Markets Cap Off Poor Second Quarter

Equity markets surged more than 2% in the final day of the quarter, helping to mitigate a mostly disappointing three months of returns for risk assets.  For the quarter, the S&P 500 fell 3.3% and the Dow Jones Industrial Average declined 2.5%.  The indices remain in positive territory for the year, up 8.3% and 5.4%, respectively.

 

A series of key agreements reached during a two-day summit in Brussels by European leaders paved the way for Friday’s rally.  Most notably, the talks yielded provisions that would directly recapitalize banks in Spain and Ireland and expand the powers of the bailout fund known as the European Stability Mechanism (ESM).  Direct recapitalization of banks was a key victory for troubled peripheral countries, as it immediately shores up the balance sheets of Ireland and Spain instead of adding to government debt levels. The debt-to-GDP ratios for each country will reduced by an estimated 30% and 10%, respectively, as a result of this action.

 

The agreements appear to have placated markets for the time being, as yields on peripheral sovereign debt fell sharply in the wake of the summit.  The steps, which also create an oversight body for Eurozone banks, initiated an integration of the region’s banking system.  While this is ultimately necessary to create a long-term solution for the monetary union, the EU summit did not address the current size of the bailout mechanisms.  It is widely assumed the EFSF and ESM facilities need to be expanded significantly – or given the power to issue bonds – to possess the necessary firepower to bail out the region.  It remains to be seen what last minute solution EU leaders will need to come up with to address this issue.

 

 

Economic data was mixed last week, with positive data on the housing front met with generally lackluster news on the American consumer.  Overshadowing those sectors was the third and final estimate of first quarter GDP, which was unchanged from its second estimate of 1.9%.  This was a disappointment to some who thought improved trade data could boost the figure.  Investors will get their first peek at Q2 GDP with the first estimate due out July 27.

 

 

Consumer data left much to be desired last week.  On Tuesday, the Conference Board’s Consumer Confidence measure fell sharply by 2.4 points to 62.0.  This indicator has been on a downward slide since peaking in February above 70, the highest level of the recovery.

 

Of the index’s components, consumers’ future expectations exhibited the biggest deterioration.  This is a notable and troubling change, as consumers had generally been less pessimistic about the future outlook previously.  Softness in the labor market, in particular, seems to be creating a new wave of negative sentiment such as that seen last summer.

 

 

The jobs picture is certainly not in the solid state it appeared in the first quarter.  Thursday’s initial jobless claims once again came in above 380,000.  The upward spike that began in April has caused the four week moving average to creep ever closer to 390,000, and the stage appears set for another disappointing government jobs report next week.

 

 

One flaw with consumer surveys is their tendency to not always track with actual spending data.  Friday’s personal income and outlays report unfortunately did not perpetuate this contradiction.

 

Personal spending was flat in May, which follows several months of weak data, including a 0.1% advance in April.  Stagnant wages continue to be the primary headwind, as incomes grew just 0.2% during the month.  This was slightly below consensus expectations.

 

 

If there was any consolation to the personal spending report, it was that lower prices shouldered some of the blame.  The Personal Consumption Expenditures (PCE) price index fell 0.2% in May, largely the result of declining gasoline prices.  A drop in purchases of durable goods such as automobiles was also to blame for weakness in spending.

 

Surprisingly, the relief provided by lower gas prices to consumers was not captured in Friday’s University of Michigan Consumer Sentiment index.  Like the Conference Board, measure declined in June, from 74.1 to 73.2 – the lowest reading of 2012.  Again, weakness in consumers’ assessment of future conditions contributed to the decline.

 

Has Housing Stabilized?

In the past two weeks, several important indicators have illustrated a market that, while not quite in a state of recovery, appears to be stabilizing. This sentiment was echoed in the latest Beige Book released by the Federal Reserve, which reported, “several Districts noted consistent indications of recovery in the single-family housing market, although the recovery was characterized as fragile.”  This seems to be an adequate description of the sector’s current state, as a few encouraging developments are offset by ever-present risks. 

 

Two weeks ago, the Census Bureau reported that existing home sales were sluggish, falling slightly from 4.62 million in April to 4.55 million in May.  Looking past that initial disappointment, however, the big takeaway was a significant drop in the level of distressed transactions. The measure fell to 25% in May from 28% in April and 31% one year prior.   

