemployed dropped by the most since they began recording them. Weekly initial jobless claims released dipped below the 400,000 figure which was the first time in a while. The numbers on manufacturing, including Chicago PMI, factory orders and construction spending were all positive, although the ISM figure was weaker than expected. In a nutshell, the economy here in the U.S. continues to trend in the right direction, but progress is slow. And on that cheery note, have a good weekend! J

SGK Blog--Update October 28, 2011 The Running of the Bulls? 

The highest profile event of the San Fermin festival in Pamplona, Spain is the running of the bulls where runners attempt to outpace the bulls through streets narrowed with wooden or iron barricades.  Only by ducking into small gaps in the barricades or leaping over them can the slower participants escape the pounding hooves nipping at their heels.  That event gets the most attention, but similar events happen throughout the rest of Europe in other parts of Spain, Portugal and even southern France.  How does this relate to finance?  Besides the bull being the symbol of a fast growing stock market, Europe’s emergency summits have resembled high octane events with wide media coverage and the outside chance of some gory casualties.  This week, at the 14th crisis summit in the past 21 months, European leaders reached an agreement in Thursday’s early morning hours that they hope will solve many of their problems.  Unfortunately, it falls short of a “Grand Plan.”  Let us look and grade the various pieces.

Haircut on Greek Bonds.  Grade: A
In a “voluntary” agreement, holders of Greek government debt will swap current obligations in exchange for more bonds with 50% face value and other cash considerations.  Only €210 billion of Greece’s €310 billion total debt is in private hands.  Nevertheless, by reducing that burden by about €100 billion, it would lower Greece’s debt to “only” 120% of GDP by 2020 (otherwise it would have been 163%).  We give high marks to this outcome simply because the market has been saying this for months and months—Greek debt is not worth 100 cents on the euro.  Actually 50 cents on the euro may be a bit generous in some circumstances, but it is a step in the right direction especially after the July summit only proposed a 21% haircut.  What cannot be forgotten is that this is “voluntary.”  That means some may not participate.  Why would someone participate if others do not?  First of all, because there is a real possibility of getting nothing as nationalization of the Greek banks is more than 50/50 at this point.  Second, the new bonds are issued under English law not Greek law.  What this means is that any further restructuring or writedown is extremely difficult.  Bonds not tendered may still be written down further so locking in the discount is not ideal but it does end the ordeal.  The euro zone also did think ahead because by declaring this a voluntary exchange, it would not trigger defaults in the credit-default swap, or CDS, market.  Avoiding a Lehman-type meltdown was key for European leaders and including that word may have done the trick.

Raise European bank capital. Grade: D+

Due to the haircut, Greek bonds on the balance sheet of European banks will have to reflect these lower amounts—even if they are not tendered.  One would think that if one’s assets were cut by 50%, that would require a pretty large capital infusion.  However, the European Banking Authority approximated only about €106 billion would need to be raised by the middle of next year.  In reality, it may even be smaller than that because internal balance-sheet adjustments and reducing dividends and/or bonuses would help cover any shortfall.  The amount to be raised may be as small as €10-€20 billion.  The International Monetary Fund identified a €200 billion minimum capital need earlier, but we guess that number was made up since it has not been referred to again.  Our low grade comes from the fact that banks and regulators have had nearly three years since Lehman’s collapse to fortify balance sheets and come up with capital requirements that can actually handle stressful situations (the S&P was up 26% in calendar 2009 and 15% in calendar 2010…a great time to solicit more capital with share issuance).  And this does nothing to deal with the prospect of similar restructurings on Portuguese debt which is already next in the crosshairs.  A 9% Tier 1 capital ratio is a good start but the shenanigans surrounding what contributes to that level leaves the Continental banks still quite vulnerable.  Investors deserve better.

Leverage the European Financial Stability Fund (EFSF).  Grade: C+

It is not quite a bazooka.  It is more like a shotgun.  It packs a kick but its aim is suspect.  We have argued for some “shock and awe” to the EFSF which would scare markets into avoiding shorting any sovereign debt or private bank.  Regulators get good marks for realizing that a €440 billion fund is not enough, especially when about €200-€240 billion is already committed to Greek, Portuguese and Irish bailouts.  What we find not so great is how the fund will be stretched.  The EFSF will offer first-loss guarantees of about 20% to investors buying bonds of troubled countries.  So if we are investors, we are essentially buying these bonds at 80 cents on the euro from day one.  That is fine if these bonds trade at 81 cents or above but as we see from the Greek situation, 40 or 50 cents is a definite possibility and no one is going to happily pay 80 cents to get 40 cents back.  Additionally, the EFSF will provide seed money to a special purpose vehicle (SPV) that will also attract funds from cash-rich countries (like China, Brazil and Middle East sovereign wealth funds).  The SPV will buy bonds or stocks on the open market from entities that get in trouble.  Here, if we are investors, we get comfort knowing that the EFSF is invested alongside us euro-for-euro.  But the question arises, why is a SPV needed?  Why not just go purchase the bonds on the open market directly?  IMF supervision of the SPV is possible but again, why doesn’t the IMF just invest itself?  The bottom-line is that the quasi-insurance and SPV is necessary to get around some contractual issues.  Namely, using the European Central Bank.  To us, this is the solution which gets an “A”.  The ECB is like the Federal Reserve for Europe.  It can print unlimited funds.  Having that as a backstop (namely the EFSF buys securities and uses them as collateral at the ECB in exchange for more funds) would put a halt to any targeting of over-indebted country debt or shaky bank.  But the hard-headed insistence that the ECB not get involved in any fiscal decisions makes this a moot point.  Extraordinary circumstances require extraordinary solutions, and European leaders have still not completely figured this out yet.

U.S. Gross Domestic Product rose at a 2.5% annual rate in the preliminary data released this week.  (There will be two more revisions to this figure as more data is collected with the next or “second” estimate released on November 22.)  That figure matched the median forecast of economists surveyed by Bloomberg News and is up from the 1.3% annual gain in the second quarter.  Final sales, which excludes the effects of inventory builds or drawdowns, rose at a 3.6% pace.  Consumer spending, the biggest part of the economy, rose at a 2.4% pace compared to the 0.7% figure from the previous quarter.  Corporate spending contributed 1.2 percentage points to growth.  Net exports contributed and government spending contributed only minimally to the growth during the three months ending September.  Overall, the figure was good considering the fears which permeated the market during the early fall months.  In a separate report, demand for goods meant to last at least three years rose 1.7% when excluding transportation items like orders for airplanes and automobiles.  That exceeding the Bloomberg News median forecast of a 0.4% increase.  Total orders for durable goods fell 0.8% thanks to a 26% decline in plane orders.  Orders for non-defense capital goods excluding aircraft (e.g., computers, engines, communications gear) rose 2.4%, the most since March.  A cheaper dollar is also helping by making American goods more competitive overseas.  According to the Commerce Department, July and August were the best month for U.S. exports on record.  Also, the Obama administration’s tax compromise allows firms to depreciate 100% of investment in capital outlays in 2011 helping to boost current demand.

In sum, it was a good week for the bulls but there still remain issues to address (e.g., the Congressional super committee seems to have made zero progress with a month to go before its deadline) before year-end.  In the weeks to come, the markets will be running like the individuals in Pamplona and elsewhere, trying to stay ahead of the herd without getting trampled or gored.  Stay tuned…

SGK Blog--Update October 21, 2011 Solid Earnings Mix With European Concerns 

In a news conference Monday, German Chancellor Angela Merkel’s chief spokesman, Steffen Seibert said, “Dreams that are again coming back, that everything will be solved and everything will be over, will again not be fulfilled.” So it begs the question, what were Merkel and Sarkozy talking about when they indicated just last weekend that they would have a definitive program in place to solve the regions debt crisis and backstop the European banking sector by the time the G-20 meets on November 3rd and 4th? Did they know what they are talking about?! Does Steffan Seibert know what he is talking about?!! Needless to say his comments threw a wet blanket over trading Monday as stocks here in the U.S. fell over 2% that day. Seibert’s comments seemed to be backed by German Finance Minister Wolfgang Schaeuble’s statement that he did not expect this weekend’s European summit to reach a “definitive solution,” according to news agency reports coming from Dusseldorf. Our view is at that at this point in time it would be much better if European politicians and officials would simply keep their mouths shut, sit down at the table, roll their sleeves up and come up with an action plan they can agree on. This pattern of stating that they are going to solve this, followed quickly by statements from others saying they are not and nothing is pending, is just frustrating market participants who are simply looking for actions and not words. So there are rumored solutions such as private Greek bondholders now having to take a 50% loss on their bondholdings (that is up from the original proposal from several months ago suggesting a 21% haircut) combined with a fund to backstop the banking sector as that would be the segment hardest hit by write-downs on debt. The reality is that the longer they continue to procrastinate, the bigger the solution is going to have to be. If they wait much longer pretty soon they will all be talking about a 100% write-down on Greek debt because it will be worthless. European leaders and officials are now hearing it from everybody – the U.S. is criticizing them for not taking stronger action sooner, as are the Chinese. Even the Aussie’s (Australian officials) came out this week and gave them a piece of their mind, which is unusual for that country to be so outspoken. So naturally stocks rose in Tuesday trading on the rumor put out by the Guardian, a British newspaper, that French and German officials had agreed to increase the size of the European rescue fund to 2 trillion euros. Naturally, after the market closed a Dow Jones source came out and said that the Guardian report was totally off base. Sheesh!! 

