The FOMC Holds Steady as Markets Hit a “Tipping Point”


Observations on the Capital Markets – Week Ended August 1, 2014

The FOMC met last week, expressed satisfaction and maintained course. While their policy decisions (continue the taper—now $25b—and keep the Fed Funds rate where it is) were no surprise, the language of the Fed statement was tweaked to reflect the continued/continuing improvement in the economy and labor markets (e.g.: “the likelihood of inflation running persistently below 2% has diminished somewhat”).  The Fed feels it is accomplishing its goal…so a continuation of policy normalization is appropriate.

At the same time, the Fed statement said “…a range of labor market indicators suggests that there remains significant underutilization of labor resources.” Analysis: the Yellen Fed is moving cautiously…with Japan and Europe still weak, the Fed appears willing to risk an inflationary boom in the U.S. to minimize the likelihood of having to fight a recession and/or deflation when it has a bloated balance sheet and low Fed Funds rate, but very robust tools to fight inflation.  As I said on CNBC last week, a submarine commander doesn’t give the order to submerge when most of the hatches are closed.

The Labor Market Continued to Improve

A higher unemployment rate is good if it’s due to an increase in the labor force participation rate – and that was the case. The unemployment rate ticked up from 6.1% to 6.2% because the labor force participation rate rose.  Why is this good?

  • Initial unemployment claims ticked up to 302k. The 4-week moving average (297k) is the lowest since April 2006.
  • If there is a “shadow inventory” of workers who will re-enter the job market as demand rises, the economy will not experience labor shortages and inflation as soon.  The larger the “shadow inventory” of labor the longer the economic expansion can last before the Fed is forced to raise rates to fight labor cost inflation.
  • As unemployment falls, consumer confidence is gradually recovering. Personal income increased for the sixth consecutive month, support both consumption and savings.
  • Comment: wages are keeping pace with inflation…but productivity growth is keeping unit labor costs (ULC) below CPI.  ULC—currently 1.1% year over year (y/y), to be reported next week—is probably the most important labor cost data point: as long as it’s well below 2%, the Fed can stay dovish.

Capital Markets: A Sudden Change in Sentiment and Direction

Markets generally started the week in “risk-on” mode, but turned decidedly risk averse on Thursday and Friday.  There was no clear single economic, political, or military development that analysts could point to as triggering the reversal: rather, it seems that sentiment hit a “tipping point.”

  • Currencies:  The dollar ended up about 0.6% against the yen, roughly flat against the euro and yuan.
  • Government Bonds:  While Treasury yields ended little changed, it was a volatile week: 10-year Treasury yields, up more than 10 basis points (bps) mid-week, ended the week up 4 bps at 2.52%; the 10-year TIP yield ended down 2 bps to 0.18%.  German 10-year Bund yields ended down 2 bps at 1.13%; Japanese 10-years rose 1 bp to 0.53%.
  • Corporate Bonds:  Waves of selling drove the BoA Merrill Lynch High Yield Index 50 bps higher, to 4.25%. It was a risk-off market as lower-rated generally did much worse than better-rated paper. High yield spreads widened from a low of roughly 3.40% in late June to 3.80% last Wednesday; the sharp move from 3.80% to 4.25% on Thursday and Friday coincided with the stock market sell-off.
  • US Equities: The S&P 500 Index started the week well, but sold off Thursday and Friday to end the week down 2.7%, its worst week in over two years. As an indicator changing sentiment, outlooks and risk appetites, domestically-focused companies are outperforming globally-focused ones. Telecom (-1.2%) was best-performing sector. The Energy sector (-4.0%) lagged as oil prices fell. Roughly 2/3 of S&P 500 companies have reported earnings; more than 75% are beating forecasts.
  • International Equities: The MSCI AC World Index was down just over 2%. MSCI Japan, down roughly -0.5%, held up relatively well; MSCI Emerging Markets (-1.7%) was OK.  MSCI Europe lagged, down roughly 2.5%. Portugal was notably weak, down 11% on banking system fears. Europe’s exposure to Russia/sanctions was a second key concern.
  • Commodities:  WTI oil fell 4% to $98. Gold fell $3 to $1292. With bond yields little changed, this price action seems to suggest the market sees little increase in the risk of a spike in inflation, an economic downturn or a dramatic deterioration in the geopolitical picture. Instead, it seems more consistent with “long” positions being unwound as part of a “portfolio de-risking” (e.g. change in sentiment).

Q2 GDP Was Better than Expected…If Anyone Cares

The advance estimate of Q2 real GDP growth came in at 4.0% seasonally adjusted annual rate (SAAR), well above expectations (nominal growth—what the cash register records—was up 5.9%).  Comment:  I wouldn’t put too much weight on the advance estimate…I expect further revisions.

In the Eurozone: Soft Economic Data…But Credit Crunch May be Easing

  • The Markit manufacturing PMI came in at 51.8, unchanged month over month (m/m) and below expectations.
  • July flash CPI dropped from 0.5% y/y to 0.4%, the lowest reading since October 2009…not what the European Central Bank (ECB) wants to see…but Core (ex-energy and food) inflation was stable at +0.8% y/y.
  • The unemployment rate dropped from 11.6% to 11.5% (good news).
  • The announcement of additional sanctions on Russia is a double-edged sword: Europe, too, will suffer.
  • On the upside, the ECB’s quarterly bank lending survey showed banks eased their corporate credit standards for the first time in seven years, even as loan demand continued to rise.

A Tough Week for Russia

  • The EU (and then the U.S.) increased sanctions on Russian companies and individuals. EU sanctions will limit the access of state-owned Russian banks to capital markets and cut trade in military tech. The U.S. sanctions also target Russia’s energy sector.
  • A court in The Hague ruled Russia owed $50 billion in damages to shareholders of Yukos.

Argentina Chose to Default

Argentina has been unable to negotiate a settlement with a group of bondholders who (U.S. courts have ruled) are owed money dating back to Argentina’s 2001 default.

  • The judge would not allow the payment of interest on other (post-restructuring) bonds unless holders of those bonds were paid what the court ruled they were owed.
  • Argentina appears to have had the ability to pay…but was unwilling to do so.
  • As a result, on Friday, the International Swaps and Derivatives Association (ISDA) declared Argentina in default, which will trigger payments on credit default swaps covering up to $1 billion (par value) of bonds.
  • The amount of those payments will be determined via an auction process in the coming days.

In China and Japan …

China’s PMIs show continuing incremental improvement, but housing sector woes are mounting.

  • The HSBC/Markit manufacturing PMI rose from 50.7 to 51.7.  The official manufacturing PMI rose from 51.0 to 51.7, the highest level since April 2012.
  • Housing market data continues to signal that demand (and prices) are weakening.
  • How much corruption is/was there?  The government’s anti-corruption campaign is being blamed for reduced sales of luxury goods and Macau casino gambling.

In Japan, recent data is leading to downward revisions to Q2 GDP forecasts.

  • Industrial production fell 3.3% m/m, the sharpest decline since March 2011.
  • The manufacturing PMI slid from 51.5 to 50.5.
  • Housing starts rose m/m but are still down -9.5% y/y.
  • A poll of economists predicted that Q2 GDP—dampened by the big tax increase—could be as bad as -7%.
  • The unemployment rate ticked up from 3.6% to 3.7% even as employment rose 560K y/y due to a rising labor force participation rate.  This is fine: it may reflect people seeking work to pay for a higher cost of living, but a growing labor force is essential to grow GDP.

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

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About Sam Wardwell

Sam Wardwell, CFA, is Senior Vice President and Investment Strategist at Pioneer Investments. He joined Pioneer in 2003.
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