Deloitte Weekly Economic Update 6 th June 2011

Transcription

1 Deloitte ly Economic Update 6 th June 2011 Updated Monday, June 13, 2011 Posted every Monday, the ly Economic Update keeps readers informed on key economic news and developments over the preceding seven days. Executive summary for the week of June 6, 2011 Financial markets crack; ECB signals a rate hike; OPEC is in disarray Double, double toil and trouble; Fire burn, and cauldron bubble. Three Witches, Macbeth, Act IV, Scene i The most significant economic news last week was the dramatic re-pricing of risk that took place in the financial markets. Like the three witches in Macbeth, market forces are stirring up trouble for the global economy. While much of the media attention has been on the six-week decline in the stock market, there has been precious little focus on developments in the credit markets. Risk spreads blew out last week. Prices for credit default swaps were up as the price for insuring against a corporate default rose. The credit markets are showing increased signs of nervousness over the end of quantitative easing and the inability of Congress to compromise on raising the debt ceiling. Adding to the witches brew of uncertainty are the Federal Reserve s difficulty in writing new rules for the regulation of derivatives as required by Dodd-Frank and a growing disagreement between the European Central Bank (ECB) and the German government over how to resolve the sovereign debt issue in Europe. The ECB met last week and kept its key lending rate unchanged at 1.25 percent. ECB President Jean-Claude Trichet made it clear the bank sees inflation as its main threat despite a growing sovereign debt crisis in Greece, Ireland, Portugal, and possibly elsewhere. Trichet promised that the bank will maintain strong vigilance against inflation, which is the ECB s way of signaling that it plans to raise rates at its next monthly meeting. Europe, China, Canada, Australia, Brazil, and India are all raising interest rates in the face of a weakening global economy. The fact that the U.S. is a long way from any rate hike points to a weaker dollar in the months ahead. President Trichet also indicated that the ECB does not want to see the rescheduling of Greek debt so favored by the German government. OPEC s meeting in Vienna ended in acrimony, with the cartel unable to come to an agreement over production. Iran, Algeria, and Venezuela opposed production hikes proposed by Saudi Arabia. OPEC has been in disarray since November 2007 when it failed to agree on production quotas for individual countries, opting instead for an overall group quota. Since that time, OPEC production has consistently exceeded the group production level and continues to rise even taking into account the loss of Libyan output. OPEC has lost both its discipline and its credibility. On the policy front, the level of regulatory drag continues to rise. McKinsey published a study of the effects of last year s health care reform and estimated that more than a third of all employers will drop health care coverage as an employee benefit by Such a development would significantly raise the cost of the Patient Affordability Act passed last year. The Environmental Protection Agency has proposed regulations that would dramatically increase the cost of using coal to generate electricity. The Federal Reserve set out regulations covering the interchange fees banks can charge retailers for consumers use of a debit card. The ruling was deemed as a victory for retailers and a defeat for property rights and free markets. Limited economic data came out last week. The trade deficit was significantly better than expected. Much of the improvement was due to a sharp fall in imports from Japan and a decline in oil imports. Exports continue to shine, rising 22 percent from a year ago. In real inflation-adjusted terms, the April trade deficit was 16.8 percent less than three months ago. The drop in the trade deficit, if sustained over the quarter, will give a significant boost to second quarter GDP. Strong export growth is also contributing to the strength of the manufacturing sector. Initial unemployment claims were essentially unchanged but the four week moving average ticked down for the third week in a row. Consumer credit rose by $6.3 billion; almost all of the gain comes from student loans, which now exceed credit card debt. The ly Economic Update Real Economy Index was down last week. The eight indicators that make up this index dropped from -1 to -3. The decline was driven by the sizable drop in the stock market and the Baltic Dry Index. The four week level moved down a notch from +4 to +3 while the current level was unchanged at +1. The ly Economic Update Credit Index rose from -4 to a still-negative -2. The four-week average fell from +1 to 11. The current level also moved lower from +2.to +1.

