Uncertainty Reigns Supreme
By Chris Maxey, Ryan Davis
July 31, 2012
Markets Rise Ahead of CEntral Bank Meetings
Equity markets rallied last week ahead of important policy meetings by the Fed and ECB. The S&P 500 rose 1.7% and the Dow Jones Industrial Average climbed 2.0%. Both indices reached their highest level since May.
Amid rising sovereign yields in Spain and Italy, ECB President Mario Draghi lifted investor hopes last week after promising that the central bank would do “whatever it takes to preserve the euro.” Rumors circulated that the ECB could undertake another bond buying program to bring relief to troubled sovereigns, leading to a sharp rally in risk assets in the final two days of the week.
Investor expectations are now heightened for additional action at the ECB’s post-meeting announcement on Thursday. Separately, the Federal Open Market Committee meets on Tuesday and Wednesday, with investors hoping to see the Fed also announce new policy action, potentially including QE3.
Investors received their first look at second quarter GDP last week, as the Bureau of Economic Analysis (BEA) reported on Friday that the US grew at a 1.5% seasonally adjusted annual rate. This was slightly above expectations, but still represented a slowdown from the first quarter’s 2.0% growth rate. Both remain below what economists would hope for at this stage of the economic recovery.
This quarter’s GDP report included annual revisions, as more complete data allowed the BEA to update its GDP estimates from the past several years. This led to notable adjustments to both the recession and recovery periods. Regarding the recessionary period from late-2007 to mid-2009, the original contraction of 5.1% was reduced to 4.7%. This was primarily the result of higher government spending levels than first thought.
Since mid-2009, however, the economic recovery was not as strong as initially believed. The BEA estimated that the US economy grew 5.8% from Q3 2009 through 2011, reflecting a 0.4% downward revision from first reports of 6.2% growth. Most of the reduction occurred in the early part of 2010, with prior estimates of 4.0% growth in H1 2010 reduced to 2.2% because of weaker business investment.
The revised GDP data reveals that the economic recovery is the second weakest since the end of World War II. This is certainly a disappointing rebound from the worst recession since the Great Depression. It should not be surprising, however, as recoveries from financial crises are notoriously lengthy as the credit excesses of the previous regime are worked through.
Although GDP dominated the week’s economic headlines, there were a few other items of note.
On Wednesday, the Census Bureau reported that new home sales fell sharply to 350,000 in June. This was well below consensus expectations, but the report included sharp upward revisions to April and May sales. In aggregate, 28,000 more sales occurred in the prior two months than were first reported.
Wednesday’s reports revealed a sharp decline in the Northeast region of more than 60%, a record decline according to Econoday. It is unclear whether this was a weather-related phenomenon, but a rebound in this region could help boost sales in the months ahead.
On Thursday, the Census Bureau also reported durable goods for June. The headline durable goods figure bested estimates after rising 1.6%. Unfortunately, the month’s positive results were entirely due to the volatile transportation component, which increased 8.0%. Excluding transportation, durable goods orders contracted by 1.1%.
June’s data is yet another indicator signaling continued weakness in the country’s manufacturing sector. With the Institute of Supply Management’s (ISM) manufacturing PMI recently falling into contractionary territory for the first time since mid-2009, concern is increasing that one of the major pillars of the economic recovery is fading. Markit Economics’ flash PMI for July, released last week, came in below expectations at 51.8, indicating that there is no immediate improvement in sight.
Amid the seemingly endless string of disappointing economic reports, economists’ estimates are finally catching up to the data. The Citigroup Economic Surprise Index has stabilized in recent weeks, albeit in negative territory, and has recently showed improvement for the first time in months.
This is an encouraging development for investors. While economic conditions may remain sub-optimal, data points that exceed expectations are ultimately a good thing for markets. The CESI typically tracks well with stock markets, so an upturn similar to the one witnessed late last year would seem to portend a favorable environment for risk assets.