Anyway, on to news we can actually confirm – earnings and the economy! As we report below on our core equity holdings, earnings have held up very well in the current environment. Most of the companies we own reported very solid results and, while acknowledging that the economic environment remains uncertain, they are not seeing the volatile situation in Europe dramatically impact their bottom line numbers yet. While banks and investment banks such as Goldman Sachs reported weak earnings, in a number of cases the numbers were not as bad as one might have thought given the tough trading environment in the third quarter. Several firms, including Goldman Sachs & Morgan Stanley, expressed optimism about upcoming quarters.  Several technology companies released earnings this week and for the most part the results were very good. Companies such as Intel and Microsoft experienced solid results and, to date, they were not forecasting a dramatic drop-off in results in the fourth quarter. On the contrary, Intel for example was very optimistic looking ahead. We report in more detail on our companies results below as we had 11 companies issue quarterly earnings results this week. 

News on the economic front was quite positive this week proving the resiliency of the economy here in the U.S. in September after fears the debt-ceiling debacle in August would totally derail the US economy. Figures for industrial production and capacity utilization were positive and right in line with expectations. Figures on housing were either better or in line with expectations, including the numbers on housing starts and existing home sales. Initial weekly jobless claims continue to hover right around the 400,000 level as they came out right in line with expectations at 403,000 for the week ending 10/08/11.   The CPI and PPI figures were pretty good and demonstrated that despite the Fed’s easy monetary policies, inflation remains in check at least here in this country. Finally, we had our first glimpse into October figures with the Philadelphia Fed survey and it came in at a robust +8.7 figure versus the gloomy expectation for -8.8 and the disastrous September figure of -17.5. So overall this was a good week in terms of U.S. economic data.

SGK Blog--Update October 14, 2011 Markets Await Earnings Deluge

There were a few bellwether companies that reported this week.  Alcoa upheld tradition as the first big name to announce.  JP Morgan, the nation’s second largest bank by assets, held court on Thursday.  Neither reported stellar figures.  The next three weeks will see a torrent of releases and conference calls which will make the amount of rainfall the northeast has received over the past month seem trivial in comparison.  Until then, the focus is on the headlines, and the headlines are about the economy both foreign and domestic.

Overseas, markets were encouraged by debt progress talks between Germany and France.  The number of nations which use the euro as currency is 17, but in terms of who has the most influence, it will come down to Germany and France.  Germany boasts the largest population and nominal GDP in the euro zone and France is second on both items ahead of Italy.  Given that Italian Prime Minister Berlusconi is standing on shaky political grounds—surviving a no confidence vote today—the future of the continent lies with German Chancellor Merkel and French President Sarkozy.  French and German finance ministers said today that they made progress on a package to stabilize the eurozone including maximizing the European Financial Stability Facility (EFSF), progressing on solutions to the Greek problem and strengthening European banks.  This weekend G-20 finance ministers are to meet, and these issues will be tops on the agenda.  The full G-20 will meet in Cannes on November 3rd.  By then, according to Germany’s Merkel, there will be solutions in place. 

What are the options?   By turning the EFSF into a bank, it could use its fund (440 billion euros) as collateral to borrow even more assets from Europe’s central bank—the ECB.  The outgoing ECB chief Trichet has been adamantly opposed to this because it appears to violate covenants of the eurozone’s main treaty preventing the ECB from getting involved in individual country affairs.  The ECB has been able to buy sovereign bonds so far due to its mandate of providing “sterile” infusions.  That is, any investment in a Greek or Spanish bond meant withdrawing liquidity elsewhere.  The new ECB chief, Mario Draghi, takes over on November 1st and it will be interesting to see if his views are the same especially with his home country Italy in such a precarious state.

The EFSF can also be used to insure sovereign debt much like an insurance company.  The problem with that is the bailout fund, recently expanded when Slovakia’s parliament approved the July expanded powers measure, is simply not large enough on its own.  The fund has 440 billion euro-bailout power because it is backed by 726 billion euros of guarantees from the member states.  Nevertheless, Italy’s financing needs are around 400 billion euros each year so backstopping that country alone could bankrupt the fund.

Clearly, something has to be done.  It is our guess that Greek sovereign debt holders—be they individuals, companies or countries—are going to have to take a bigger haircut than previously agreed to.  The 21% discount is merely not enough and something closer to 50%-60% is likely.  That will severely cripple the balance sheet of many European banks which continue to show Greek, Spanish and Italian debt at levels much higher than they are currently trading (and 0% risk according to their stress tests because they are government securities!).  A debt-for-equity swap might be a palatable, and only, solution at this point.  The U.S. government did it by buying stakes in U.S. banks via common equity or preferred.  The banks grumbled but today they stand on much stronger ground because of it.  Again, what makes the market nervous is that solutions that depend upon the political will are much more tenuous than those enforced by the discipline of market forces alone. 

Meanwhile, as that situation continues to churn overseas, some mixed data points appeared this week in the U.S.  Retail sales rose 1.1% in September which exceeded the median forecast of Bloomberg economists of a 0.7% month-to-month rise.  The August figure was revised from no change to a 0.3% rise.  Vehicle sales rose 3.6%, the most since March 2010.  These reports show consumers are weathering a stagnant job market.  To that point, the government’s Job Openings and Labor Turnover Survey for August showed that there were about 4.6 job seekers for every job opening in August.  During the worst of the last jobless recovery back in 2000-2002, there were never more than three job seekers per opening.  A figure closer to two would be normal for an economic expansion.  And here is a sobering thought: if every job vacancy was filled overnight, that would still leave 11 million people without employment.  That is approximately the combined population of New York City and Los Angeles.  And that does not include the one million or so who have given up altogether and are classified as “discouraged”.  With holiday shipments arriving at ports in LA and Long Beach very, very light in terms of tonnage, retailers are betting retail sales will not top last year’s 4.1% growth figure.  Thus, it is encouraging to see that sales so far have not collapsed and the risk of a double-dip recession has not increased, but it is also scary to think that two years after the “official” end of the recession, many households have nowhere to turn to get a job.

SGK Blog--Update October 7, 2011 It's All About Europe!!  

All eyes were once again on Europe this week as the continent continues to dominate headlines and move markets. After Monday’s sell-off in equity markets, the EU’s executive arm said it would present a plan for member states to coordinate a recapitalization of their banks, as regulators met in London to reassess the capital buffers of stressed lenders that received a clean bill of health in July. Sound familiar?! The European Central Bank met this week and, while they did not cut interest rates (huh?!), they did throw a lifeline to commercial banks by turning up its liquidity pumps to provide longer-term cheap money for the growing number of European lenders that have seen wholesale funding dry up as market confidence has ebbed. While this is positive in the sense that the proposed action will be coordinated, in other words markets would not want to see Germany recapitalize their banks on their own, the devil is, as always, in the details. If they implement the “Jeff Gordon SGK” plan as written in last week’s e-mail to our clients then we believe that would go a long way to restoring confidence over there and subsequently in the world economy. The Obama administration is ratcheting up pressure on the Europeans, and rightfully so, to come up with a solid plan prior to the Nov.3-4 Group of 20 summit meeting to overcome the debt crisis by coming up with enough “firepower” to help the weaker member states. This makes sense because simply giving money to the Greeks or providing financing is unpopular in Germany whereas one can present a positive case to the German people to support German banks in the face of the significant financial stress that sector is under. So the key now is to actually come up with a coordinated plan and the ECB’s actions this week has bought them some time. 

