When ‘OK’ is Good Enough
June 5, 2012
In the US, economists have been pouring over data in an attempt to divine the strength of the economy. What has been clear is that nothing is clear. The US economy continues to grow, but in recent months manufacturing and employment indicators have remained positive but have been flagging. GDP growth is currently estimated at 1.9% annually while job growth has been reduced to a trickle. In the last Fed meeting, the state of the economy was deemed “expanding moderately”, yet according to the minutes, committee members remain divided about the need for further easing. Several members are open to further action if the recovery continues to erode. While there might not be a lot to get excited about economically here in the US, ‘OK’ is better than elsewhere, like Europe.
In Greece, elections on May 6th left the country without a clear majority and set up a fresh round of elections on June 17th. The radical left party, Syriza, is in a tight race with the conservatives and it is unclear how Greece would behave if Syriza were to come out on top. Syriza leader, Alexis Tsipras, feels that Greece can halt austerity and continue to remain in the EU, receiving financial aid. Tsipras, is unafraid of the rest of the EU, stating "the big weapon of Greece in this moment is that the European banking system will collapse if the Greek financial system collapses."
Spain has become the market’s latest whipping boy. Yields on 10-year Spanish debt rose from below 5.80% to above 6.40% by the end of May. In May Bankia SA, Spain’s third largest bank, was effectively nationalized when it went to the government for a €19 billion bailout, the largest yet to-date in Spain, setting off a fresh round of concerns about the financial system in the country. In reaction, three Spanish savings banks announced a merger while Banco Popular Español SA announced it will attempt to sell assets in an effort to bolster its cash reserves.
All this comes as freshly-minted French President, François Hollande, has toured the political circles with his anti-austerity agenda. His political agenda, backed by similar unrest in members such as Greece and Spain, may be finding some fertile soil. Germany, whose diagnosis for member countries has been strictly one of austerity, may be softening. German Chancellor Angela Merkel seems more willing to discuss measures that would be slightly less draconian in nature.
This leaves us in a similar position to that of a month ago. There is financial and political uncertainty in Europe which has led to ballooning bond yields and declining stock markets. Domestically, the trajectory of the economy is uncertain, but some growth still remains. This somewhat stable footing has been good enough to attract ‘safe haven’ assets as bond yields have plummeted in the US, with the 10-year note reaching all-time yield lows. In June, look for politics in Europe and economic numbers in the US to drive the markets. More disappointing US numbers will likely spark talk of another recession and additional accommodation.
Employment - Gains Still Moderate
Employment gains continued to moderate. ADP reported that the private sector added 119K jobs in April, well below expectations. The BLS report similarly missed expectations with an estimated 115K jobs added in April. However, for the third consecutive time, estimates for the previous month were revised higher – in this case from 120K to 154K for March. For the second consecutive month the unemployment rate edged lower by 0.1%, to 8.1% in April, largely due to a decline in the participation rate. ADP released its May employment report on the last day in May, showing 133K jobs added during the month. This was a slight improvement over April, but missed expectations. Weekly jobless claims were slightly lower for the majority of May, hovering around 370K before ending the month at 383K.
Manufacturing - Beginning to Moderate
ISM Manufacturing rose from 53.4 to 54.8, while the non-manufacturing survey dipped for a second consecutive month to 53.5 from 56.0. While production, new orders and employment were all higher in the manufacturing report, they all were lower in the non-manufacturing survey. Factory orders reversed a 1.3% gain in February by declining 1.5% in March while industrial production grew by 1.1%. The second estimate for Q1 2012 GDP was in line with estimates, showing a downward revision from 2.2% to 1.9%.
Things were also quite mixed with the regional reports. Surveys from New York and Milwaukee rose, indicating growth at a faster rate, and showing improvements in production, new orders, and employment. Chicago and Richmond were both lower and showed moderation among key components, yet remain at levels that indicate economic expansion. Philadelphia and Dallas are in negative territory, indicating economic contraction in those regions. Some of these indicators are now in their second month of decline, causing worry among some economists that a trend is setting in.
