STOCKS FEEL THE LOVE, BUT HOUSING DOES NOT

The resurgence in risk appetite continued apace this past week, allowing the S&P 500 index and the Dow Jones Industrial Average to return to positive territory on the year.  By the end of the week, the S&P was up 2.4% and the DJIA finished up 2.3%. 

 

Source: Wall Street Journal

 

Yields on US Treasury bonds ended moderately tighter on the week despite the strong performance in risk assets.  At the beginning of the year, numerous prognosticators were calling for a surge in Treasury yields, but to the contrary, yields fell from 3.8% at the start of the year to 3.2% this past Friday.  The explanation for this move may be simpler than we all realize. 

 

Based on data from the Federal Reserve’s Flow of Funds report, US households are severely underinvested in Treasury and Municipal securities. With more than 50% of household assets tied up in equities and real estate, the recession of 2008/09 seems to have left a mark on many individuals, especially those in the baby boomer generation who are inching ever closer to retirement.  This is fueling a reallocation away from equities in favor of bonds and income producing securities. 

 

Source: The Big Picture

 

This is certainly not a panacea for low interest rates forever, especially considering the uncertainty around China’s future appetite for Treasuries, but it does provide a sorely needed source of financing for the Treasury Department in coming years. 

 

Housing: with the government gradually removing its chokehold on the housing industry, economists are growing concerned that housing is set to experience a slowdown in the second half of the year.

 

As expected, the initial reports surrounding May housing data are weak with housing starts falling 10% due to a 17% drop in single family starts.  The weakness in residential investment represented a major drag on GDP from 2006 through the first quarter of 2009, before finally contributing to positive growth in the second half of 2009.  Those gains were rather fleeting and housing once again became a net detractor to growth in the most recent quarter. 

 

Source: Haver Analytics

 

Perhaps more problematic was the news that Fannie Mae and Freddie Mac, the beleaguered US mortgage financing companies, have requested $145bln from government coffers, with one ratings agency suggesting that a $1trln financing package for those two firms is not out of the question. 

 

According to the New York Times, foreclosures forced the two firms to take over ownership of a new home every 90 seconds during the first quarter of this year.  By the end of March, the firms owned a combined 163k homes. 

 

Source: New York Times

 

This is actually not as detrimental as it appears on the surface because Fannie and Freddie represented a dwindling slice of the market during the years between 2005 and 2007 and were fortunate to avoid a good portion of the poorly originated loans.  However, as we are all acutely aware, the firms are the de facto lender of last resort and by some estimates, account for as much as 97% of the mortgage market. 

 

Long term, Fannie and Freddie will face years of losses related to sour mortgages, all at the expense of the US taxpayer. 

 

Taxpayers are also on the hook for the current home modification program, which is looking like an unmitigated disaster at this point.  The Home Affordable Modification Program (HAMP) was originally designed to provide payment relief for homeowners who were struggling under the burden of debt.  Sounds simple enough, but what the government forgot to account for was all the other debts (credit cards, auto loans, student loans, etc) those individuals are carrying. 

 

For the average person, HAMP provides $500 a month in mortgage payment relief.  Even accounting for that deduction, 64% of pretax income is spent on debt payments.  That is an unserviceable burden and Fitch Ratings estimates that 65% to 75% who enter the HAMP modification process will re-default within 12 months. 

 

THE INFLATIONARY TRAP

Last week’s news on the inflationary front proved to be as benign as everyone was expecting.  The headline Consumer Price Index was down 0.2% month-over-month and the Producer Price Index for Finished Goods eased by 0.3%.

 

From the consumer standpoint, headline CPI was off modestly in the month and is now up 2.0% in the past 12 months.  Core CPI, which excludes food and energy, is up only 0.9% in the past year and the Cleveland Federal Reserve’s preferred measure of consumer inflation, which excludes outlier categories, is even weaker at 0.5%.

 

Source: Federal Reserve Bank of Cleveland

 

With unemployment at elevated levels, producers are not able to pass along higher costs to consumers, reflected by the 5.1% increase in the PPI index for finished goods and the 8.4% increase in the intermediate goods index over the past 12 months. 

 

Source: Haver Analytics

 

By all accounts, industrial production is well on its way to recovery, largely a function of inventory restocking since early 2009.  Unless consumer demand catches up with that restocking, companies will be facing challenges in the coming quarters. 

 

Source: Royal Bank of Canada

 

The primary problem for those companies will be higher input costs that consumers will be unwilling to stomach, placing pressure on profit margins.

 

On the positive side, monetary policy remains extremely accommodative as the Fed is embracing a zero interest rate policy.  According to the Federal Reserve Bank of San Francisco, interest rates should be even lower based on the interplay between rates of inflation and unemployment.  Even when accounting for asset purchases by the Fed, the first Fed Funds rate hike is not anticipated by the model until 2012. 

 

Source: Federal Reserve Bank of San Francisco

 

Unfortunately, should we face the double-dip recession that many are now predicting, the Fed will have little to no room to re-stimulate the economy. 

 

In the end, inflation is showing absolutely no indication of pricing pressure on the horizon.  On the other hand, companies are dealing with higher commodity prices that will likely eat away at profit margins in the next several quarters and should the economy dip back towards recessionary territory, the Fed will be limited in its ability to provide appropriate stimulation to the economy. 

 

THE WEEK AHEAD

There are relatively few economic data points to digest this week and traders will focus on dissecting the news from China regarding the revaluation of its currency.  

 

Important economic releases for the week will concentrate on May housing data, specifically the existing home sales report on Tuesday and the new home sales report on Wednesday.  Both indicators are likely to give back the gains experienced in April as buyers rushed to purchase homes prior to the expiration of home buyer tax credit. 

 

The Russell Indexes are scheduled to be rebalanced on Friday, an annual event that generates plenty of trade volume. 

 

The treasury Department returns with $108bln worth of securities to auction this week.  The list includes $40bln of 2-year notes (Tuesday), $38bln of 5-year notes (Wednesday) and $30bln of 7-year notes (Thursday).  In addition, the Federal Reserve holds its regularly scheduled meeting on Tuesday and Wednesday.  The Fed Funds rate is expected to remain range bound between 0% and 0.25% and the use of the language “extended period” is likely to continue generating contention.  

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