Title: Advocacy Investing Portfolio Strategies, Issue 66 By: Karim Pakravan, Ph.D. Copyright: Marc J. Lane Investment Management, Inc. Date: March 17, 2015 A SLOWER FIRST QUARTER A wow payrolls report raises likelihood of earlier Fed tightening 4Q14 GDP growth revised downwards Severe February weather will affect 1Q15 The global economy shows signs of improvement, but downside risks remain The equity markets struggle to break through 2,100 Second Revision: The Bureau of Economic Analysis (BEA) adjusted 4Q14 economic growth down from 2.6% (annualized) to 2.2% (second estimate). On the negative side, we saw an increase in imports, an unusually large drop in federal spending, a slowdown in business capital expenditures and a downward revision in inventories. On the positive side, personal consumption expenditures accelerated. Fig. 1: Flat Industry Surveys
No Clear Signals from Date: Economic data releases for January and February were mixed. Industrial production and manufacturing both expanded in January by respectively 0.3% and 0.2% (month on month, m/m). Durable goods ex-transportation rose by 0.3% (m/m), but factory orders declined by 0.2% (m/m). Manufacturing surveys were relatively flat. Early-month February surveys Empire State and Philadelphia Fed were both respectively at 6, relatively unchanged. Late-month surveys were also flat: The ISM-Manufacturing remained at around 53, while the Markit PMI-Manufacturing rose from 53.9 to 55.1. The broad-based Chicago PMI fell unexpectedly below 50, but that result is considered an outlier due to the impact of bad weather and West Coast port strikes. The services sector expanded, with the ISM-Non-Manufacturing rising slightly to 56.9. Households continue to be cautious. While consumer confidence indicators were generally good (the University of Michigan Reuters index was up to 95.4 at the end of February from 93.6 a month earlier), both personal consumption expenditures (- 0.3% m/m) and retail sales (-0.8% m/m) were down despite a 0.3% m/m gain in personal income. The housing market remains soft despite faster price gains. Oil prices have recovered somewhat and seem to have found a floor, with West Texas Intermediate (WTI) trading at around $50 per barrel (bbl) in the past few weeks. Despite a sharp fall in drilling, US oil supplies continued to rise in the first two months of the year. Fig. 2: Oil Prices Stabilize The strong US oil supply position is reflected in the rise of the spread between WTI and Brent, which had narrowed at the end of last year now back to its more normal levels of $10-12/bbl.
Fig. 3: Strong Job Performance A wow Jobs Report: Despite the awful weather in January, a strong dollar and the West Coast ports strikes, the economy managed to create 295,000 jobs (288,000 from the private sector) last month. The job gains were broad-based: (29,000 for the goods-producing sector, 259,000 for the private business services and 11,000 for government). While the number for the previous two months was revised downwards by 18,000, the three-month moving average stood at 288,000, and job creation for the previous 12 months reached 3.2 million, the strongest performance since 1998. Moreover, the economy created 12 million jobs in the past 60-months, an unmatched winning streak. The unemployment rate, which is derived from a separate household survey, dropped to 5.5%. However, the labor participation rate remained at 62.8%; thus, the drop in the unemployment rate was partly due to a decline in the labor force. The disappointment to this wow jobs report the strongest jobs creating streak since the mid-1990s comes from both weekly hours worked (unchanged at 34.6) and the hourly wages increase (0.1%). The high frequency data also show some unusual deterioration, although it was most likely weather-related initial jobless claims exceeded 300,000 for the last two weeks of February. Improved Prospects: The global economy shows signs of improvement, but also greater divergence. Recent data on the eurozone, especially Germany, has been encouraging, with higher retail sales and industrial production. Furthermore, the European Central Bank s (ECB) quantitative easing (QE) was launched this week, pushing eurozone bond yields and the euro further down. The ECB president Mario Draghi offered a more optimistic view of the eurozone economic prospects, upgrading growth forecasts for 2015 and 2016 to close to 2%, and predicting that inflation would gradually inch up to the ECB 2% target. However, the eurozone recovery remains fragile, with much stronger German growth not matched by other major core economies. Moreover, the Greek financial problems remain and
solutions once gain postponed, and the country continues to present considerable downside risks. The Chinese government has announced a new normal, putting the double-digit growth period behind it by announcing a new economic growth target of 7%. We also expect a widening of growth divergences between the G-7 and emerging markets, as well as among the BRICs. In the latter group, India is expected to achieve rapid growth, China to slow down to around 6-7%, Russia to slip into a deep recession and Brazil to be flat at best. Defining Patience : In her semi-annual testimony to Congress, Janet Yellen did address the future course of monetary policy. Yellen refined the term patience in monetary policy as meaning that no interest rate moves would be undertaken for at least two FOMC meetings (effectively three months). Nevertheless, the Fed chair also stressed the improvement in the performance of the US economy, and hinted at a relatively near-term end of patience. The key driver of a monetary move will continue to be the labor market conditions, in particular stronger wage gains. Nevertheless, the Fed will also bring inflation (or rather the lack thereof) in the decision-making process. Ultimately, this should translate into an expected short-term interest increase