2 The financial market activity last week had an August 2007 feel to it. Then, the failure of two Bear Stearns hedge funds that invested in sub-prime mortgage backed securities sent credit spreads soaring and stock prices falling. This time may be different but the accumulation of governmental inability to address structural problems of debt and to get their regulatory house in order is putting significant and unneeded stress on the financial system. Couple these issues with the temporary problems created by rising energy prices, weather disruptions, and Japan and we have the makings of a real Shakespearean tragedy. s last week Consumer credit rose in April Trade deficit narrowed sharply in April Commercial paper outstanding continues to rise Chain store sales were up 2.5 percent in the most recent week s last week The budget deficit for May was $58 billion Wholesale inventories and sales slowed in April The rest of the story for the week of June 6, 2011 ECONOMIC POLICY UPDATE Policy summary: It is hard to imagine a time when there have been so many unresolved policy issues. In no particular order these include: 1. Raising the U.S. debt ceiling 2. Defining rules for derivative trading 3. Deciding the future of quantitative easing 4. Restructuring Greek debt 5. EPA s role in setting energy policy 6. OPEC s viability The debt ceiling: Negotiations continue on raising the debt ceiling, but with little apparent progress. Some have suggested that we may see a small hike in the debt ceiling to give Congress more time to negotiate a large settlement. The market fear here is of the unknown impact that a credit default would have on credit default swaps on U.S. debt. Fitch, Moody s, and Standard and Poor s have already warned that the U.S. is at risk of a credit downgrade should Congress fail to raise the debt ceiling in time. The Chinese ratings agency Dagong declared that the U.S. has already defaulted on its debt as a result of the significant drop in the value of the dollar. With the Chinese yuan still closely tied to the dollar, the yuan has also dropped significantly in the past year, making the Dagong pronouncement a case of stone-throwing by those who live in glass houses. Derivatives trading: The Federal Reserve is having difficulties crafting workable rules for future derivatives trading. Dodd-Frank puts an end to the current over-the-counter derivatives market come the end of July. If the Fed fails to issue new rules and Congress does not pass an extension, the entire $500 trillion derivatives market will be in limbo. The possible effects of such a development are unknowable and hopefully will remain so. The future of quantitative easing: With the economy throwing off weak economic data of late, speculation about a possible third round of quantitative easing is growing. Such a move would probably require a decline in employment. The very fact that such a policy move is being considered adds to the overall level of economic uncertainty while undermining the credibility of the Federal Reserve. Restructuring Greek debt: The ECB and the German government have sharply conflicting views on the policy approach needed to address the problem of Greek sovereign debt. Berlin wants a soft restructuring of the debt which would extend the current maturities of Greek debt, putting off the need for Greece to return to the credit markets. The ECB views such a move as a default that could trigger credit default swaps. The ECB as a holder of Greek debt views such a move as undermining its own solvency. The German government rightly views the debt as unsupportable. The disagreement adds to the environment of uncertainty. EPA sets energy policy: A variety of proposed EPA regulations affecting the use of coal to generate electricity could force the closure of many existing coal plants, and push the utility industry to spend billions on mitigation and a transition to natural gas. American Electric Power announced last week that it will close five coal fired plants and spend $6-$8 billion retrofitting existing plants if regulations the EPA is considering are implemented. AEP also announced that the regulations would force it to raise electricity prices by percent and cut 600 jobs. Higher electricity prices would have a negative effect on both businesses and households.

3 The future of OPEC: In a period of excess oil capacity, OPEC can play a significant role as a cartel to the degree that it can limit supply. In periods of rising demand, the market plays that role. The changing nature of the oil markets was on display for all to see last week as OPEC failed to come to any agreement on production. Price hardliners Iran, Venezuela, and Algeria were unwilling to agree to an increase in production. Still, actions speak louder than OPEC agreements. OPEC production continues well above agreed upon production limits. Saudi Arabia left the meeting vowing to lift production. The immediate market reaction to the failure was to bid oil prices up. Rising oil prices do have the benefit of creating incentives for producers to bring more oil to market and to discourage consumers from using oil. That is if markets are allowed to operate. Subsidies to consumers in many developing countries and environmental limits on producers in the United States force prices to go well beyond where markets alone would take them.

4 THE REAL ECONOMY Summary: Not much economic news came out last week. On the positive side, the trade deficit narrowed sharply in April and consumer credit rose as well. However, wholesale inventories and sales fell, indicating that confidence in the recovery might be waning. The budget deficit continues to be a cause for concern. The budget deficit for May was $57.64 billion. The deficit in May takes the federal government's budget shortfall to $927.4 billion for the first eight months of fiscal This is $8 billion more than the deficit recorded during the same period last year. The government is on track to run a deficit of $1.6 trillion for fiscal Trade deficit narrowed sharply in April to $43.7 billion. Fewer oil imports and strong demand for American goods and services drove the trade deficit down nearly 7 percent in April, providing a break from a recent string of economic news that had called into question the pace of the nation s fragile economic recovery. Imports stood at $219.2 billion while exports stood $175.6 billion. China continues to account for about half of the trade deficit. Real Economy Index: The eight indicators that make up this index fell from -1 to -3. The Baltic Dry Index and S&P 500 fell sharply. The overall four-week trend was fell from +4 to +3. The current level was unchanged at +1. Indicator Real Economy Index: Taking all eight indicators together as a whole. Baltic Dry Index. The index fell sharply to The index is still well below last year s high of 4209 in May The index, which measures rates charged for bulk shipping of commodities, is a good leading indicator of future global industrial activity. Four- Trend +3 Last -3 Current Level +1 North American rail car loadings for the week through June 4 were up 3.7 percent from a year ago, while the four-week moving average was up 3.6 percent. Rail traffic is a leading indicator for the construction and manufacturing sectors. Copper prices fell to $ a pound. Economists often refer to copper as Dr. Copper because it correlates closely with the global economy. S&P 500: Equity markets fell 2.2 percent last week. The four week moving average is down 1.5 percent. Mortgage applications fell during the week ending June 3. Mortgage applications were down 0.4 percent. The four-week moving average was up 1 percent. Initial unemployment claims increased by 1,000 from the previous week's revised figure of 426,000. The four-week moving average was 424,000, a decrease of 2,750. Claims are a good indicator of labor market direction. M2 money supply: Growth remains slow despite the Fed s efforts. The lack of qualified borrowers is hurting both credit and money supply growth. M2 decreased.14 percent in the week of May 30. The four- week moving average increased by.07 percent. Money supply growth is a broad measure of economic activity. Chain store sales were up 2.5 percent for the week ending June 4. Chain store sales are a measure of consumer spending.