Here in the U.S. we had some interesting data on the economy released and for the most part the results were trending in a positive direction. The big news in Friday trading was the better-than-expected payroll numbers for the month of September which indicated the economy created 103,000 new jobs vs. the expectation of 60,000. While positive news indeed, this figure is still below the estimated 125,000-150,000 new jobs needed to be created each month to bring down the unemployment rate. Sure enough this rate stayed stubbornly fixed at 9.1% nationally. Still there were a number of highlights in the report worth noting. Once again, the private sector accounted for all the job gains adding 137,000 while the government shed 35,000 jobs. Additionally, the figures for both July and August were revised upwards. If you recall, the August report indicated that there was 0 job growth in that month and the revised figure came in at +57,000 which is obviously better. On Thursday the initial weekly jobless claims figure for 10/1/11 came in at 401,000 which was also better than expected, as was the report from ADP which we highlight below. Two very important figures were released this week and those were the Institute of Supply Management’s ISM report for manufacturing, which came in at 51.6 versus the expectation of 50.5, and the ISM Services report which came in at 53 versus the expectation of 52.8. While the numbers did not blow away estimates, a number above 50 in each of these measurements is a signal the economy expanded in September so, once again, we will take it!!
SGK Blog--Update September 30, 2011  Europe Gets a Lifeline  

On Thursday, Germany’s parliament agreed to increase the euro-zone bailout fund’s lending capacity to 440 billion euros from 250 billion currently. Many view this step as one that was crucial but probably not sufficient to solve the continent’s problems. All 17 euro-zone governments must ratify this change which grant new powers to the fund. So far fourteen have authorized the changes including France, Italy, Spain and Finland with Estonia and Cyprus approving yesterday and Austria today. Germany’s vote was the most important because with it, that country will have to guarantee 211 billion euros of the total, up from 123 billion euros previously. German Chancellor Merkel was feeling heat within her own party concerning supporting the increase as many citizens are very reluctant to bailout what they see as undisciplined financial systems in the south. The European Financial Stability Facility is due to expire in 2013 and will be replaced by a permanent European Stability Mechanism.

We have argued in the past that even more is needed. The “bazooka” strategy suggests that the bailout fund should be allowed to borrow cash against its capital from the European Central Bank (ECB). That cash can then be used to offer loans to member states or even take stakes in banks which are starving for capital. Those stakes can then be used at the ECB as collateral for even more cash. And so on and so on. This creates a virtually unlimited money machine and unlimited is larger than 440 billion euros. No sane investor in the world is going to bet in favor of a decline in value of any bond or equity stake if infinite resources are available to prop up the price. Some critics worry that such a strategy would violate the ECB pledge not to fund member states. German lawmakers also fear that such leveraging might cost the country its AAA-credit rating.

The European Union’s stat agency Eurostat said consumer prices rose 3.0% in the 12 months ending September. That is above the ECB target of 2%. Why this is important is because the ECB only has one mandate—to control prices. The U.S. Fed has two—stable prices and full employment. In fact, the ECB has raised rates earlier this year due to inflationary concerns. Meanwhile, since that rate increase the euro-zone has experienced a slowdown in all its regions. The purchasing managers index for the euro-zone fell to 49.2 in September from 50.7 in August. A number below 50 is generally considered a signal of contraction. Economic sentiment among manufacturers have also fallen. Unemployment continent-wide is 10% with a 6.0% rate in Germany and a 21.2% figure in Spain.

What does all this mean for the future? In terms of a timeline, on October 6th, the ECB will meet and might possibly lower their benchmark rate given the fall in region-wide growth. That will also be the last meeting headed by outgoing ECB President Jean-Clause Trichet. The incoming president, Mario Draghi, is Italian and will be under pressure to prove his inflation-fighting skills lest observers brand him profligate like the image many of have of his countrymen. On October 13th the euro-zone finance ministers will meet to decide on releasing the next aid payment to Greece. If they do not, it is likely the Greek government will run out of money by the end of October. On October 14th-15th there is a G-20 finance ministers’ meeting. By then, all of the EU nations should have ratified expansion of the stability fund and meaningful discussions on leveraging the fund can be had. On October 17th-18th there will be a EU summit to discuss reform of euro-zone economic governance. So, the calendar is full of key dates and potential headline-making moments. With U.S. companies reporting their third quarter earnings about this time, expect a volatile month ahead.

In domestic news, real gross domestic product rose at a 1.3% annualized pace in the second quarter, faster than estimated last month. Previously, that figure was 1.0%. The figure was revised upwards because net exports were better and consumer spending, the bulk of real GDP, was 0.7%, up from 0.4%. According to a Bloomberg survey of economists, the economy is expected to expand at a 1.8% pace in the third quarter and 2.2% in the final quarter of the year. If the predictions hold true, it would continue the slow but steady progression many have come to expect. And even if those numbers are uninspiring, it would put to rest fears of a recession which involves at least a quarter of negative growth.

SGK Blog--Update September 23, 2011  Fed Pushing on a String  
The Federal Open Market Committee met this week and stated they would begin another program intended to push the U.S. economy higher. Dubbed “Operation Twist”, the Fed will sell $400 billion of Treasury securities that will mature within three years and re-invest the proceeds in securities that mature in six to 30 years. According to the FAQ statement that was released with their usual statement, “the action should put downward pressure on longer-term interest rates…The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery.” The Fed also take proceeds from its maturing mortgage-backed securities and invest them in other mortgage-backed securities. For the past year, they had been using those monies to invest in Treasury bonds. However, pressure in the mortgage-backed securities market has led to widening yields (falling prices) lately and was threatening financing in that important part of the real estate market.

Now that we know why the Fed did what it did, the big question is will it work? It had an immediate effect. Yields on short-term Treasury securities inched a little higher and yields on the 30-year Treasury bond fell the day of the Fed announcement. But these moves were not huge. More importantly, will the overall program, due to conclude by June 2012, achieve the Fed’s mandate: maximum employment and price stability? Our opinion is it is highly unlikely. First the bad news. Corporations in the S&P 500 are currently sitting on trillions of dollars of cash. Yes, some of that is held overseas and would be subject to high tax rates if repatriated, but the majority of funds are held domestically and are not being spent. Mortgage rates are at multi-decade lows and housing affordability is approaching levels last seen in the middle of the previous decade. Banks are still reluctant to lend given the uncertain regulatory environment and also because they realize that some of the real estate held on their books are likely not truly marked-to-market making their capital position even more precarious. Keeping rates low has not triggered massive investment and the latest Fed program is unlikely to change that, hence the title of this week’s weekly update.

What’s the good news? All of these problems are solvable. The issue is who in the political world has the will and support to carry them through? The tax system in this country, in our opinion, needs a critical, fundamental overhaul but there are still no credible plans on the table. Foreclosure issues which are plaguing large banks around the country need to be solved quickly. Instead, state attorney generals continue to bicker with the banks and with each other meaning that the “shadow inventory” of houses gets no lower and prices in the market remain far from market clearing levels. The congressional supercommittee has just over two months to reconcile their differences or automatic spending cuts will come into play as determined by the budget deficit compromise reached in August. As we stated in earlier weekly writings, austerity with no tax increases is exactly playing out in real time in Greece (of course, the problem there is a failure to collect taxes rather than the level itself). This country has ability to collect higher taxes but political forces have dug deep trenches against such solutions virtually ensuring that what we are seeing in Athens will play out on our streets in the future. As we stated, these issues are solvable but it will take ceding ground on both sides to come to a workable solution.

Officials from the group of 20 advanced and developing economies said yesterday they would “take all necessary actions to preserve stability of banking systems and financial markets.” Of course, like a lot of communications from such bodies, there were no concrete actions given. They did vow that by their next meeting in mid-October, European parliaments would have passed the European stability fund. That would take pressure off the European Central Bank which has had to step in and buy sovereign debt as investors shunned credits from Italy and Spain due to their debt uncertainty. We remain in the wait-and-see camp. As bad as Capitol Hill has been, it is an ocean of harmony and peace compared to the European Union.

Against this geopolitical backdrop, there was some good news. Existing home sales, which comprise more than 90% of all home transactions in the country, was up a surprisingly 7.7% in the month of August compared to July. That stat reached a five month high of 5.0 million annualized compared to 4.7 million in July. Nevertheless, it would now take about 8.5 months to clear all the unsold homes on the market given this sales pace.  Of course, that also does not include foreclosed or foreclosure-in-process properties which have not been put on the market for various reasons. Thus, this figure may turn out to be a one month aberration, but at this point, any good news is more than welcome.

