Search This Blog

Friday, February 22, 2013

Deflation or Correction?


After reaching fresh five year highs with the S&P closing at 1530.94 on 19 February 2013, stock markets sold off on warnings from Walmart (WMT), and commentary from the Federal Reserve. Shares in Walmart have been outperforming the broader market, which raised some warning signs, then late Friday 15 February leaked e-mails from Walmart executives warned of extremely weak sales. The news caused a drop in the S&P 500 as Jerry Murray of Walmart suggested that the weakest sales month in seven years was the result of expiration of a payroll tax cut, and a slowing economy. That news prompted some early speculation on what might trigger a correction, though markets rebounded on Friday with the S&P 500 finishing up at 1515.60. Our downward support level is 1496, meaning a close below that level may indicate the beginning of a downtrend. Recent Redbook Research US same store sales figures for the week ending 16 February showed sales up 3.1% over the same period in 2012, which questions the warnings of those Walmart e-mails. The next move downward in stocks came as Caterpillar (CAT) announced a 4% decrease in sales of construction and mining equipment for the three months ending in January 2013. Concerns that the Federal Reserve might end stimulus measures early, along with some disappointing economic figures, caused the worst decline on the S&Psince November 2011. Gold futures and oil futures also declined, as rumours of a commodities hedge fund in trouble began to circulate.
The G20 Finance Ministers and central bank governors met in Moscow recently to discuss ongoing economic issues in the top 20 countries. Amongst the official releases was a promise of central banks to avoid "competitive devaluation" of currencies. There was some expectation that countries would try to prompt Japan to reverse their recent aggressive stance on Yen (JPY) values, though the Japanese claim that unlimited government bond purchases are intended to pull the Japanese economy out of recession. It was difficult to find a central banker or finance minister willing to address whether monetary policies target currency values, or are strictly aimed at boosting local economies. As usual in G20 (or G7) meetings, the end results and statements lack any real disincentives towards continuing loose monetary policies. Australian Treasurer Wayne Swan, in an interview with CNBC, expressed concern about the rise of the Australian Dollar(AUD), yet gave support for market-based exchange rate mechanisms. Demand for iron ore, coal and natural gas, most of it exported to China, has driven the AUD higher over the last few years. The failure to make a statement against Yen (JPY) manipulation reinforces the Japanese Government push on monetary policy, and may influence the choice of the next head of the Bank of Japan, who will be under continued pressure to devalue the JPY. Danish financial companySaxo Bank warned that the recent rise in the Euro (EUR) would not last much longer, as the failure to form a true fiscal union fails to solve long term problems. When we look at forex (foreign currency exchange) markets, we can see a continuation of large volumes in USD/JPY transactions, above the usual EUR/USD leading pair. Our market correlation indicator in currencies, the EUR/JPY rate, suggested a decline in risk markets (equities) prior to the downturn of the S&P 500. Analysts at JPMorgan (JPM) and Nomura (NMR) note a recent trend of large Japanese pension funds shifting investments away from Australia and towards Europe, though it appear some may be taking profits on the recent run-up in the yen (JPY). There is some indication that Japanese investors are moving into South African, Brazilian, and other emerging market choices. Whether this trend continues depends upon the continued weakness in the Yen.
ForexLive - Housing Starts ChartJanuary housing starts disappointed with a reading of 890k against an expectation of 920k, though building permits increased slightly to 925k, showing that the recovery in housing continues. The decline was largely due to a decrease in building of multi-family dwellings. Fitch Ratings notes that the balance of Commercial Loans in special servicing declined from $83.1 billion at the end of 2011, to $70.5 billion at the end of 2012. Liquidations remain the main area comprising this activity, though attempts at pushing through modifications and work-outs appear to be changing the market. The average time in special servicing has gone from 9.1 months in 2009 to 21.6 months in 2012. This continues to overhang the Commercial Loan and Commercial Mortgage Backed Securities (CMBS) markets, indicating that we still have years ahead of us for a complete recovery in real estate markets. CMBS delinquencies declined for the eight straight month in January 2013, which is a great sign of continued improvements, though Fitch Ratings note that Georgia continued to be a problem area. Fitch maintain a Stable outlook on commercial real estate, based upon a continued decline in delinquencies. Late payments fell to 12.7% in January, compared to 13.4% in December 2012. The performance of the AUD appears to be fuelling some overseas investments, as Australians are now seen to be investing heavily in US rental markets. Institutional investors are putting $6 billion to $8 billion into buying houses and converting them into rentals, with a large portion of those funds coming from Australia and Canada. Given the improvements in housing and commercial real estate, it should not be surprising that JPMorgan (JPM) are looking to sell the first non-agency Mortgage Backed Securities (MBS) since the beginning of the financial crisis. Non-agency means these MBS are not backed by government supported programs, such as through Fannie Mae and Freddie Mac. The recent Federal Reserve policy of buying MBS on the open market may be prompting this move by JPMorgan, who follow Credit Suisse (CS) and Redwood Trust in issuing non-agency MBS. Most of these MBS offerings are comprised of prime jumbo loans of "exceptionally high quality", according to S&P ratings. Credit Suisse (CS) was one of the first companies to delve back into the market for Residential Mortgage Backed Securities (RMBS), though the company now finds itself under investigation by the US Department of Justice over "misleading investors" on the valuation and risk levels of those RMBS. This overhang of investigations and allegations may be holding back mortgage markets, since securitization of mortgages is an important component of the housing sector.