sometime in 2Q15 (probably by the June 15-16 FOMC meeting). Yellen also reiterated the view that the key policy rate is likely to be kept below normal run levels for an extended period of time. The last period of rate increases lasted 25 months (May 2004 to June 2006), with the Fed Funds rate increasing from 1% to 5.25% over this period. In any case, the latest payrolls report has raised the likelihood of an earlier tightening, although the Fed will still bring wage growth and core inflation levels into the equation. The financial markets showed a sharp reaction to the latest payrolls report. The 10-year Treasuries yields, which had recovered from their historic lows 0f 1.58% in January to 2.11% by early March, jumped on Friday by 13 bp to 2.24%, the highest level since last December. Steady as She Goes: The economy expanded by 2.4% in 2014, remaining on the same trend experienced since 2009. However, if we exclude the first quarter, growth over the 2Q14 to 4Q14 period ran at an annualized 4.0%. Such a pace is not sustainable. Although we expect the economy to continue on a respectable growth trajectory in 2015, it could suffer from a loss of momentum in the first half of the year. On one hand, the impact of low oil prices is gradually going to filter through the economy, leading more confident consumers to loosen the purse strings. At the same time, low oil prices are not sufficient to restore faster household consumption expenditures, and we will need evidence of stronger income gains. Export growth has been disappointing as a result of the strong dollar. Inventories ramped up to their highest level since 3Q14 in the 4Q14, which could eventually become a drag on manufacturing. The government sector has stopped being a drag on growth, but no big boost is public expenditures is likely. Finally, despite record cash levels, business capital expenditures are lagging. Economic performance in 1Q15 is also likely to be adversely affected by the extreme weather conditions faced by most of the United States, with GDP expected to barely achieve a 2% growth
(annualized) pace. However, the economy should accelerate to around 3% in 2Q15, then settling at around 2.5% in the second half of the year about the level of potential output growth. While the economy and labor markets have performed well, some cyclical and structural issues continue to prevent a durable improvement: weak business capital expenditures, wage stagnation and declining labor force participation. Shades of Grey: The equity markets are faced with a dilemma. Should they respond to the positive economic news or the prospects of Fed tightening? The answer seems to be that so far, they seem driven by the specter of monetary tightening. The S&P500 index performed strongly for most of February after a volatile January (up 5.4% for the month). However, it experienced a two-week losing streak starting in the last week of February. Fig. 4: The Bulls Return The index lost 1.6% on Friday March 6th alone, when a strong payroll number was announced, ending the week at 2,079. At this stage, the index, which entered 2015 at a high valuation, seems to have reached a resistance level at 2,100. However, we have seen better performance in the cyclical sectors relative to defensive ones both on a 30-day and 90-day basis, which seems more in line with the improving macroeconomic indicators.
Fig. 5: 90-day Sub indices Performance While the markets have reacted negatively to the prospects of Fed tightening, we should see some normalization in this regard. First, the markets have had a long time to adjust to the notion on tightening we saw the same reaction to the end of QE last year. Second, any adjustment is likely to be gradual and spread over time. Finally, such a Fed move will occur in a steadily improving economy. Prospects for corporate America do not seem promising over the next few months. Buffeted by a strong dollar and low oil prices, the S&P500 corporations had a disappointing 4Q14 earnings season. Moreover, the consensus forecast is for earnings to decline in the first two quarters of 2015 by respectively 4.6% and 1.5% (year/year). The decline in profitability is expected to be broad, affecting most of the S&P500 subsectors. Markets will continue to be supported by record levels of buybacks and dividends. Flush with record cash S&P500 corporations have returned $900 billion to shareholders $550 billion in buybacks and $350 billion in dividends. With these factors in mind, it seems that the S&P500 will have difficulty breaking through the 2,100 resistance level until we see evidence of a stronger and broad-based economic recovery.
February Data Releases Dr. Pakravan has been a senior economic strategist in global financial markets for 25 years. Dr. Pakravan is a recognized specialist in leading-edge applied macroeconomic and financial research on currencies and emerging markets, country risk assessment and modeling in an enterprise-wide risk management context, as well as international financial architecture. Dr. Pakravan has a Ph.D. in Economics, University of Chicago, a M.Sc. in Econometrics and Mathematical Economies, London School of Economics, and a B.A. in Mathematical Economics, University of Geneva. He is the author of numerous publications and is an Associate Professor of Finance at the Kellstadt Graduate School of Management at DePaul University. The Advocacy Investing Portfolio Strategies newsletter is a publication of Marc J. Lane Investment Management, Inc. We attempt to highlight and discuss areas of general interest that may be useful for anyone interested in the dynamics of our economy and our markets. Nothing contained in Advocacy Investing Portfolio Strategies should be construed as investment advice or a market recommendation. Consultation with a financial professional is recommended before implementing any of the ideas discussed herein. Copyright 2015 Marc J. Lane Investment Management, Inc.