SGK Blog--Update September 16, 2011  Central Banks Inject Liquidity Into European Financial System in Coordinated Action  

The major headwind which continues to suppress equity prices and keep interest rates low here in the U.S. remains the uncertainty surrounding the European sovereign debt issues. There were several important developments on that front this week. Certain bank stocks, particularly in France, remained under pressure this week due to their exposure to the debt of nations currently facing borrowing issues including Greece, Italy and Spain. This raises the issue of whether or not governments in Europe are going to have to step in to recapitalize the banking sector in Europe. While our banks here in the U.S. are very well capitalized and have limited exposure to European sovereign debt, the selling pressure on financial company stocks in Europe has spilled over to our banking and investment banking sector here in the U.S. The major banks and investment banks do have operations in Europe so there is the direct impact. We believe the counterparty risk in terms of money market exposure or exposure through derivative transactions is limited and U.S. banks have been paring back sharply in these areas anyway. If governments in Europe are forced to recapitalize banks in Europe it would imply that the equity in these banks would basically be potentially worthless or close to worthless and it raises issue over their subordinated debt as well. We received assurances this week from the CEO’s of each of the three major banks in France but assurances do not placate traders. They need hard facts! These same banks claim to be well funded and well capitalized but it is also true that they have not marked-to-market the value of some of their sovereign debt holdings. Some Greek debt is trading at $0.40 on the dollar or a 60% discount to par value. SocGen, a prominent French bank at the center of much of the attention, issued statements on capital suggesting that even if Greek debt was marked down 26% they are still fine. Their logic is that this was the mark-down being discussed at the private sector debt negotiations meetings. Our issue is that this does still not represent a true mark-to-market price.

The issue ties back to how the United States handled the situation both during and post financial crisis. While not perfect, the U.S. threw close to $900 billion in total at financial companies if you include Fannie, Freddie and AIG along with the banks during the heat of the financial crisis. (Think TARP!) This helped stabilize the system. Once stability was established, we performed rigorous stress tests on all the major banks and made the results transparent. We also required many of these banks that did not pass muster to raise capital, which they subsequently did. They raised capital at a time when confidence in the financial system had been restored. Europe, as we have already written, did not go through this process and it is now coming back to bite them in a really big way. Their stress tests were simply not very good and they have repeatedly kicked the can down the road. News out of Europe this week was mixed.  The European Central Bank or ECB once again stepped in to lend dollars to two euro-area banks, a sign those banks are having difficulty borrowing US dollars in the markets. The ECB allotted $575 million in a regular seven day liquidity providing operation at a fixed rate of 1.1%. The fact that two banks had to borrow from the ECB at those levels is a sign of stress in the system.

Thursday five central banks, including the ECB, our Federal Reserve, the Bank of Japan, Swiss Central Bank and the Bank of England, acted in a coordinated effort to add liquidity to the global financial system – specifically to help European financial institutions. The ECB coordinated the offering of three separate three-month loans through an auction facility to ensure that institutions there have funding through the end of the year. We have been following closely the fact that US money market lending to European banks has dried up as funds have become more conservative given the banks’ exposure to sovereign debt. So while this action does not solve the issues we highlighted in the above paragraphs, it did provide a boost to confidence and a much needed injection of liquidity. This helped stocks rally globally in Thursday trading. The key to the action is that the European banks could provide euro denominated collateral instruments and receive dollars in return – and this makes these swap facilities unique. These facilities were used extensively during the heat of the financial crisis in 2008 and helped alleviate interbank lending pressures. 
Enough about Europe! How are we doing here in the US? Once again the data was mixed for the week. There were positive indicators, some of which were surprising after the shocks to the system that occurred in August. For example, important measures of manufacturing including capacity utilization and industrial production came in meeting or exceeding expectations which was a bit of a surprise to us as we expected a sharp slowdown in activity in August. Manufacturing for the month was helped by strong exports so that was a positive development, as evidenced by the lower than expected current account deficit figures. The early read on consumer confidence for September, the University of Michigan sentiment survey, came in at 57.8 versus the expectation of 56.3 which we actually felt was lofty. This was a positive and perhaps an indicator that the consumer recognized in part that the world did not come to an end in August and things are not quite as bad as the volatile stock market and so-called pundits made things out to be. Worrisome to all though, the weekly initial jobless claims ending 9/10/11 rose to 428,000, considerable higher than the estimates of 410,000, and this was disappointing to say the least. Inflation data was mixed according to the PPI and CPI figures that came out this week and retail sales were weaker than expected. All this points to a continued slow-growth environment from the standpoint of the big picture in terms of the U.S. economy.   
SGK Blog--Update September 9, 2011  ECB Shakeup Roils Markets as Obama Unveils Jobs Plan   

President Obama delivered his highly anticipated speech to a joint session of Congress last night.  The main points of the plan include payroll tax cuts for employers and employees, extending unemployment insurance and infrastructure investments.  On the one hand, these are not new ideas--the president did comment frequently that they were born out of policies previously winning bipartisan support.  On the other hand, given the stage in which they were delivered—to a national television audience close to prime time and mere weeks after the S&P U.S. debt downgrade and only a few months before the Congressional Super Committee must come up with deficit compromises—the proposals took on an added weight.  How will the $447 billion plan be paid for?  The usual closing of tax loopholes and other deficit-reduction deals was mentioned.  Only through the usual 10-year budget planning window does $447 billion of spending today get covered with $447 billion of revenue.  This logic helped pass the health-care reform bill under the guise of “reducing the deficit”.  More mortgage modification plans (this time, they will work!!) and more unemployment benefits are simply more examples of kicking the can down the road in our opinion.  The likelihood of his entire package being passed is close to zero.  Tax cuts are likely to be pushed through since the Republican-controlled and Tea Party-influenced House seem to have a firm control over Congressional direction even in the face of the Democratically-dominated Senate.  The bottom line is that a $447 billion proposal with over half of it based on temporary tax cuts is not enough in a $14 trillion economy.

We believe the tone and direction of the president’s message is correct but it is not bold enough.  A recent article in the “Heard of the Street” column in The Wall Street Journal hits the nail on the head.  The markets are screaming for the government to borrow and spend.  The 10-year Treasury is getting comfortable in the yield range below 2% finishing today at 1.92%.  For ten years, investors are lining up to give money to the government for a decade and expecting a mere 2% in return.  Our advice is listen to the markets.  However, as the article points out: “The key question when contemplating further stimulus is whether the money can be spent sensibly.”  This is the problem.  More tax cuts don’t help people who don’t have jobs.  Payroll holidays only inspire hiring if there is demand for the product.  The folly of buying two to get the third item free only becomes apparent when the shopper realizes they didn’t even need one in the first place.  In other words, small business is the engine of growth for the country job-wise yet they won’t hire just to get a tax break.  The main reason they are not hiring is because the usual buyers of their product—big business—continues to sit on cash and not invest and banks are hesitant to lend given uncertain financial regulations and global environment.  The article also states: “It is through improved competitiveness that the apparent paradox of an expansionary fiscal contraction is resolved, not via confidence alone.”  Fingers crossed is not a strategy.  There are indeed hundreds of billions of dollars’ worth of “shovel ready” projects but the red tape has to be cut and quickly.  Massive projects like upgrading the national electric grid, modernizing our air traffic control system and establishing a true, national high-speed rail network would put millions back to work…but it will cost much more than $447 billion.  That is why higher taxes in some way, shape or form is crucial for the U.S. to bring itself out of its malaise.  We dislike them just as much as the next person, but sometimes bitter tasting medicine is what it takes to heal the patient, nothing more and nothing less.

Against this backdrop comes a bombshell out of Europe: Jurgen Stark, Germany’s top representative on the European Central Bank’s executive board, resigned today.  This was clearly a political move though the ECB said it was for “personal reasons.”  He had three years left on his contract and he was head of the economics group which did the analysis for ECB’s interest rate decisions.  He has been outspoken against the ECB’s bond buying program.  Former Bundesbank President Axel Weber resigned in April after he was tagged by many to succeed current ECB President Trichet who will step down himself in October at the end of his eight year term.  If Mr. Stark is not replaced by another German, the ECB could have only one German on the 23-member governing council.  Given that Germany is the Euro zone’s largest nation and strongest currency, such a small representation would suggest that the country cares very little for European unification which would spell doom for the common currency.  This is exactly what the markets do not need right now especially after Trichet this week said threats to the Euro zone faces “particularly high uncertainty and intensified downside risks.”   These remarks and Stark’s resignation have sent the euro down.  Now $1.37 buys a euro compared to $1.44 at the end of August.  Rumors have also circulated that Greece will go into default thus wiping away a lot of their obligations but also crushing the European banking industry which still has not written down sovereign bond investments to market value.  In doing so, many of them would become insolvent.  U.S. banks have much stronger capital bases but the global financial markets are correlated unlike ever before which is why banking issues abroad are also headaches here domestically.

