Nice Speech, Tough Crowd
By Christian Thwaites
October 30, 2012
Sandy is pummeling everything we know on the eastern seaboard. I hope everyone stays safe and we can ride this out without too much damage. Thankfully markets are closed. Meanwhile, here's our views on capital markets on Monday.
A quieter week but some valuable insight into the skillful game played by the ECB's Mario Draghi. At the risk of oversimplifying, what we have in play (and see TOTW passim) is: i) an asset repurchase program promised but neither funded or exercised ii) and the same for a Spanish bank bailout iii) a major reliance on bank lending for growth but banks tightening credit standards and lowering loans by €250bn in the last year. So when Draghi presented himself at the Deutscher Bundesdtag last week he explained about the very real threat of deflation and that it was a bigger risk than inflation. He was in town to assure the Germans that any policy actions by the ECB would not finance governments (so no monetization), nor compromise central bank independence (so no political pressure), nor create taxpayer risk (so no increased taxes) and nor create inflation (the German nightmare). It was a deft maneuver by the ECB into a position with its most important political partner so that it could continue policy at time when banks seem unwilling to pass on monetary stimulus to the real economy.
There's a pretty dismal picture of growth in Europe with recent PMI surveys falling fast and Bund yields with them. But two smaller stories remind us that slow successes happen. First, the IMF reported "progress" in Greece and Portugal so freeing up some €1.5bn in funding. And second, the IMF noted that Ireland was in line to meet the budget deficit target of 7.5% next year and had regained market access for its sovereign debt. This shows up in the sharp reduction of the Irish 9-year benchmark yields from nearly 8.3% last year to 4.7%, a gain of 34% over the year if one had the stomach for it (few did). So quietly, perhaps the periphery is mending albeit at some significant social cost.
The meeting last week was a "no presser" so expectations were low and they met them. Which was good because the new polices announced in September were radical and the market needs further time to digest. The wording changes from last month were minor and Richmond Fed president Lacker upped his dissent, this time disagreeing with both the forward guidance and the low rates. He must not put too much store in his own region's manufacturing and service sector surveys because both were down in October after a brief respite in September. The Fed is surely right to pursue unchanged policies. Compare adjectives in their outlook last week compared to six months ago. Same as it ever was:
|March 2012||October 2012|
|Employment||Declining but elevated||Slow and elevated|
|Household Spending||Advancing||Bit more quick|
|Securities Repurchases||Maturity extension||Continue outright purchases|
Nor is it much changed from a year ago. The Fed knows that today's growth is insufficient to bring about any material gain in employment, even with demography and labor withdrawal helping recent improvements. Looking ahead, the Fed will probably keep the asset purchases in place beyond the maturity extension (Twist) program in December. That means they will likely revert to treasury buying to maintain the $85bn per month rate. The reaction to QE3 diluted fast. At first stocks rallied 5%, mortgage rates fell 16bps and the Fed's Five Year Forward Breakeven Inflation Rate rose 40bps to 2.87%. But recently, stocks fell, mortgages backed up and inflation expectations fell. One can imagine the Fed's anxiety in trying to come up with targets for both inflation and employment in light of the palpable lack of momentum. Part of which is explained by...
We have tended to ignore this on the basis that it has been in the news since the spring and was one of those "surely they won't do it" threats. But it's coming closer and it's the topic of many an earnings call. The actual figures for the drag on the economy range from $540bn to $610bn and their effect depends on whether one believes that a negative multiplier will go into effect or that increased revenue and lower deficits will spring confidence back into life. But we do know that the Bush-era tax cuts, expiration of the payroll tax holiday, reduced unemployment benefits and the Budget Control Act spending cuts are already weighing on people and businesses. Last week the Chairman of General Dynamics said that as far as he was concerned, the sequestration was a question "no one on earth could answer" but that it was:
And that he had already seen slowing contract awards from the planned $1 trillion in defense cuts over 10 years and that he would have to reduce costs. That also explains the general slowing of capital expenditure despite a small rebound in durable goods orders. The increase was 9.9% but almost all due to the volatile series of aircraft orders. Here's what it looks like after Boeing received only one order in August and 143 last month:
Source: Federal Reserve Bank of St. Louis, Economic Research
Across a broader group, here's the downturn in non-defense capital goods, so that's all the plant making capex stuff. Normally, when companies cut capex, staffing follows. This time could be different because so many costs were cut to the bone in 2009-2011 and companies may defer spending until the cliff is out of the way. Still, sobering stuff.
Source: Federal Reserve Bank of St. Louis, Economic Research
There was also some slippage in two key order components. In the three months to October Durable Goods Orders excluding aircraft were at $441bn compared to $455bn in the prior three months, so a 3% decline, and Orders for Non Defense Capital Goods were $205bn, down 7% from the prior quarter's $221bn. Put all this together and we see businesses running scared ahead of the tax changes and so a big slow down in inventory build and investment. These two components have contributed around 50% of growth for the last three quarters so unless we see a pick up in exports (unlikely based on two out of three months data) or from government (probably not) then the personal consumption side has a lot of pulling to do to keep growth at around 2%. All this makes Q3 GDP growth a real challenge...
The first estimates for any quarterly GDP change are a bit dicey. The swing between first estimates and final numbers has been between 0.2% to over 1.0% in the last two years. The flash numbers that came out Friday had a few interesting points: i) nominal GNP was up 4.9%, the fastest rate in twelve months, which is critical for revenues ii) government defense spending jumped 13%, that hardly looks sustainable but meant iii) government was a contributor for growth for the first time in nine quarters iv) businesses pulled back on investment and inventories, which is no surprise as the Fed regional reports were telling us that for months and v) personal compensation grew at around 2.5% which was slower than last quarter. Put all this together and it's probably not enough to dent unemployment.
Some of the consumer side of growth is picking up. Following on from the new housing starts two weeks ago, we saw pending home sales increase. But it's very slow and personal consumption growth continues to struggle. And if the Fiscal Cliff hits, it will hit those in the bottom two thirds of earnings the worst, which will stop the recovery dead in its tracks.
It was a quiet week in treasuries with the GT10 price moving around less than a point. Two auctions at the 7- and 5-year went well with slightly higher direct bids. Credit continues to outperform equities as investor demand remains robust. For the retail investor, industry flow data showed inflows of $1.9bln into IG, just $10m into HY and $666m into municipal funds.
We're looking beyond the current earrings season. Revenue misses are more important than earnings misses and the market's reaction has been muted. The cause of the guidance corrections has been very specific, namely the September slowdown and fiscal cliff. If a deal is done, market relief will be swift.
Treasuries remain in a range which is good given the news from companies. We're making few changes to the equity/fixed allocation. The dividend yield on the market is back to its highest level since August.
Sources: IMF, Bloomberg, Bureau of Economic Analysis, Federal Reserve Bank of St. Louis, Capital Economics, High Frequency Economics, US Census Bureau, US Bureau or Economic Analysis, US Dept of Housing & Urban Development, European Central Bank, TrendMacro, CRT Ader, J.P. Morgan Market Intelligence, Q3 2012 General Dynamics Earnings Conference Call, Sentinel Asset Management, Inc.
 There is a position in General Dynamics as of October 26, 2012. To see Sentinel Investments' Top 10 Holdings for all funds, please click here.
 There is a position in Boeing Corp. as of October 26, 2012. To see Sentinel Investments' Top 10 Holdings for all funds, please click here.
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