BlackRock's Weekly Investment Commentary from Bob Doll, Vice Chairman and Chief Equity Strategist
Some weaker economic data and statements from the Federal Reserve indicating that it has downgraded its view of the economy caused stocks to sink sharply last week, ending a multi-week run of gains. The Dow Jones Industrial Average lost 3.3% to end the week at 10,303, the S&P 500 Index declined 3.8% to 1,079 and the Nasdaq Composite fell 5.0% to 2,173. With these losses, all three indices are back into negative territory on a year-to-date basis.
The major economic story last week centered on the Fed’s policy meeting Tuesday. The central bank indicated that it expected weaker growth in the months ahead and reiterated its view that it was too soon to consider a shift in interest rate policy. The Fed also stated that it would begin to reinvest the proceeds of maturing agency and mortgage debt into long-term Treasuries. The total amount of these investments may not be overly significant, but the actions signal that the Fed is not starting to think about shrinking its balance sheet, which may have been the case before the onset of the current period of economic weakness. On balance, investors interpreted the Fed’s statement as a broadly negative one, as it indicated that economic growth had again deteriorated to the point that action was required. In response, Treasury yields fell sharply (as prices rose) and stock prices sank.
Recent economic data seemed to confirm the Fed’s view. July’s weaker-than-expected labor market report was followed last week by worse-than-expected unemployment claims. Retail sales figures also were somewhat disappointing, as consumer spending has been struggling to improve in the face of ongoing deleveraging. Additionally, last week brought news that the trade deficit had deteriorated in June, which likely knocked about 0.5% off of second-quarter gross domestic product growth.
One bright spot in the macro picture continues to be corporate earnings, as the faltering of the economic recovery has not stopped the recovery in profits. Based on the almost-complete second quarter reporting season, earnings per share were 84% higher in the second quarter than they were one year ago. Companies that have high levels of foreign exposure have produced particularly good results — corporations that have over 20% of their businesses outside of the United States saw revenues advance by 16% for the quarter.
The combination of extremely low Treasury yields (the yield on the 10-year Treasury fell to just over 2.6% by the end of last week — its lowest level since April 2009) and struggling equity markets has again caused many observers to raise the specter of deflation. Some are suggesting the United States is entering into a deflation spiral similar to that seen in Japan in the 1990s or the US version from the 1930s. While there are some similarities between those time periods and the present, one of the main differences is that today the US Federal Reserve is fully aware of the policy mistakes made in the past and is deeply committed to pushing hard in the opposite direction in order to minimize the probability of a long-term period of deflation. We place a low likelihood on the chance that the United States will endure prolonged deflation.
At this point, economic forecasts have diverged into two possible paths. The more optimistic view is that US gross domestic product (GDP) grows at around the 2% rate for the next couple of quarters, while experiencing continued high levels of unemployment and low inflation. The more pessimistic outlook is that the economy experiences a double-dip recession and deflationary pressures continue to grow. Our view leans more toward the former. We still expect that the economy will continue to muddle through and grow, as financial conditions remain conducive to growth. While some areas of the economy, such as housing and jobs growth, remain quite weak, there is still progress being made in terms of the recovery. In many ways, the root of the current problem is one of confidence. There is a high degree of uncertainty around such issues as the future direction of tax policy and high deficits, and the mid-term elections remain a wildcard. It is hard to imagine confidence levels getting much worse than they are at present, and we are hopeful that as the year progresses some of these issues will approach resolution.
For stocks, the outlook will be highly dependant on the direction of the economy. Despite last week’s decline in both equity prices and Treasury yields, we believe financial markets are signaling that the worst of the deflation scare is ending and that renewed recession is unlikely. A strong current of skepticism is likely to persist for some time, and volatility levels will likely remain elevated, but as we have been saying for several months, as long as the economy does not retreat back into recession, stocks should be able to continue to make gains.
THERE’S STILL GROWTH IN THE MARKET, From Jeffrey Saut, chief investment strategist, Raymond James
Edgar Winter was right, “The mountain is high, the valley is low; and you’re confused on which way to go.” As for leading you into the Promised Land, I think that was done in March 2009 (I was very bullish); this year, however, my mantra has been, “the trick in 2010 is going to be keeping the profits accrued from the March 2009 lows.” Last week, however, investors gave up on stocks, worried that Wednesday’s 90% Downside Day marked the end of the summer rally, punctuated by fears that another big decline was in the offing as we enter the dreaded months of September/October. While statistically those months tend to be the worst of the year, that wasn’t the way it played last year; and, I doubt that is the way it plays this year. While the equity markets may pull back, NONE of the characteristics that mark a major “top” are currently in place.
IT’S NOT A DOUBLE DIP, From David Kelly, chief market strategist, JPMorgan Funds
In the thick fog of our national pessimism, only the lowest-toned tales of impending doom find any resonance. So as summer winds down, fears of deflation are suddenly gaining wide attention. Deflation is both more serious in its consequences and more plausible as a scenario, than the inflation fears given wide circulation a year ago. But in the final analysis, how likely is it?
Last Friday’s CPI report gave us an update on the current balance of inflation pressures with consumer prices rising by 0.3% in July and by 1.3% over the past year. Core inflation, which excludes food and energy rose by 0.1% and was up by 1.0% year-over-year, the sixth straight month where year-over-year core inflation has been between 0.9% and 1.1%. Tuesday’s Producer Price Index report should also be mildly reassuring on the issue of imminent deflation.