SGK Blog--Update September 2, 2011  It's All About the Economy!   

This week we witnessed a ton of information issued on the current state of the U.S. economy, including our first taste of the uncertainty that embodied the month of August.   As we suspected, the data indicates that the economy had been on an upward trajectory according to July data, albeit a slow & somewhat uneven upward trajectory. That all did not exactly come to a screeching halt in August, but the initial data we do have on the month indicates that confidence, both at the consumer and business level, has been altered in a negative way thanks largely to political uncertainty stemming from both Washington and Europe. 

Our point with respect to July was reinforced first thing Monday morning when data on personal incomes and personal spending were released. This helped set a positive tone for equities Monday as consumer spending climbed 0.8% which was more than the expected 0.5%. Income grew at 0.3% which is a sign that the consumer was becoming a little more confident about saving a little less and spending a little more in July. Autos, for example, sold at the fastest pace in three months as supply constraints from Japan’s March earthquake began to ease. There were some other positive underlying trends which initially bode well for the third quarter GDP calculation as, for example, spending adjusted for inflation figures, used to calculate GDP, grew at 0.5% which was the highest level since December 2009. There was also a little bit of positive news on housing this week as the Case-Shiller 20-City Index for June showed that prices in the 20 cities actually climbed 1.1% from the previous month before adjusting for seasonal changes. Case-Shiller emphasizes that the year-over-year gauge, which declined 4.5% from June 2010, is a better measure of the long-term trend. While it is hard to argue with that, this number was better than expected and we are really seeking hints of stability in the market as opposed to a dramatic shift in the year-over-year trend at this point, so the news was received reasonably well. Although construction spending was weaker than expected in July, factory orders came in at a relatively robust +2.4% which was higher than expected reinforcing our point that the economy was on better footing in for the month of July.

We had a taste of what is to come on August data when we received the Conference Board’s measure of consumer confidence for the month of August. This came in at 44.5 which was well below economists’ average forecast for 52. We would emphasize this was not our forecast. We wrote two weeks ago we need to brace for some tough economic data coming out of the month of August. This measure came as no surprise to us whatsoever. As we previously indicated we believe certain economists are prone to mailing in their forecast weeks in advance so as to not interfere with their vacation time in the Hamptons! While initially dipping over 100 points on the Dow, markets climbed back throughout the day as apparently traders were not completely taken off guard by the result as well. Some August data was surprisingly not as bad as expected. The Chicago purchasing managers index or PMI came in at a healthy 56.5 versus the expectation for 53 and the national manufacturing figure, the ISM index, was better than expected at 50.6. A number above 50 signals expansion and economists had forecast a figure that would have reflected contraction in the economy. Unfortunately, economists had forecast that the economy would create 65,000 new jobs in the month of August according to a Bloomberg survey and the figure came in at unchanged. In other words, no job growth for the month of August. This includes 48,000 striking workers at Verizon though as the national survey is conducted differently than the ADP report, which does not count these workers as unemployed. Now that those workers are back to work they will be added back to the September figure. Additionally though, job growth for July was revised downward to 85,000 from the previous figure of 117,000. Hourly earnings also dropped -0.1% so there really was no good news in the August jobs report and this, along with further pressures from European markets, contributed to the sell-off in equities and the rally in bonds in Friday trading.  

Two other important factors also played into market results this week. While there were several tragic stories coming out of the aftermath of hurricane Irene, the overall damage resulting from the storm turned out to be less than expected. This helped boost the stocks of insurers and financial shares in general early in the week. Additionally, the minutes from the last meeting of the Federal Open Markets Committee or FOMC were released this week and traders were surprised that a few of the Fed’s policy makers were in favor of more aggressive action on the part of the Fed at their August meeting to stimulate the economy and lower unemployment.  This implies the Fed will rigorously debate their options at their meeting in September, which has now been extended to two days probably to help forge a consensus given the Fed now seems somewhat divided. So we are certainly noting that meeting on our calendars!  

As far as Europe is concerned, it is almost as though no news coming out of there is good news on a typical trading day. Monday’s markets were sparked in part by news that two large Greek banks had decided to merge and that sent their stock market up 14% which we have not witnessed in a really long time. Finland remains an obstacle as they are demanding collateral for any loan support they provide Greece. While that sounds great for Finland, we do not believe Germany and France are comfortable lending money to Greece for Greece to then basically turn around and give the money to Finland in order for Finland to loan them money. As confusing at that sentence appears to be at first glance (or after several glances) that is basically what they are asking for because Greece is basically bankrupt at this point and frankly it undermines the underlying tenets of the rescue package. We have officially nicknamed it the “European Financial INStability Facility.” This mess in Europe is not likely to be cleared up over there any time soon as they are all seemingly up for reelection in the near future. Christine Lagarde, the current chief of the International Monetary Fund, called on European countries to urgently recapitalize their banks. Her comments resonated well with investors and represented a refreshingly honest new approach to the situation in Europe, as that has been one of the key sources of uncertainty that has been brewing for some time and really came to a head here in the month of August. Of course, French finance minister Christian Noyer reassuringly (that’s sarcasm by the way!) said Tuesday he really didn’t understand her comments and that French banks were fine so she must have been referring to other banks. And we thought some U.S. politicians were knuckleheads! In Europe, they keep making comments to reassure markets while kicking the can down the road so-to-speak and that is anything but reassuring to market participants. This is likely to remain a headwind for years to come as these problems will not be solved overnight and the economic data coming out of Europe indicate they are very close to tilting back into recession.     

We always find ADP’s National Employment Report to be interesting when released. While a lousy predictor of what the Department of Labor national report will look like, which comes out the first Friday of each month, it is a good indicator of where the jobs are being created in the private sector. According to this month’s report for the month of August the private sector created 91,000 new jobs. 58,000 of these were created by small businesses, 30,000 by mid-sized businesses and 3,000 by large businesses. This has been a consistent pattern as we monitor the data all year. So the primary driver of hiring in the economy right now is the small business sector which primarily consists of S corporations and LLC’s. So when President Obama indicates he wants to “tax the wealthy,” which he defines as those earning $250,000 or more, then he is squarely targeting small business owners right on the chin. As small business owners who in fact hired someone in 2010 during a still tough economy we do find this rather irritating at times. Boeing earned $1.9 billion in profits last year and benefitted from tax loopholes approximating $400 million. Boeing may be hiring but it is certainly not happening here in the United States according to the data. So we are all for everyone paying their fair share, including us, but please let us establish a simpler tax code with a fair tax rate for all. Predictability and stability would be nice as well! When we hire and invest as small business owners, we are efficient and those dollars are directly injected into the U.S. economy, which in turn has a multiplier effect. It would be refreshing if more in Congress grasped that concept.  

The Obama administration further strained relations with the business community when the Justice Department sued AT&T to block their acquisition of T-Mobile. It is one thing to sue a company but the way they have gone about it, which we discuss further below in our “Company Events” section, is just not business friendly. Add to this news that the regulator that oversees Fannie and Freddie, the Federal Finance Housing Agency or FFHA, is going to sue the banks accusing them of bundling subprime home loans into bonds that should have never been sold to investors. So let us get this straight, the government gave the banks money as part of the TARP program during the heat of the financial crisis and now when confidence in the banking sector is fragile and weaker now than it has been at any time since the financial crisis, the government is going to sue the banks?! I am not sure we have much to write about this subject that is appropriate to print in this forum!

SGK Blog--Update August 26, 2011  Much Ado About Bernanke  

Fed Chairman Ben Bernanke’s Jackson Hole, Wyoming speech got plenty of market attention.  Similar to the gossip and rumors which propelled the plot of Shakespeare’s 16th century play, traders and investors were seeing ghosts of QE3 when in reality there were none.  Though many market pundits said in advance that they did not expect any more quantitative easing, their constant and repeated denial almost made it seem as though they were trying to convince themselves of that fact.  When all was said and done, the speech was nothing more than its title—“The Near- and Longer-Term Prospects for the U.S. Economy.”  The annual event is an economic symposium—not exactly rock concert material.  Last year Bernanke hinted at QE2 at Jackson Hole and then the Fed implemented the program last November.  As a result, this year’s event became the must-have ticket of the summer.