Prices - Energy Falling but Core Rising
A series of very tame price reports were directly attributable to falling energy prices. Import prices fell 0.5% in April, while producer prices were down 0.2% and consumer prices were flat. Core prices, which exclude food and energy, were 0.2% higher for both producers and consumers in April. The decline in energy prices over the past month has been significant, with the price of oil falling from over $105 per barrel to under $85. It will remain to be seen if moderating energy prices will help to stem the consistent increases we have seen in core prices.
Consumer - Slight Dip in Confidence
Consumer confidence has been on the upswing lately in conjunction with falling gasoline prices and an improving job market. While gas continues its decline, the job market has lost some steam, and with it some steam has come out of consumer confidence. Both the University of Michigan and Conference Board measures have been creeping higher, but last month they were mixed. University of Michigan confidence surged to a post-crisis high of 79.3 from 76.4. The Conference Board measure slipped from a downwardly revised 68.7 to 64.9. Growth in personal consumption remained solid, being adjusted slightly downward from 2.9% to 2.7%. Retail sales grew slightly, by 0.1% in April. Looking forward, there is some risk that if the job market continues to deteriorate, a dip in spending could follow.
Housing - It might not be good, but it’s not all bad
Housing starts rose 2.6% in April above an upwardly revised figure from March. The pace of both existing and new home sales also improved and according to the National Association of Realtors, the median home price climbed yet again. While the headlines trumpet new lows, the S&P / Case Shiller home price index was practically unchanged in March, falling from 134.14 to 134.10. 17 of the 20 cities in the 20-City Composite saw improvements in their annual rate of change (Atlanta, Chicago, and Detroit were the exceptions). Seven cities now have a positive annual change in prices. For the month of March, only seven cities showed declines in home prices.
Economic Calendar (June 2012)
US Treasury Market
Global investors fled risky assets in May due to endless bad news from Europe and a waning domestic recovery. Money rushed into US Treasury debt and the benchmark 10yr note lost a whopping 36 basis points over the month to close at an all-time record yield low of 1.59%. The prior yield low was experienced in September 2011 when it touched 1.67% intraday after the G20 failed to ease concerns the global economy was on the brink of another recession. The benchmark note closed below 2% every day in May and slid 71 bps since yielding 2.3% on April 4. The 30yr long bond fell 74 bps over the same period to close May at 2.67%. The record low was set in December 2008 at 2.52%. The yield curve flattened over the month with the spread between the 2 and 30yr compressing to 240 bps versus 377bps a year ago. The 7yr note fell below 1% for the first time ever.
A TIPS auction was held in May ringing in the third consecutive auction that the notes sold at a negative yield. The $13 billion auction set a new record low yield of -0.391%. This essentially means investors are paying the government to hold their money. Furthermore, demand for the securities, as represented by the bid-to-cover ratio was 3.01 vs. an average of 2.73 over the last ten auctions. This strong demand indicates investors are worrisome of rampant inflation when the Fed begins to unwind stimulus.
Operation Twist will come to an end this month. Minutes from the last FOMC meeting indicate policy makers will consider additional stimulus measures if the recovery loses momentum. An extension of Operation Twist is somewhat priced into the current 30yr bond yield but surveys reveal expectations for more quantitative easing are split narrowly. A study by the San Francisco Fed found that QE1 had the most impact on market rates vs. QE2 and Operation Twist, yet additional stimulus in the form of a Twist would be more favorable politically. Many question what additional easing will accomplish when rates are already at such depressed levels. Either way, it seems investors have fully embraced the “lower for longer” mantra as evidenced by demand for bonds with yields below the rate of inflation.
Dismal jobs data on June 1 sent the benchmark 10yr note yield below 1.50% for the first time ever. It was bad timing for additional worrisome economic data. This month marks the 3yr anniversary of the official trough of the recession and beginning of economic expansion, determined by the Business Cycle Dating Committee of the National Bureau of Economic Research.
Corporate Bond Market
The overall trend this year for corporate debt yields has been a downward trajectory as investors have accepted ever increasing credit risk in search for slightly higher yields. The Barclays U.S. Investment Grade Index closed at 3.249% on May 4th the lowest point dating back to January 1973. The Euro-area debt crisis took over credit market headlines as the likelihood of default and/or exit from the Euro by Greece increased. With the markets fretting over the domino effect of Greece’s exit from the Euro, investments moved over to assets deemed safe which benefitted high grade corporate bonds. The Barclays U.S. Investment Grade Index ended the month at 3.3%, 2bps wider for the month.
