Stocks and Bonds Both Again Rally as Bernanke Soothes

Wardwell’s Weekly Market Report

Observations on the Capital Markets – Week Ended July 19, 2013

  • Detroit files for bankruptcy: pensioners and bondholders square off
  • Bernanke on Capitol Hill: no surprises
  • Still on “soft parch” watch, but last week’s economic reports were generally solid
  • Inflation remains quiet
  • U.S. retail sales fell short of forecasts
  • Housing: Too soon to know the impact of higher interest rates
  • The Bernanke “put” remains in place in the housing market
  • Europe watch: Greece crosses a key hurdle
  • China watch: GDP doesn’t disappoint
  • Japan watch: after the elections comes the hard part
  • Earnings season: so far, so good
  • Washington watch
  • The week ahead

Detroit files for bankruptcy: pensioners and bondholders square off

Fed Chairman Ben Bernanke’s congressional testimony got more headlines, but Detroit’s long-anticipated formal filing for Chapter 9 bankruptcy was by far the more important development. Billions of dollars of losses will be imposed on general obligation bondholders and/or retired employees.

The bankruptcy may well lead to the U.S. Supreme Court being asked to rule whether federal law trumps a state’s constitution or vice versa. Michigan’s state constitution says “. . . benefits . . . shall not be diminished” but federal law allows bankruptcy judges to cut pension benefits. In the case of Central Falls, RI, bondholders were paid while retirees saw their benefits slashed, but state law in Rhode Island clearly put bondholders before retirees. That’s not the case in Michigan. It’s likely to get political, loud, and ugly. Billions are at stake. (p.s. don’t expect the U.S. House of Representatives to vote for a Federal bailout.)

Bernanke on Capitol Hill: no surprises

Good parents communicate clearly, repeating and rephrasing as necessary, and follow through in a consistent manner. Clear communication from central banks is a generally-accepted best practice as well.

Bernanke’s Congressional testimony broke no new ground. He still sounded like a dove at times (e.g. “Very low inflation poses risks to economic performance . . .”) but gave no indication of a change in the Quantitative Easing timetable he suggested in late June (start tapering QE later this year, end it by mid-2014, “data dependent”). He used slightly different words (e.g. “. . . our asset purchases depend on economic and financial developments. They are by no means on a preset course.”), but said nothing that contradicted anything said before. The outlook remains the same: We expect capital markets to wean off QE over the next year while maintaining ZIRP(zero interest-rate policy) . . . “data-dependent,” of course.

Still on “soft parch” watch, but last week’s economic reports were generally solid

  • Weekly unemployment claims fell -24k to 334k, according to the Department of Labor ‑ a new cycle low.  Weekly data is noisy, but the four-week moving average is below 350k…that’s good.
  • The Institute of Supply Management’s (ISM) Industrial Production Index rose 0.3% in June; capacity utilization rose to 77.7% . . . consistent with slow growth, little inflation.
  • The Conference Board’s Composite Index of Leading Indicators (LEI), which measures economic expansion and contraction cycles,, was unchanged in June; May was revised up, consistent with continuing 2% economic growth.
  • The Empire Manufacturing Index, which measures industrial production in New York State, rose from 7.8 to 9.5; the Philly Fed Manufacturing index, produced by the Philadelphia Federal Reserve as a general measure of manufacturing strength, rose from 12.5 to 19.8.  Both rose more than expected; in both cases, the underlying details were solid.

Inflation remains quiet

Core CPI (Consumer Price Index minus food and energy) ticked down from 1.7% to 1.6% year over year (y/y) for June. Headline CPI (which includes food and energy) rose 0.5% month over month in June (1.8% y/y), boosted by a 6.3% one-month rise in gasoline prices. Higher gasoline prices increase soft patch risk (see retail sales).