The only semi-hints of future policy action were two items.  First, the scheduled September Federal Open Market Committee (FOMC) meeting was expanded to a two-day meeting from one day.  That may mean simply that it will allow time for further discussion among the Fed governors.  Does that mean more time to discuss QE3?  Possibly, but that would be a stretch to assume.  Second, Bernanke noted the Fed is “prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.”  That was a little more detail than was provided in the statement released after the August 9th FOMC meeting.  But again, it would be a bit of a stretch to think that this statement is the precursor to another multi-billion dollar bond buying program.  He did not discuss in depth the actual tools that could be used (he said refer to the August statement) or what triggers would cause such tools to be pulled out of the toolbox (like he did at last year’s speech).  As such, we believe that the Fed realizes that it has done a lot but it cannot do it all in terms of healing the economy.  With deflation less of a threat this summer than last year, we believe the Fed will be on hold though they could implement some tweaks to policy that increases the duration (price sensitivity) of their holdings or make it less desirable for money center banks to hold deposits at the Fed window.

A portion of his speech was directed towards Capitol Hill and the White House.  He urged Washington to put the country on a “sustainable path” by promoting growth through “the design of tax and spending programs” promoting expansion.  He emphasizes that in order to have the “country’s fiscal house in order” it will take making better fiscal decisions.  The markets have been telling Congress and the President this for some time.  An article which was circulated in our office which is simply excellent in describing what has happened not only over the past month but over the past few years was published in the Outlook section of The Washington Post on August 14th (click the link here: http://www.washingtonpost.com/opinions/what-is-the-stock-market-telling-us/2011/08/10/gIQACdVoBJ_story.html ).  It was written by Liaquat Ahamed who won the Pulitzer Prize in 2010.   The markets don’t care about austerity.   Budget deficits are about as new as color TV.  Yes, those two statements are a bit heretical in today’s political climate and possibly a bit simplistic but the bottom line is that the markets are not overly concerned if $15 trillion is spent, as long as it generates $15 trillion + $1 in income.  It wants growth and that comes from jobs which is the byproduct of wise investment.  Bernanke is too much of a politician to say the same thing outright.  The markets, however, have no problem voting with their feet—no major bourse in the world is down less than 10% year-to-date.  As the article states and we have been stressing week after week: “economic recoveries from such crises tend to be anemic and protracted.  This one will not be different.” 

SGK Blog--Update August 19, 2011  Equity Markets Rattled By Uncertainty in European Banking Sector 

After last week’s market volatility, the relative calmness for the first three trading days of the week was a welcome relief. That calmness was shattered in Thursday trading as markets were impacted on several fronts. There was a headline article in the morning’s Wall Street Journal about how the Federal Reserve and the New York Fed were closely monitoring the U.S. funding reserves of European banks with operations here in the U.S. The concern being if European banks were siphoning off dollars to help support their European operations. This makes sense and it is what the Federal Reserve and New York Fed should be doing. The article pointed out that while cash reserves were plentiful and were at $758 billion as of August 3rd, significantly higher than one year ago and higher than at the start of the year, they were about 16% lower than three weeks previous implying that funds had been withdrawn during the recent turmoil. Add to that the news Wednesday that an unidentified European bank had borrowed $500 million in one week debt from the European Central Bank and the combination of this news sent banking stocks down globally, and with them global equity indices. 

This is not 2008, we do not have a financial crisis and the Fed and ECB have mechanisms in place to support the banking system, but it built on last week’s shaken confidence in the European banks and whether or not their levels of capital are sufficient to withstand an economic downturn. So it is a question of confidence. Borrowing $500 million from the ECB is peanuts compared to the levels of borrowing banks did during the financial crisis or even during the second quarter of 2010 but the fact that a bank had to do it at all points to a level of stress in the European banking system that is concerning. That bank paid a higher cost than what other banks would pay to borrow dollars from fellow lenders. It ties back to our comments during the period when the Europeans were stress testing their banks – there was simply not enough information released at the time. To simply say that 95% of the banks passed was not enough – market participants need more information. So the uncertainty and waning confidence is what sent European bourses sharply lower and our stock indices lower as well, while bonds rallied sharply.

Feeding off of that anxiety was the first bit of news we have had with respect to how consumers and manufacturers are receiving the news with respect to the latest round of the European Sovereign debt issues and the gyrations in global stock markets, and the news was not pretty. In fact it was pretty awful! There is no sugarcoating the US Philly Fed manufacturing survey which dropped to -30.7 in August from +3.2 in July. Economists had forecast a number of +1 which proves once again that they must have all been on vacation in August when polled and mailed their answers in during the month of July. The new orders index plunged to -26.8, the shipments index dropped -13.9 and the employment index fell -5.2. So there really was no good news in this report. It does not bode well for the ISM number for August which will be released in September. We would expect this to drop below the boom/bust level of 50 when released in September. So we must brace ourselves for tough economic news to be released in September based on the preliminary look we have had here in August. 

Wednesday also coincided with the release of the data on existing home sales in July which showed a 3.5% decline to 4.67 million from 4.84 million in June. Part of this fall was due to an unusually high number of signed contracts being cancelled and again is a sign of falling housing demand and waning confidence. Adding to concerns, both the producer price index (PPI) and consumer price index (CPI) figures were higher than expected and this diminished traders hopes that an additional round of quantitative easing, which we shall heretofore refer to as QE3, is pending or will be on its way anytime soon. We should mention that core CPI, which excludes food and energy, was in-line with expectations up 0.2% in July. Initial weekly jobless claims unfortunately climbed back up above the 400,000 level to 408,000 which was about 8,000 more than was expected. 

It was not all horrendous news this week, the figure for the leading indicators in July was up 0.5% versus the expectation of 0.2% and industrial production for July came in at a relatively robust +0.9% compared to the expectation of +0.4%. Capacity utilization also showed that factories in the US were working harder in July than in previous months as this number came in above expectations at 77.5% which was up from the June figure of 76.9%. We will have to see but we would suspect that these numbers will also come in lower for the month of August when released in September as companies adopt a wait and see attitude before ramping up production again. 

There is no question the market turmoil here in August, precipitated by the acrimonious debate over raising the debt ceiling in Congress, will exact a toll on the consumers’ psyche in particular. Once again people will have seen their 401k’s decline for the month (the month is not over of course) and every day they are reading headlines about market volatility and political bickering. These two ongoing concerns do not inspire confidence. Europe seems to be teetering on the brink of recession based on the latest readings on their economies over there. Concerns over their banking sector may be overblown but those concerns can feed off of each other and rumors can eventually lead to reality. Central banks have mechanisms in place to ease pressures on the credit markets and banks are significantly better capitalized than pre or during the financial crisis of 2008. With that said, confidence is a fragile thing and leadership seems to be sorely lacking at the political level. European politicians, and the ECB for that matter, seem to be frequently playing catch-up. The meeting between French President Nicolas Sarkozy and German Chancellor Angela Merkel produced some positive initiatives but was once again short on substance and the proposal of a tax on financial transactions did not help soothe traders concerns. They called for better integration and coordination amongst members of the European Union especially as it relates to fiscal matters and budget deficits, but they dismissed calls for a European bond which would have helped alleviate concerns over there. The problem is that coordination amongst the 27 EU member states is frequently like herding cats! 

