Macro forces continue to overwhelm the micro

Continuing in the ongoing vein of extreme volatility, equity markets staged a steep retreat over the past trading week, with the S&P 500 Index falling 6.5% and the Dow Jones Industrial Average losing 6.4%.

 

Equity markets fell each of the first four trading days, before posting a mild rally on Friday.  Markets opened the week on a poor note, enduring a Europe-induced sell-off.  The situation was compounded by mid-week when the Federal Reserve announced intentions to purchase $400 billion of longer-dated Treasuries.  This supported the notion that economic growth is weakening, as is the outlook for domestic growth. 

 

Source: Econoday

 

Housing markets reentered the spotlight last week and data for August mostly surprised to the upside, despite severe weather conditions. 

 

The positive news was concentrated in existing home sales, which rose 7.7% to a seasonally adjusted annual rate of 5.03 million, ahead of economist’s consensus expectations for 4.75 million homes sold.  Gains were evident across the country, with the strongest increase in homes sold occurring in the West, which posted an 18% month-over-month jump. 

 

Source: Haver Analytics

 

A reduction in available supply of existing homes resulted from the gain in sales.  Housing inventory stood at 3.58 million in August, according to the National Association of Realtors.  That translates into roughly 8.5 months of supply based on current sales rates.  While that is down dramatically from the peak in 2010, it remains well above typical inventory levels prior to the crisis.  

 

Source: Haver Analytics

 

Data on housing starts and building permits was a touch less optimistic, but showed that the housing sector is unlikely to be a drag on domestic growth after contributing positively to GDP in the second quarter. 

 

For August, housing starts fell 5.8% to a seasonally adjusted annual rate of 571,000, while building permits rose 7.8% to 620,000.  Housing starts were down largely due to a 14.0% fall in multi-family starts.  Despite the fact that starts and permits are hovering at depressed levels, they are no longer declining as precipitously as in prior quarters, and are unlikely to drag on quarterly GDP growth.

Source: Federal Reserve Bank of St. Louis

 

According to the Conference Board, the Leading Economic Index (LEI) rose 0.3% in August. Four of 10 components contributed to the overall growth rate, led by the M2 money supply and the spread between 10-year Treasury bonds and the fed funds rate.  According to research firm Econoday, the M2 rate was strong because investors were moving money away from market-related investments into money market funds.  That is generally not a positive development and without the strength of the M2 rate, the LEI would have fallen 0.4% in August. 

 

Source: Econoday

 

Consumers received good news last week in the form of the household debt services and financial obligations ratios.  The household debt service ratio (DSR) is an “estimate of the ratio of debt payments to disposable personal income,” and includes mortgages and consumer debt payments.  The financial obligations ratio (FOR) aggregates the DSR with auto lease payments, homeowners insurance and several other metrics. 

 

In the second quarter, the DSR fell from 11.24% to 11.09%, the lowest reading since 1994.  Similarly, the FOR fell to 16.09% from 16.26%, the lowest such reading since 1993.  It is clearly good news that consumers are deleveraging and putting their balance sheets in better order, although one major reason for the decline has been refinancing and debt default.  Regardless of how they get there, consumers are gradually reaching a point where debt payments are becoming less ominous.  A continued deleveraging is obviously hampering economic growth, but a healthy economy requires a healthy consumer. 

 

Source: Federal Reserve Bank of St. Louis

 

Downside risk soars in latest week

It was a difficult week from a number of standpoints, not the least of which was the growing number of downside risks that rose to the surface.  A broad number of financial markets broke down this week, including copper, the Hang Seng and precious metals.  Struggles in those markets came from any multitude of reasons, including the acknowledgement of slower growth ahead from the International Monetary Fund and the US Federal Reserve. 

 

As mentioned previously, the Federal Reserve indicated economic growth is “slow” at nearly the same time as the International Monetary Fund released its World Economic Outlook under the title “Slowing Growth, Rising Risks.” 

 

In the Fed’s estimation, there is “significant downside risks to the economic outlook, including strains in global financial markets.”  In an effort to lift the economy from its doldrums, the FOMC announced intentions to purchase $400 billion of Treasury securities with maturities between six and 30 years. 

 

The IMF piled onto the bandwagon, with Economic Counsellor Olivier Blanchard writing, “the economic recovery has become much more uncertain.” 

 

The IMF further highlighted the growing risk of recession sent by equity markets, and according to the IMF, the historical probability of a “new recession starting in the third quarter of 2011 is about 4.5% for the United States.”  Unfortunately, when recent equity market behavior is taken into account, the “predicted likelihood of a new recession rises about eightfold for the United States.”  

Source: International Monetary Fund

 

Dire warnings from the Fed and IMF weighed heavily on financial markets during the week, evidenced by the 6.5% decline in the S&P 500.  “Dr. Copper,” which remained in a trading range through much of the August sell-off, plunged in the last week and is now down more than 20% in the month of September, sending an ominous warning for the economy. 

 

Source: Financial Times

 

As concerns about a renewed recession grow, and fears of a European sovereign default increase, interbank lending markets are also becoming more prohibitive.  The Treasury-Eurodollar (TED) spread, which measures the difference between the risk-free T-bills and the London Interbank Offered Rate (LIBOR), jumped to the highest point since early last year.  At 36 basis points, however, the TED spread is only a fraction of its 2008 peak.  Regardless, there is concern the banks are becoming less and less trusting of one another. 

 

Source: Bloomberg

 

With the “risk on, risk off” trade once again becoming a dominant force, equity investors are facing an ever more challenging investment environment.  Goldman Sachs reports that the average sector correlation in the S&P 500 is currently at 0.94, while the average stock correlation in the S&P 500 is 0.75.  The lack of differentiation between equities leaves investors with only two choices right now – in the market, or out. 

 

Source: Goldman Sachs

 

There is a marginal degree of hope on the horizon.  Although macro forces are overwhelming the markets right now, September is historically a weak month for the markets.  Consider that since 1896, the Dow Jones Industrial Average lost an average of 1.07% in September, compared to an average gain of 0.71% in the other eleven months of the year.

 

Resulting from the recent sell-off is an S&P 500 that is two standard deviations below its average over the past 60 trading days, according to US Global Investors.  It is a very rare occurrence for the S&P to fall that far that quick, and investors generally view this as a buy signal.

 

Source: US Global Investors

 

Despite this fact, most data suggests downside risk is rising exponentially, as suggested by the Fed and IMF.  This is propelling an accelerated sell-off in financial markets and by most accounts, markets are oversold.  Environments such as these are rarely as simple as oversold/overbought, however, and investors should ready themselves for heightened volatility while the situation in Europe remains unresolved.

 

The week ahead

Europe will continue to be in the forefront as investors hope for a resolution.  Data in the US turns to personal spending, regional manufacturing, Case-Shiller home prices and consumer confidence.   

Several Treasury auctions are set for this week, including $35 billion of 2-year notes (Tuesday), $35 billion of 5-year notes (Wednesday) and $29 billion of 7-year notes (Thursday). 

Only a handful of central banks are meeting, including those in Israel, Romania, Taiwan and Colombia. 

 

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