Last week saw more dire talk on the end of the euro, the lowest ever GT10 auction, a 2.2% swing in SPX[1] and an overly dramatic reaction to hedging losses at JPM[2]. But these are not big enough to push aside the broad positives: i) Europe will cobble together some compromise...there's already broad agreement that pure austerity needs dilution and the Bundesbank even made soothing noises on inflation ii) US economic data was broadly helpful iii) market metrics remain solid and iv) the federal government is in budget surplus. Yes, no lies. Read on.

NFIB: The monthly NFIB survey does not always get the attention it deserves. For months, businesses have said that, no, credit access is not a problem, but, yes, demand, sales, inventories and orders were, so there was no reason to raise capital expenditure plans. Then last week, they reported the strongest headline since December 2007 and signaled an intent to increase employment and capital outlays. We have seen a divergence between the ISM manufacturing numbers, which had been rising steadily since July, and the NFIB which is way off its peaks. They should move somewhat in tandem as the ISM is the big cousin of the NFIB.

But in the 2009 to 2010 period, small businesses were cut off from bank loans while larger companies enjoyed access to bond and equity markets. Now it looks like NFIB capex intentions are on the rise, not just to replace equipment but also to increase capacity. This should be good in the coming months especially if the trend to lower fuel costs continues. This is a very economically sensitive part of the economy and they are the key to a broader and more sustainable recovery closer to 3%. So watch this space. (HT, Ian Shepherdson).

Some of these Fed regionals: go along, not really saying much, then have a true "say what?" moment. Last week's was from Minneapolis Fed president Narayana Kocherlakota who argued that the dual mandate of maximum employment was all too hard to reconcile with a 2% inflation target. The basic thesis, not uncommon among those calling for inaction, was that labor participation rates were on the decline and that vacancy rates are higher than unemployment warrants. This is also called the Beveridge Curve. And the plots on the curve are not where they should be.

He then basically said if we're going to run 2% inflation (which for the record is just a Fed number and probably lower than the markets or the economy needsand it's an average number when it should be cumulative...but we'll let that go), then we may be near maximum employment. Ergo, he does not favor accommodative policies...luckily he's a non-voting FOMC member this year.

What's wrong with that? 
1. There is scant evidence the natural rate of unemployment has climbed and that we're in some new era of labor scarcity. Certainly job losses and gains are pretty uniform across industries, if not wage cohort (see TOTW passim).

2. Calculating how Labor Force Participation Rates (LFPRs) change employment is tricky stuff but it probably has not led to much more than a 0.3% change in the unemployment rate, i.e. it would be around 8.4% not 8.1% if LFPR had remained constant.

3. Last week's JOLTS report saw a nice increase in private sector job openings but the drag from much lower growth in openings in the government sector means we are below what we need to increase employment. Here's the graph...still way off the peak.

 

And here's the difference between private openings to separations, so still running some 500,000 more separations than openings, which given the slowdown in government jobs, is not enough to create 144,000 monthly NFPs needed to reach 7.5% unemployment by 2013.

4. Wage inflation remains low. There's not much to suggest wage push inflation is on the way, whether we look at i) last week's Producer Price Inflation, which came in at 1.9% and has declined every month since last year's energy hike, or ii) wages. Here's wages as a proportion of all personal income...still some ways off inflation territory. And as we have suggested here before, a mild inflation overshoot would give much desired top line growth to companies.

Put all this together and the case for continued easing, especially in face of the fiscal drag, looks strong. An occasional straw man argument can be a fine thing but we need more momentum before positing inaction on the employment front.

That Fiscal Cliff: The expiration of the Bush tax cuts, payroll tax holiday, extended unemployment benefits and sequestration cuts on January 1st, 2013 amount to about 3.5% of GDP. And because it happens all at once, the hit to Q1 GDP could be as much as 5%. It's unlikely to happen but the talk is going to be around for a while yet. Interestingly, the April Treasury Statement came in last week showing a surplus for the first time since September 2008. April is, predictably, a good month for receipts so the trend won't continue. But diving into the numbers showed some reveals:

1. YTD spending in the big five departments, so defense, Medicare, Medicaid, Social Security and interest, was down 4%. Among the biggest hits was Medicaid aid to states, down 15%.
2. Federal interest payments were unchanged over the year, once the remittances back from the trust funds and QE are factored in.

Both of which suggest that the fiscal drag will continue throughout this year so GDP will be stretched to rise much above 2.5% this year.

One news item: that dominated the tape was the $2bn "loss" at JPM. This is not nearly as dramatic as it sounds. When a bank hedges its exposure it tries to overlay a risk control on its entire book. So that includes C&I loans, private loans, fee income, client trading, assets held at inventory, fees...everything. In this case, JPM most likely used instruments like credit default swaps, total return swaps, to hedge tail event credit risks. It's a complex balance sheet so the risk wasn't perfectly matched and they would have made some best judgments to minimize basis risk (i.e. the mismatch that occurs in every hedging transaction) to the underlying exposure. The hedge didn't work, maybe because the limits weren't set correctly, but the losses were netted against the gains in their available-for-sale portfolio and currently stand at around $800m.

Now, I'm all for a pig-pile on banks and this may not have been the smartest hedge. But they probably had the correlations right and it does not mean they misunderstood basis risk. So far, it does not sound like a breakdown in economic rationale nor does it appear systemic (i.e. no one else on the street is crying right now). JPM can easily absorb the losses and it barely affects their Tier 1 capital ratio. We doubt the story has legs. (HT, Jason Doiron and Helena Ocampo here at Sentinel) Generally, I support the Volcker rule, but you can't regulate stupid. And this was just stupid.

Bottom Line: For the last month, long duration governments outperformed MBS by around 500bp, the Barclays Aggregate [3] by 430bp, corporates by 380bps, high yield by 448bp and SPX by 883bp. So the place to be was i) long duration ii) governments and practically nothing else. But this may not last. Equities trade on an 8.2% FCF yield compared to Baa[4] bonds at 5.1% and multiples are not stretched. We still put new money to work in equities.

Sources: FT Alphaville, Ian Shepherdson, High Frequency Economics, Federal Reserve Bank of Minneapolis, National Federation of Independent Business, US Treasury Department, Federal Reserve Bank of St Louis, Bureau of Labor Statistics, David Altig, Bureau of Economic Analysis, US Department of Commerce, Bloomberg, Sentinel Asset Management, Inc.

[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
[2] To see Sentinel Investments' Top 10 Holdings for all funds, please click here.
[3] Barclays Aggregate Index is an unmanaged index that measures the U.S. investment grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. An investment cannot be made directly in an index.
[4] Moody's Seasoned Baa Corporate Bond Yield, source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis, Economic Research