5 THE MANUFACTURING SECTOR Wholesale inventories and sales slowed in April. Inventories of wholesalers climbed 0.8 percent to a seasonally adjusted $ billion. Auto inventories fell amid supply disruptions caused by the earthquake in Japan. Petroleum inventories surged during the period. Sales of wholesalers went up a mere 0.3 percent to $ billion after a 3 percent gain in March. THE CONSUMER SECTOR Consumer credit rose in April for 7th straight month. Consumers took on $6.25 billion more in debt during April. They took out loans to buy new cars and pay for schooling while paying down credit-card balances. Revolving credit shrank by $943.5 million in April following a $36.7 million increase in March.

6 THE FINANCIAL MARKETS Summary: Equities were down once again last week. Commodities had a mixed week. Oil and bullion prices fell during the week. The Treasury yield curve was flatter last week. Last week s credit index improved: The credit crunch indicator improved from -4 to -2. The four-week average was down from +1 to -1. The current level slipped from +2 to +1. Indicator Credit indicators aggregation: Taking all eight indicators together as a whole. The TED spread: The spread between three-month LIBOR and three-month T-bills fell from to last week. A normal spread would be around 50 basis points. The post-lehman bankruptcy peak was around The four-week average fell marginally to Four- Trend -1 Last -2 Current Level +1 Three-month T-bill: Rates rose marginally to.04. The four-week moving average of the three-month T-bill rose to Zero interest rates are one sign of a liquidity trap. Two-year credit default swaps: The price of insurance against default fell to The fourweek moving average rose marginally to A normal market price would be 35-50, which means that the market s current perception of risk is at low levels. Corporate risk spread: The spread between BAA bonds and 10-year Treasury rates was up 13 basis points last week. At 283 basis points, the spread is still well elevated above the normal levels of 200. The four-week average rose to Commercial paper outstanding: Increased by $23.9 billion last week. Commercial paper outstanding had increased in fourteen previous weeks. The four-week moving average of total commercial paper rose strongly. Commercial paper risk spreads: The spread between 30-day A2/P2 rates and AA non-financial rates at 24 basis points was one basis point more than last week. A normal spread would be between 10 and 25 basis points. The four-week moving average rose to Treasury yield curve: With short rates up 1 basis point and long rates down 7 basis points, the best single leading indicator of the economy was flatter by 8 basis points last week. A steeper curve is a leading indicator of stronger growth; a flatter curve is a signal of slower growth. Size of the Fed s balance sheet: The Fed is committed to near-zero interest rates and an expanding balance sheet until it sees a sustained recovery taking shape. An expanding Fed balance sheet poses the danger of higher inflation for the future. Total assets on the Fed s balance sheet increased by $22.5 billion last week. The four-week average of the percentage change in Fed s total assets was 0.6 percent.

7 Equity markets: Stocks fell for the sixth straight week. Technology stocks and consumer companies reliant on discretionary spending led losses in the Standard & Poor s 500 Index. The S&P 500 lost 2.2 percent during the week, reaching its lowest level since March 16. The Dow fell 1.6 percent. Its last weekly slump of this length was in October Commodity markets: Commodities had a mixed week. The Standard & Poor's GSCI Index of 24 raw materials rose during the week but fell on Friday. Overall, the index was up for the week. The Thomson Reuters/Jefferies CRB Index of 19 raw materials exhibited a similar trend. Gold fell almost 1 percent on Friday for its biggest oneday decline in a month, as a dollar rally coupled with losses in crude oil and other commodities prompted investors to sell ahead of the weekend. Bullion also came under liquidation pressure on weaker Chinese trade data and as the euro tumbled more than 1 percent. Gold futures settled at $1, an ounce, and silver ended the week at $36.32 an ounce. WTI crude ended the week at $99.29 a barrel. Bond markets: Treasuries rose, pushing two-year note yields down for a ninth week in the longest stretch of decreases since February 2008, on fears of economic weakness and bets the Federal Reserve will maintain monetary stimulus to boost a stalling economy. Yields on benchmark 10-year notes touched their lowest level this year after Fed Chairman Ben S. Bernanke said that the recovery was frustratingly slow. The two-year yields dropped on June 8 to 0.37 percent. Yields on 10-year notes decreased 7 basis points this week to 2.97 percent. The Treasury yield curve was flatter last week. A look ahead The economic calendar picks up considerably this week, with readings on prices, retail sales, industrial production, and housing starts. While prices are expected to be well behaved, market attention will focus on retail sales, industrial production, and housing starts for hints about the strength of the expansion. Given the poor showing in auto sales, retail spending is expected to be weak. If industrial production and housing starts follow suit, then worries over the strength of the recovery will grow.