Banks already had a spotlight on them heading into May as Moody’s was expected to release revised ratings on banks before JP Morgan Chase dropped a bombshell of a $2 billion loss tied to derivatives over a six-week period. JP Morgan is considered one of the safest banks and the revelation of the loss caused a shock in the marketplace which led to corporate spreads of JP Morgan and other banks to widen as investors shied away from the sector. The loss, which is expected to widen, raised calls for the Volcker Rule’s implementation in an attempt to avoid such incidents in the future. JP Morgan’s CEO noted the bank will still be profitable in the current and upcoming quarter despite the loss. The returns in the financial sector were pressured downward due to effects of the loss by JP Morgan.
The Barclays Capital U.S. Corporate Index returned 0.76% for the month of May underperforming similar duration Treasuries by 1.59%. Year-to-date corporate bonds have returned 4.29% outperforming similar duration Treasuries by 1.79%. The 10+ year component was the best performer returning 2.44% compared to the 1-3 year component that had a negative return of -0.19%. From a sector perspective, utilities outperformed the other sectors returning 1.89% while industrials returned 1% and financials turned negative and returned -0.02%. From a quality perspective, AAA-rated securities led the pack returning 2.14% followed by A-rated securities that returned 0.80%. AA-rated and BBB-rated securities returned 0.75% and 0.67%, respectively.
United Technologies Group sold $9.8 billion in corporate debt, the largest US Corporate bond sale in more than three years since Pfizer’s $13.5 billion debt issue in March 2009, to help finance its $16.5 billion acquisition of Goodrich Corp. Issuers have been taking advantage of the low yield environment, helped by sovereign debt issues, to reduce their interest burden by refinancing at lower rates. Down the road there seems to be plenty of supply coming as Standard and Poor’s estimates $30 trillion in corporate debt will need to be financed between 2012-2016 in the US, the Eurozone, U.K, China and Japan.
Municipal Bond Market
Strong demand for municipal debt continued throughout the month of May as global economic fears led investors to withdraw money from equities and pour into safe haven assets. Year-to-date municipals have performed better than their federal counterpart, with a total return on the Barclays Municipal Index of 3.78% vs 1.86% for Treasuries.
State tax collections have exceeded pre-financial crisis levels, according to the Nelson A. Rockefeller Institute of Government, and more than half of states expect to report a cash surplus to end their 2012 budget year later this month. This positive data along with a slowdown in municipal defaults has caused investors to become more confident in the muni market. While some investors get sticker shock with yields as low as they were in the 1960s, comparatively, municipals are priced cheap. After the huge run-up in Treasuries the last few trading days of the month, munis became even more relatively attractive. The 10 and 30yr muni/Treasury ratios both climbed to 119%, the highest ratios since October and January, respectively.
States and cities continue to take advantage of the ultra-low yield environment and have refunded the most debt in five years. States and cities have sold $146 billion this year, up from $85 billion the same period last year, according to Bloomberg. Municipalities have become more confident in the economic recovery and are poised to invest in infrastructure projects. New debt versus refunding debt represented 44% of the total in May, the greatest percentage since December.
While most risk-averse investors continue to concentrate on the perceived safety of unlimited GOs and essential service revenue bonds, even credits with higher headline risk, such as California, have seen their bonds trade with the smallest yield spread since December 2008, according to S&P Index data. The spread on lower-rated investment grade debt is also approaching the cheapest levels since before the crisis as investors with less risk aversion look to boost return. The spread of BBB over AAA rated debt has potential to compress even further because demand greater than supply is expected to persist in the coming months.
$113 billion in coupon and principal payments are expected from June through August but issuance is expected at only $90 billion. June and July are known to be the heaviest reinvestment months of the year. Issuance for 2012 is now projected around $350 billion, up from 2011’s $295 billion which resulted in a net negative supply of $52 billion, the greatest in history.
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