 

The overhang of this discounted property has weighed on housing prices since the housing crisis erupted in 2007.  Clearing out the excess inventory of homes sold as foreclosures or short sales is essential to creating price stability and, in turn, home sales.  The improving trend in distressed transactions, therefore, is an extremely encouraging development.

 

Indeed, there has been discernible improvement in housing prices.  Tuesday’s release of the S&P/Case Shiller Home Price Index, which tracks housing prices in 20 major metropolitan areas, reported a sharp uptick in April prices.  This was the first increase in eight months, and gains were reported in 19 of the index’s 20 component cities.  And while the year-over-year data is still modestly negative, the level of declines has moderated significantly in recent months.

 

 

Other data sources reflect this trend.  The existing home sales report noted that prices firmed to a median level of $182,600 in May, 7.9% higher than one year prior.  Similarly, the FHFA Home Price index has risen in five of the past six months. While the latter index includes only agency properties, which are generally of higher quality than the broader housing market, improvement price improvement is nonetheless encouraging.

 

Homeowners are also benefiting from record low financing rates.  In an analysis by Bloomberg of Federal Reserve data, the news agency reported that home equity levels rose to 41% of US residential property value in Q1, the highest level since 2008.  A rash of refinancings caused the largest jump in home equity in more than 60 years, according to the report, as many homeowners paid down principals.

 

Improved home equity levels could prove beneficial if there is another leg down in the housing market.  Despite some positive developments, home sales remain sluggish.  While existing home sales have risen in the past 12 months, the market has only incrementally improved since 2008.  The government’s home buyer credit program in 2009 led to an artificial boost, but those effects have all but dissipated.

 

 

New home sales surprisingly edged up last week to their highest level in more than two years, reaching an annual rate of 369,000.  Unfortunately, that segment of the market has not yet escaped the doldrums, bumping along at under 500,000 sales for virtually all of the past three years.  This compares to sales of well over one million in mid-2006.  With so many existing properties selling at a discount, there is little incentive for buyers to pay a premium for new housing.

 

 

 

Worse yet, the improvement in distressed inventory could reverse itself in the coming months.  Many banks put their foreclosure practices on hold in light of the infamous robo-signing scandal of 2010 and the resulting litigation by the Justice Department.  Now with that situation mostly resolved, banks are beginning to process delinquent mortgages at a faster rate.

 

Source: Washington Post

In a recent Washington Post article, finance blogger Barry Ritholtz noted that 2.8 million Americans are 12 months or more behind on their mortgages.  With the “foreclosure machinery” ramping back up, he expects “more distressed sales, lower prices and increasingly tough comparable appraisals…over the next 12 months.”  He pointed to May’s RealtyTrac report as evidence of this, which revealed that foreclosure filings jumped 9% during the month.

 

Where housing goes from here is difficult to predict.  While there is incremental data suggesting stabilization, a deteriorating economic climate could strike a blow to housing’s “fragile recovery.”  In the face of continued economic uncertainty and tenuous labor market, consumers’ willingness to make such significant purchases and/or to leave their jobs remains a headwind for activity in the market.  The shadow inventory of foreclosures also remains a real threat, as any significant pick up will reverse recent price gains and send housing into deeper retrenchment.

 

the week ahead

There are a few important indicators to watch in this holiday shortened week.  The Institute of Supply Management reports both its manufacturing and non-manufacturing indices on Monday and Thursday, respectively.  The ISM manufacturing report will likely soften given negative trends seen in other manufacturing data points.

 

The government jobs report will headline the week’s events on Friday, as market participants hope to see a rebound from an incredibly disappointing May reading.  Consensus is looking for just a 90,000 gain following May’s 69,000 advance.

 

The decisions made during last week’s EU summit should also continue to dominate the financial dialogue this week.  Pundits and market participants alike should flesh out the impact of the various new measures on Europe and markets.

 

Rate decisions are due out from the Bank of England and the ECB this week, with the latter expected to cut its key interest rate by as much as 50 bps.  The central banks of Russia, Uruguay, Australia, Poland, Sweden, and Malaysia also meet.

 

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