U.S. retail sales fell short of forecasts

Retail sales, which the U.S. Census Bureau releases, climbed 0.4% (half of what was expected) in June and May was revised down. This data will lead to further downward revisions in Q2 GDP growth forecasts. Auto sales have been solid, but spending excluding autos and gasoline was -0.1% month over month. Moreover, consumers cut back on “nondiscretionary” items, suggesting higher gasoline prices are crimping budgets. On the brighter side, sales are up 3.7% y/y (sales ex autos and gas are up 4.6% y/y), the household debt service and financial obligations ratios are low, the savings rate is healthy, and employment and disposable income are trending upward.

Housing: Too soon to know the impact of higher interest rates

  • Total mortgage applications fell in the latest week, but the purchase component edged up.
  • The National Association of Homebuilders’ Index of Homebuilder Sentiment) rose 6 to 57 in July, its highest reading since January 2006 (but still well below bubble peaks). All components posted good gains for a second consecutive month. Caveat: sentiment is usually a lagging indicator at tops, and other data suggests some caution is warranted.
  • Permits and starts surprised by falling in June, weighed down by a 20% drop from the often-volatile multifamily segment. Single family starts fell 0.8% in June, but permits rose 0.6%. That said, monthly data is noisy—don’t leap to conclusions.

The Bernanke “put” remains in place in the housing market

Here’s another thing Bernanke said: “The main thing is to see housing continue to grow. If we think that mortgage-rate increases are threatening that progress, then we would need to take additional action in the monetary sphere.”

Europe watch: Greece crosses a key hurdle

  • European Union motor vehicle sales fell to a 17 year low.
  • The media led with a corruption scandal in Spain; the Prime Minister didn’t resign in response.
  • Fitch cut its rating on the European Financial Stability Facility from AAA to AA+
  • The Greek Parliament narrowly approved some very unpopular austerity measures, including public employee pay cuts and layoffs, clearing the way for the release of $9 billion of aid.
  • German Finance Minister Wolfgang Schaeuble described Greece’s progress on reform as “impressive” and said further debt relief could be on the table in 2014 “if Greece has implemented reforms and achieved a primary surplus.”

China watch: GDP doesn’t disappoint

  • China’s reported GDP was 7.5% y/y through June 2013, pretty much right at the level the government has said it’s targeting. There isn’t much transparency or detail around Chinese GDP, so there are skeptics, but the number was a relief to the market, which feared a miss.
  • Separately, Chinese holdings of U.S. Treasuries topped $1.3 trillion, a record.
  •  House prices rose too fast again in June.

Japan watch: after the elections comes the hard part

Prime Minister Abe’s LDP party and its coalition now have a majority of seats in the upper house after winning the lower house in December – which hasn’t happened in 25 years. Now we’ll see whether they will tackle unpopular structural reform.

Earnings season: so far, so good

So far, second quarter earnings are on track to deliver 2% above consensus performance and be up 3.5% or so y/y, according to Bloomberg.

Washington watch

  • Moody’s Investors Service affirmed its triple-A credit rating for debt issued by the U.S. government and upgraded its outlook from negative to stable.
  • The U.S. Senate reached a deal to vote on a number of Obama’s appointments, ending filibusters without resorting to the “nuclear option.”
  • U.S. Treasury Secretary Jack Lew said central pieces of the Dodd-Frank Act will be enacted by year-end, saying “Major change is underway and will continue as the powerful tools created in Dodd-Frank are implemented fully.”
  • The FSB (Financial Stability Board) appears about to designate big life insurers as “too big to fail”.

Over the weekend

G-20 Finance Ministers (and Central Bankers and entourages) meeting Moscow…no progress on anything is expected

The week ahead

Key US data this week: New and existing home sales, FHFA house prices, mortgage applications

And beyond

July 31: flash Q2 GDP . . . now there are fears it might be below 1%. But there will also be revisions to past reports released; these may revise GDP upward. September 18-19: next Fed meeting . . . will the pace of QE be trimmed?

Data Sources: The Wall Street Journal, Financial Times, Bloomberg

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