So with the generally negative news out this week the question is will the US dip into another recession and is that currently priced into equities? The answer to the first question is that it is possible - the definition of a recession is two consecutive quarters of negative GDP figures. Given weakness in GDP early in the year (the figure for the second quarter was +1.9% and is subject to further revision) and given shaken confidence here in August we cannot rule out that possibility but we do not believe the economy is there yet. There is no question that with the stock market (measured by the S&P 500) having retreated over 10% here in the month of August following the 2.1% decline in July that stocks are pricing in a great deal of negativity. Valuations are far more attractive than they were during the second quarter and we are hearing from the companies we own for you that they are doing just fine. We will definitely hear more cautious tones when third quarter earnings are released in October as it is very important for companies to set appropriate expectations. At the same time, the company’s we own have been taking all the right steps in strengthening their balance sheets and pursuing cautious approaches with respect to spending and hiring so they are well prepared for a downturn in the economy. As we have said on numerous occasions, the best approach right now is to maintain a healthy balance in our portfolios. Fixed income securities have done well and help to offset stock market volatility. We own gold through our diversified commodity security and it varies between the second and third largest position within that holding. At current prices though gold is both risky and expensive. By itself it is not a safe haven as it is extremely volatile on a day-to-day basis. It is currently appreciating on concerns over sovereign debt issues and, from a supply standpoint, central banks are adding to their reserves. At the same time, gold does not provide any income nor is it used in industrial production. The largest holders of gold are hedge funds and ETF investors – both notoriously fickle traders. As prices have risen, prominent hedge funds such as those run by George Soros have been cutting back on their gold holdings. As we have said, it makes sense to own gold but in our view in the context of a balanced and diversified set of commodity holdings. As a “Fast Money” trader recently said on CNBC, when your cab driver tells you he sold all his stock holdings and bought gold, you know it is time to sell all your gold and buy stocks! We want to reiterate, our focus is on balance, high credit quality and diversification and this over time has been proven to be the best approach in weathering economic cycles.

SGK Blog--Update August 12, 2011  Fed To Keep Rates On Hold To Mid 2013 

After Monday’s dramatic sell-off in equity markets worldwide based on S&P’s downgrade of the US credit rating from AAA to AA+, all eyes were on the Federal Open Markets Committee chaired by Ben Bernanke and their statement released at 2:15 in Tuesday trading. As the market digested their statement, the Dow initially dropped 200 points before climbing back and rising over 400. There are a couple of key points to mention here. First the Fed seems to have their pulse on the general economic malaise and they went through the whole list from high unemployment to lower consumer spending. So their outlook has moderated, which makes sense given the recent data and the pullback in the stock market. They took the unprecedented step of indicating that the current Fed Funds rate – now between 0 and 0.25% - will stay at these levels “at least through mid-2013.” Wow – that is almost two full years! They recognize, as we have been stating for quite some time, that is going to be a long, tough slog to dig our way out from the last severe recession. Our economy is dependent on consumer spending and with consumers continuing to deleverage, along with governments thereby reducing their ability to respond to current conditions, it will be a slow process. Americans are saving more and tempering spending, which is good for their balance sheets but not great for the general economy. The Fed will basically hold their balance sheet steady (translation – no QE3 for now) while reinvesting principal payments from its existing securities holdings. The final paragraph was telling in our view and helped lend at least temporary support to the market. We will note it here because it is important, “the Committee discussed the range of policy tools available to promote a stronger economic recovery in the context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.” The implication here being they reserve the right to engage in further quantitative easing in some form if the need arises. The Fed of course cannot directly hire people – they do not engage in setting fiscal policy – but it is comforting to know they are on it and they will not hesitate to use the tools at their disposal to help provide confidence in the marketplace in general. This is particularly important in light of declines in the stocks of French banks that occurred during Wednesday’s volatile trading session on concerns over their exposure to European debt and a possible downgrade by S&P of France’s sovereign debt from its current triple-A status. All three ratings agencies came out that day and reaffirmed France’s credit rating as stable which seemed to calm nerves to a degree. Importantly we also witnessed sharp declines in the yields on Italian bonds due to the intervention by the European Central Bank. In Thursday trading the yield on the Italian five year dropped below 5%. When will Trichet learn his lesson that the market actually appreciates telegraphed moves? Probably never but that is okay as he will not be around much longer as he is due to be replaced soon.

The implications of Standard & Poor’s downgrade of US debt are quite far reaching. To rub salt into open wounds they downgraded the debt of Fannie Mae and Freddie Mac along with the rest of the government agencies about mid-day Monday and, even though it did not come as a big surprise, their timing basically stunk and contributed to the steep declines in stock prices Monday. In contrast to Moody’s and Fitch’s rating service which reaffirmed the US triple-A rating after the debt ceiling was increased, S&P seems to be suffering from an already beaten down reputation and their credibility is clearly suffering – perhaps rightfully so. Moody’s is basically going to provide time for the Super-Committee to make recommendations for spending cuts and tax reform as part of the debt ceiling increase deal. That seems to make sense to us. By contrast, S&P then proceeded on Tuesday to downgrade several insurance companies, including Northwestern Mutual, from AAA to AA+, which we are fairly certain peeved their CEO rather severely as their balance sheet is really pretty pristine. So S&P is in the process of downgrading several companies and municipalities and in our view it seems to be somewhat indiscriminate. After all there are rather significant differences between the balance sheet of Northwestern and a number of their fellow formerly triple-A rated competitors. So market participants, including us, are rather confused – are they implying that each of these companies or institutions or states for that matter are basically the same and therefore deserve to get downgraded all at the same time? We definitely do not think so and we strongly disagree with their broad, relatively indiscriminate, across-the-board downgrades. Don’t even get us started on S&P’s $2 trillion math error on their projections which made headlines over the weekend! The damage is done and S&P has taken it on the chin, deservedly so in our view, for helping contribute to negative sentiment. A continuous cycle of downgrades and negative ratings becomes a self-fulfilling prophecy. They downgrade debt (whether sovereign or corporate) the security goes down, forcing them to downgrade again further based on having to adjust their forecasts due to higher costs, etc. etc. So are they really helping or hurting their clients? Watching their stock go down sharply in trading this week, even on a day like Tuesday when stocks rallied sharply, implies a lot of investors are questioning their business model as well and their relevance. In a $24 billion auction of US Ten-Year Wednesday, the yield set a record low of 2.140% compared to the previous record of 2.419% set on January 2009, implying demand is very high in spite of S&P’s downgrade. 

Is there a silver lining on S&P’s downgrade? Back in 1992, when S&P had considerably more credibility than it has today, S&P downgraded Canada’s rating from AAA to AA+ and this served as a real wake-up call to the debt-encumbered, Liberal-party led government of Jean Chretien (eh!) which subsequently slashed spending and returned to running a surplus in three years. Canada did not get its triple-A rating back until 2002 – a full decade later. Canada’s national newspaper, the Globe & Mail, this week approvingly quoted the New York Times by saying, “American policy makers might learn a thing or two from Canada’s patient, hysteria-free pruning.” Back then Canada managed to implement both spending cuts and tax reform, without sacrificing growth. As it stands now, that country has about $564 billion of debt, a manageable number, and the new Conservative government of Stephen Harper expects to be running a surplus in 4 years. Looking on the bright side of our current situation, S&P’s action and the whole debt ceiling debate has clearly raised the average person on the street’s awareness of the seriousness of the issue. Will this result in serious modifications to our spending, including entitlement reform, along with a less contentious debate over tax reform? Will our political leaders in Washington work together on a long range solution? It remains to be seen… but the ramifications of the downgrade have to have provided a wake-up call to those in Washington, at the very least.   

There is no question this period has been tough – it is never fun to see the stock market drop like it has over the past two weeks. While we do not claim to be perfect by any stretch of the imagination we have had a very active year so far. Leading up to this point during the first and second quarters of the year where our equities had really performed so strongly we had trimmed positions in the following securities for clients who were overweight these companies: Accenture, IBM, Check Point, Thomas & Betts, Baker Hughes, Kinder Morgan and Service Corp International. We also sold our position in Conagra and Iron Mountain at the end of the first quarter. Ultimately markets do revert back to the fundamentals and our analysis told us that stocks in these companies had appreciated to the point where their valuations had become stretched and it made sense for us to take profits in the positions where appropriate. Proceeds from sales have generally been added to very high quality investment grade bonds – corporates in the IRA’s & pensions and high quality muni’s in the taxable accounts. While not eliminating the pain associated with equity market drops, it does help alleviate the volatility to a certain degree and we are on top of your portfolios in this regard. Our measure of our equity portfolio shows that we are about seven percentage points ahead of the S&P 500 year-to-date. We also have a higher average dividend than the equity market with approximately 20% less volatility. All-in-all this is a favorable combination – unfortunately it is all relative and the major stock indices are now negative on the year. We have been using the recent declines to add to positions where appropriate and “nibble” away on days where sentiment is negative. We are very confident in the securities we hold for clients. To provide some perspective on where income is coming from these days, let us take the example of Johnson and Johnson, a company with a credit rating now higher than the US government combined with a pristine balance sheet and strong cash flows. Up until recently we had been buying bonds in the company maturing in 2018 with yields in the range of 3%-4%. Today the yield on that bond sits at 1.8% if we were to buy it at today’s price – which we are not. JNJ’s stock on the other hand yields approximately 3.8% and trades at just 12 times forward earnings. This can be an indicator of where the opportunity lies in the market right now. The market has pulled back on uncertainty over future earnings based on a cloudy economic outlook. A stock’s price today trades on a value based on a discounted valuation of future cash flows. This is highly dependent on two things – future earnings and interest rates. Interest rates are at rock bottom levels so this part of the equation is attractive. The earnings picture is muddied due to the economic uncertainty across the globe. And that is where our analysis comes in and we believe in part explains why we are doing better than the broader market in this type of uncertain environment and why we find the current risk/return equation tilted towards the high quality equities we hold for our clients.