Uncertainty Reigns Supreme
With the first half of the year in the rearview mirror, investors might be lulled into thinking the most active period of the year is also in the rearview. Fast forward to year-end, though, and investors may beg for a return to the sanguine days of early 2012. A range of events in the coming months will likely dictate market optimism for 2012, 2013 and possibly beyond.
Several issues are likely to receive the most prominence. Chief among those is the U.S. presidential election in early November. Without offering an opinion on either candidate’s policies, it remains clear that American citizens are deeply divided. Projection website Real Clear Politics currently anticipates Romney winning 191 electoral votes, while Obama will pick up 231. In order to win the Presidential election, one candidate will need to pick up 270 votes, meaning that 116 electoral votes remain up for grabs.
As soon as the election cycle is over, politicians will have their work cut out for them, given the “fiscal cliff” approaching at the start of 2013. At the heart of the fiscal cliff is what the Congressional Budget Office (CBO) describes as “scheduled increases in taxes and, to a lesser extent, scheduled reductions in spending.”
The expiration of Bush-era tax cuts, along with an expiration of the payroll tax cut and fixes to AMT, are the biggest current contributors to the fiscal cliff. As presently estimated, the economy will face a 4.1% drag on growth on January 1, 2013.
With these two major impediments looming, it should not be a surprise that uncertainty is rising. Economists from Stanford University created an Economic Policy Uncertainty Index based on the number of articles “discussing economic policy uncertainty of some type” among the 10 largest newspapers in the U.S.
According to their research, economic policy uncertainty peaked around the time of the debt ceiling debate last August. Since that time, uncertainty troughed to post-2008 lows. Unfortunately, it was only a temporary reprieve, as uncertainty reemerged and began to rise sharply.
Source: Economic Policy Uncertainty
Similar concerns are apparent in recent surveys from the Pew Research Center. According to Pew, four in 10 respondents are currently hearing mostly bad news, in stark contrast to the 24% that agreed with that statement in March. At the top of the list are concerns such as jobs, health care, the budget deficit and social security.
Source: Pew Research Center
Two groups are already beginning to see the effects that uncertainty can have on the overall economy – consumers and businesses.
Recent data on retail sales showed that sales were negative in every month during the second quarter, the worst such streak since 2008.
Just as problematic is data from Gallup suggesting that wealthy Americans are cutting back on spending. In June, average daily spending among Americans making $90,000 or more declined from $136 to $116.
On the corporate front, FactSet calculated that 71% of the 265 companies in the S&P 500 to report earnings have beaten the mean estimate. The bad news is that 47 companies offered negative forward earnings guidance and a mere 13 issued positive guidance on 3Q earnings.
The second half of the year will offer up a number of headline events. Until further clarity is available regarding the outcome of those events, consumers and businesses will continue to maintain a defensive crouch, at the expense of domestic growth.
the week ahead
The upcoming week contains a series of very important economic data releases, headlined by the Employment Situation report on Friday. Consensus currently estimates 100,000 jobs were added to nonfarm payrolls in July and that the unemployment rate was unchanged at 8.2%.
The ISM also releases both its manufacturing and non-manufacturing indices for July, important measures of the health of the US economy. Investors are hoping to see the manufacturing PMI rebound back from its below-50 reading last month.
Other important US indicators include the personal spending and income report, the Case-Shiller Home Price index, and consumer confidence.
Earnings season continues this week with over 100 companies scheduled to report. Among the most notable include Anheuser Busch-InBev, BP, Pfizer, UBS, BMW, MasterCard, SocGen, Time Warner, Standard Chartered, BNP Paribas, Kellogg, Kraft Food, Allianz, AXA, Petrobras, Proctor & Gamble, and Toyota Motor.
As mentioned, both the FOMC and ECB have scheduled monetary policy discussions this week. Investors are hoping to see additional steps taken by both groups to combat deteriorating economic conditions.
Other central banks meeting this week include the Bank of England, Russia, India, Czech Republic, and Romania.
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