European GDP Since Intro of the EuroAs the latest minutes of the Federal Reserve meeting began to appear, the Pound (GBP) and Euro (EUR) declined sharply, while the US Dollar (USD) strengthened. Easy credit led peripheral economies in Europe to grow much faster than the average GDP growth of the Eurozone. Recent data from the Organization for Economic Co-operation and Development (OECD) indicated much worse fourth quarter 2012 GDP figures than had been expected. The OECD noted that many countries in Europe were slipping towards a recession, while the United States GDP growth went from 0.8% in the third quarter, to 0.0% in the fourth quarter, a significant slowdown. Fed officials expressed concern about the affect on markets of continued asset purchases and stimulus programs. These were the first hints that the Federal Reserve might end some stimulus measures earlier than previously expected. Atlanta Federal Reserve President Dennis Lockhart told Reuters that potential stimulus benefits continue to outweigh longer term risks of current unconventional monetary policies. Much of this continued risk weighting appears to be as a result of a lack of progress on unemployment levels. As long as the Federal Reserve appears willing to continue asset purchases, then markets should continue to respond positively to the additional stimulus. As a popular saying goes amongst financial analysts, don't bet against the central banks. So far consumer prices have not been rising fast, with 12 month price levels through January 2013 just 1.6% higher. The US economy grew 2.2% in 2012, despite a slowdown in the fourth quarter. Unemployment came in at 7.9% in January 2013, and job growth has remained below levels needed to make an impact on unemployment levels. Many people feel that the US economy is in recession, though technically that requires more than one quarter of slowdown in economic activity. Different regions of the United States are performing far better than other regions. However, when we look at employment, average worker pay levels have declined. That is one component of deflation. In the week ending 16 February, initial jobless claims came in at 366k against 355k expected, with continuing unemployment claims somewhat lower at 3.148 million. There have been very real worries about stimulus and central bank activity causing inflation, though economic figures continue to point towards the possibility of deflation. Recent data from the Federal Reserve Bank of Philadelphia Business Outlook Survey indicated a surprise slowdown to -12.5 (negative) as a decline in new orders and activity offset improvements in shipping and employment in the region. While business outlook remains positive for the future, the numbers and data are somewhat mixed and do not yet give a clear indication of future direction. Markit Research February PMI figures came in at 55.2 against an expectation of 55.5 on the Purchasing Managers Index. Demand amongst US consumers appeared to be good, though export demand slowed somewhat, which correlates well with the Philadelphia Fed Survey data.
It seems that markets may be heading downwards into the end of February. The battle over automatic spending cuts (The Sequester) in the United States will take place prior to 1 March 2013. President Obama recently suggested that the spending cuts are not inevitable, but with Democrats and Republicans in the House of Representatives and Senate so far unable to come to any agreement, it does seem somewhat inevitable. Given the recent track history of the Legislative Branch, and with 1 March 2013 falling on a Friday, a market decline on that day has a high probability of occurring. Fiscal stimulus and government spending arguably tried to create a soft landing in the economic decline, though the way to drive an economy is through capital spending. Many companies have held back capital spending due to uncertainty, though it appears that some companies may now be ready to boost spending. One major holdback has been uncertainty over government action. If politicians can remove some of that uncertainty, and choose a definitive path of some sort, then many businesses will know how to react and plan future activity. Hopefully it is near the time that government moves out of the way of business, and moves more towards letting the real economy come forward once again.
Congressional Budget Office - Sequester BreakdownAs we head into the close of February, we can watch some of our correlation indicators for a better idea of where markets are headed. Of these indicators SPXA50R now appears to be heading towards a downtrend (weekly chart view). This tells us the percentage of companies on the S&P 500 whose share prices have dropped below their 50 day moving averages. Using SPXA50R, we may have books some profits over the last few weeks, and now we are waiting for a low indication for possible buying opportunities. We can also watch the Volatility Index (VIX), especially if VIX goes above 20 in the near term. So far US Treasuries have not come under selling pressure, with yields on the 10 year and 30 year Treasuries still quite low. A yield above 3.5% on the 30 year note, or above 2.5% on the 10 year note, would be an indication of a major shift in market sentiment, though with the Federal Reserve buying some Treasuries, and investor demand continuing forsafe haven assets, we may not see that shift this year. As we head towards The Sequester on 1 March, we might see a pullback in markets as major investors await the outcome of negotiations in Congress. A failure to negotiate a long term agreement may prompt a market sell-off or lead to a correction. More can kicking with temporary measures could hold back the economy, while a longer term agreement could lead to greater capital spending by businesses. As long term investors we can take some comfort in the long term economic improvement, even if the current pace is quite slow. While politicians do have the capability to derail the economy in the short term, we may view those events as buying opportunities for long positions, or times for shifting asset allocations. The recovery in housing continues, despite the recent slowdown. Stay aware, remain informed, watch for indications of shifts in markets, and be ready to take advantage of buying opportunities.
G. Moat
Disclosure: I hold a long positions in Credit Suisse (CS). This article is not a recommendation for investors to either buy, nor to sell, shares in Credit Suisse. Investors are advised to perform their own research prior to making investment decisions.