On the week, the news on the economy was mixed. Initial weekly jobless claims for the week ending 8/6/2011 came in at 395,000 which was better than expected and below the important 400,000 level. This pushed the four week moving average down to 405,000. Breaking 400,000 is psychologically important because it is considered a signal that companies are hiring and the economy is expanding so we really want to see the four week moving average decline below that level. The US trade deficit widened to $53.1 billion from $50.8 billion in the prior month. US shipments of capital equipment and industrial supplies fell in June which may reflect the start of a cooling in the global economy. This was also as a result of continued strains in the auto supply chain as Toyota and Honda reported declining sales due to these constraints. There are some companies like Caterpillar Inc. that remain optimistic that demand for American-made goods will be sustained, helped in part by a weaker dollar. Sluggish US demand this year has restrained imports but the fall in imports is also due to the decline in oil prices. US worker productivity declined less than expected in the second quarter while unit labor costs were in-line with expectations. The Thomson Reuters/University of Michigan preliminary index of consumer sentiment for August dropped dramatically to 54.9 from 63.7 the previous month. This is not a big surprise given the circus that was the debt ceiling debate and the decline in global stock markets and confidence in general. The retail sales figures for July came in at a reasonably robust +0.5% and while June’s figures were revised upwards. Excluding gasoline and autos the figure for July was higher than expected at it also was +0.5% and this came as a welcome relief and helped lend support to the stock market in Friday trading.

SGK Blog--Update August 5, 2011  Wild Ride For Stocks
There were numerous headline-making events this week from the Capitol Hill deficit battle to the European Central Bank’s actions to a few more corporate earnings reports and, of course, the monthly payroll figure.  Let us concentrate on the facts and our outlook based upon those events.

As we wrote last week, the deficit battle is no reason to make drastic changes with respect to one’s portfolio.  Politicians may have their hearts in the right place but often are so busy to please every voter that frustrating results ensue.  That was the case this week as President Obama signed the latest bill into law trimming spending and paving the way for raising the debt ceiling before the “drop dead” date of August 2nd.  Numerous politicians came out against the measure but ended up voting for it anyways which is typical for Capitol Hill.  As we mentioned, we are not heavily invested in U.S. Treasuries outside of inflation-protected securities, so the stream of cash from our bond investments (mostly municipals and corporate fixed income securities) was not really ever in doubt.

The European Central Bank (ECB) kept its main benchmark interest rate at 1.50% and the Bank of England also remained in neutral at 0.5%.  These non-moves were already anticipated by the market.  What spooked investors on Thursday was the comments made by ECB President Trichet when he did not directly confirm European government bond purchases, simply stating “you will see what we are doing.”  Since observers did not really know what he was talking about, it took London traders to report that the ECB was buying bonds—but only Irish and Portuguese securities.  Positively, that would be the first such intervention since March and the initial move after European leaders recently decided that buying bonds would be the wise move to help stop the spread of contagion on the continent.  However, investors were spooked when he made no mention of buying Italian or Spanish bonds.  Yields on those instruments were hovering near 6% for short-term paper which is very close to the level Greek bonds were at before they reached out to the ECB for a bailout.  Trichet added that some members of the ECB governing council were not behind the bond buying decision (rumor has it Germany was not happy) but yet he said the “overwhelming majority” were in favor.  Our take on this is: not good enough.  That is, as the spokesman for Europe’s monetary policy, dropping obscure hints is not going to cut it and Thursday’s market meltdown will be the result.  More went into the Dow’s 500 point drop than that which we will get to later, but transparency is of utmost importance when markets are on edge.  Trichet bought a knife to a gun fight.  Investors want to see uncertainty bludgeoned to death through confident statements and unhesitating action.  The mechanisms are in place, they just have to be used.

Domestically, jobs took center stage near the latter half of the week.  After Thursday’s weekly initial unemployment claims decreased by only 1,000 to 400,000 in the week ended July 30th, market watchers assumed the worst for Friday’s monthly payroll data.  Though the claims data was below the forecast of 405,000, the number of people continuing to collect jobless benefits rose by 10,000 to 3.73 million.  Basically, there has been no momentum in these figures suggesting that we were not headed to sub-400,000 data points anytime soon.  Friday’s numbers provided a little respite.  July’s 117,000 increase was above consensus and June’s initially dismal figure was revised upward from +18,000 to +46,000.  Also, the national unemployment rate fell to 9.1% and, more importantly, average hourly earnings climbed 0.4%.  Higher earnings in the past has been a precursor to more hiring down the road.  But if there is anything this latest recession has taught investors is the fact that it is not like others that preceded it.  Remember the unemployment rate was under 9% in March of this year only to creep higher recently.  Again, there just does not seem to be any traction in payroll creation even with company’s sitting on piles of cash.  Private hiring, which excludes government agencies, rose 154,000 compared to June’s 80,000 gain so there is some evidence corporate America is reaching out to available workers.  However, the share of the eligible population holding a job declined to the lowest level since July 1983 suggesting the amount of discouraged workers continues to grow.  Our view is that employment will improve but not in a straight line, and it will take many more months for there to be proof that a sustainable resurgence is underway.


SGK Blog--Update July 29, 2011  Political Debt Ceiling Wrangling Overshadows Strong Corporate Earnings

Traders attention was squarely focused on the continuous news on the debt ceiling negotiations taking place in Washington. While all politicians, with the exception of a number of Tea Party members, agree that a default on US Treasuries and not coming to a resolution over the current state of affairs with respect to the debt ceiling negotiations would be damaging to the US economy and harmful to our global reputation, the debate will definitely continue over the weekend and quite possibly beyond. That is, as of the market close in Friday trading we did not have a resolution on the matter. There is no point in our making political statements in this forum as reports on the latest status of the negotiations are all over the web, the papers and any news service that you may be inclined to read or peruse. One positive that will hopefully come out of this, is that it has brought an issue that we have been writing about for years to the forefront – how to tackle the serious problems we have with current levels of deficit spending and the overall level of debt in this country. With the issue making headlines day-after-day, the American populace is becoming more and more familiar with the potential problems and the tough choices that are going to have to be made in tackling the issue. 

As we wrote in December of last year, if they were inclined to extend the Bush era tax cuts then they should have adopted the recommendations of the President’s deficit commission – all of them! At the time the Republicans walked away from serious discussions about the issue and the President chose to ignore the recommendations from the panel he set up to make recommendations on the issue! We would add that the commission was bipartisan and the leaders were a retired Democrat and a retired Republican. They tackled tough issues such as entitlement reform, tax code simplification and spending on defense. However, that is in the past now…

Our view is that the debt ceiling will be raised, it may not happen exactly on August 2nd, but it will happen at some point via some method. While stock prices declined this week on the associated uncertainty, bond prices rose on the week. One would think that if bond traders felt that the US would default on its obligations for a sustained period then they would sell Treasuries and bond prices would decline sending interest rates higher. So why did this not happen? The simple answer is that bond traders simply do not buy into the notion that the US is going to default on its debt obligations. We have said in the past that bond traders tend to be brighter and more focused on the longer term than equity traders. (I spent time in the fixed income area at Goldman so there may be a wee bit of personal bias creeping into that statement!) There are other more complex issues at work as well. Despite the current wrangling, Treasuries (and gold) are still considered safe havens in times of turmoil. Moody’s also chose to downgrade Spanish debt this week so Europe is clearly not a safe haven at this time. Demand for Treasuries remains high and money flowed in this week from Europe. With the supply at Treasuries auctions for next week being very uncertain at this precise point in time, traders and institutions bought Treasuries this week sending the prices higher.

Our position is the current wrangling is no reason to make drastic decisions with respect to one’s portfolio. We feel we are well positioned for clients in good solid securities. We mai