As for inflation going forward, it is ultimately a statistical question. American inflation comes from two sources: the inflation we import through higher global commodity prices and a lower dollar, and the inflation we generate internally through the interaction of supply and demand in labor markets, housing markets and our industrial sector. Numbers out last week and this week should provide some insight into both.
With regard to the former, last week’s trade report confirmed that the improvement seen in U.S. trade statistics between 2005 and 2009 has halted with the trade deficit rising for the fourth quarter in a row. This reality, combined with slow U.S. economic growth and an easy monetary policy, could push the dollar down over the next few years. Meanwhile, the Russian drought has boosted farm commodity prices and oil prices should rise in tandem with growth among developing nations.
As for domestic inflation, Tuesday’s Housing Starts report should show continued moribund housing activity. So far this year, multi-family housing starts have averaged less than a quarter of their average pace over the last 60 years. This virtual stall on supply should at least stabilize and eventually boost rents, an important component of core inflation. Similarly, with U.S. manufacturing capacity actually falling, the July report on Industrial Production should confirm that the manufacturing sector has now recovered half of the drop in capacity utilization seen in the recession.
The report on Unemployment Claims on Thursday is unlikely to show similar progress with regard to jobs. However, even with labor market weakness, provided we avoid a double-dip recession, the U.S. is unlikely to fall into outright deflation. Avoiding that double-dip still seems probable, based on the already rock-bottom levels of economic activity in the economy’s most cyclical sectors. For long-term investors, this should mean that the fog of economic pessimism will eventually burn off, allowing both stock prices and Treasury bond yields to rise.
MEASURING THE NEW NORMAL, From Charles Biderman, CEO, and David Santschi, executive vice president, TrimTabs Investment Research
Two years ago, we introduced an indicator called consumer spendables. It consists of the sum of three components:
· After-tax income from wages and salaries
· After-tax income from non-wage sources, such as capital gains, dividends, and interest
· Cash harvested from home equity when mortgages are refinanced.
Consumer spendables peaked at $7.0 trillion annually over the four quarters ended in Q4 2007 (we use trailing four-quarter periods to smooth quarterly volatility). In the four quarters ended in Q2 2010, consumer spendables amounted to $5.9 trillion annually, down $1.1 trillion, or 14.9%, from the peak. Consumer spendables continued to drop in recent quarters, mostly because capital gains kept falling.
Much of the economic growth in the middle of the previous decade was fueled by an explosion of consumer debt. Consumers treated their homes like automatic teller machines—cash-out refinancings topped out at $804 billion in the four quarters ended in Q2 2006—and they borrowed freely on low-rate auto loans and credit cards given to almost anyone with a pulse.
Now that the era of easy consumer credit is over, the economy is resetting to a lower level of activity. We believe the interventions of the Fed and the government to try to head off this adjustment will do more harm in the long run than the adjustment itself, because the interventions risk undermining the creditworthiness of the government’s enormous liabilities.
YES—IT’S A BEAR, From David Rosenberg, chief economist and strategist, Gluskin Sheff
The markets are beginning to sniff something out and the smell isn’t so good. The equity market was so oversold going into last Friday’s action that a technical rally should have been baked in the cake. The fact that the major averages faltered in such a deeply oversold market is not good news for the bulls. The bond market is really telling the tale as the long Treasury has generated a total return of 17% so far this year while the S&P 500 has triggered a loss of 2%. In fact, the 10-year note yield closed the week at a new low of 2.67% — the lowest since March 20, 2009 when the stock market was still struggling around the 12-year lows at the time. The long bond yield is all the way down to 3.86%, the lowest it has been since April 27, 2009. The big bull flattener in bonds seems to be starting. No doubt there is always the risk of some countertrend reversal in yield activity after the monumental rally we have seen in the bond market, but the charts don’t lie and the case they present is one of a major downward trend in interest rates right out the curve.
Bonds do not generally outperform equities to such an extent without a pronounced slowing in economic activity or a recession coming down the pike. This was not well advertised but the yield on the 5-year TIPS swung into negative terrain last Wednesday (-2bps) in a clear sign that the bond market is pricing in a recession. Imagine where yields go to when deflation gets more appropriately discounted.
So far this meltdown in yields is only a “real economy” event, not a “price stability” or deflation event. The last time the yield on the 5-year TIPS was this low was back on March 10, 2008 when, amazingly, everyone was debating whether the economy was in a hard landing or a soft patch, and whether the near-20% selloff in the equity market at the time was a bear market or merely a correction. Well, history doesn’t lie and we all know that in the ensuing year — the year after the TIPS yield touched zero — the equity market was down 40%. Suffice it to say that few saw that coming, and by and large, the folks that didn’t see it coming are the same ones telling investors to hang onto their overweight equity positions today. Someone should really call the police.
Monday, Aug. 16:
August National Association of Home Builders housing market index; June International Capital Flows
Tuesday, Aug. 17:
Retail In-Store Sales (weekly); Q2 Online Retail Sales; July Housing Starts; July Producer Price Index; July Industrial Production
Wednesday, Aug. 18:
Mortgage Applications (weekly)
Thursday, Aug. 19:
Jobless Claims (weekly); Money Supply (weekly); August Philadelphia Fed Business Survey; July Index of Leading Indicators