WEATHER DELAY, BUT THE RECOVERY IS ON, from Bob Doll, vice chairman and chief equity strategist for fundamental equities, BlackRock
Recent economic weakness in the United States has come largely from home sales, goods orders and unemployment claims. Last week’s sore spot was consumer confidence, which experienced a sharp drop, although we would point out that the data was not consistent with other consumer surveys, and we believe might be an aberration. Business confidence levels have been trending upward, which suggests that the broader economy continues to improve. In the housing arena, prices have been slowly recovering, with the sharpest rebounds seen in California and the Southwest.
Of all the economic data, employment trends remain the most critical. The jobs picture will determine whether this recovery is sustainable. At present, we believe corporate earnings and balance sheets are supportive of companies increasing their payrolls. We have already seen improvements in productivity and business sales figures, and we think jobs growth should also resume in the months ahead. We had hoped to see a turnaround in February data, but the many weather issues that have plagued much of the country have made this less likely.
Overall, we would paint the economic picture as one that includes strongly rebounding manufacturing activity; moderately improving consumer spending; a still-depressed housing market; ongoing declines in bank lending; slow progress on the employment front; and downward trending inflation. In sum, we continue to believe the economic recovery remains intact, but will produce mixed data and ongoing uncertainty. From an interest rates perspective, we maintain our view that the Federal Reserve is likely to raise the Fed Funds target rate by year-end, but, at this point, is still awaiting meaningful improvements in the labor market.
At present, investors are caught between the crosscurrents of lingering debt and deflation concerns and fears over premature monetary policy tightening on one hand, and signs of improvements in economic growth and the corporate earnings landscape on the other. It comes as no surprise that we have been witnessing increased back and forth in stock prices over the past several weeks, as this bull market has matured since last year. We expect to see continued uneven trading in the markets for the time being, but maintain our belief that the positive factors are a sign that there is still long-term upside potential for higher-risk assets.
THE LONG UNWINDING ROAD, from Liz Ann Sonders, senior vice president and chief investment strategist, Charles Schwab & Co., and Brad Sorensen, director of market and sector analysis, Schwab Center for Financial Research
Stock market action remains relatively choppy following the correction we saw at the beginning of February. Despite a strong earnings-reporting season, we saw markets pull back in a noticeable way—a development we believed was overdue. Investor sentiment, according to our favored Ned Davis Research Crowd Sentiment Poll, had moved into extreme optimism territory, typically a bearish indicator for the market.
Following the pullback, sentiment corrected quickly and is now positioned for a renewed market uptrend. While we don’t believe the sharp gains we saw last year are going to recur, we remain relatively optimistic and don’t believe recent action is anything more serious than a healthy correction and consolidation of gains. We urge investors who need to increase their equity exposure closer to their target do so using dollar-cost averaging.
Helping support our optimism is continuing improvement in some important economic data. Manufacturing, which tends to lead the economy, has seen steady improvement. The Institute for Supply Management manufacturing index for January came in at 58.4—its highest reading since August 2004, and both its new orders and production indexes were above 60.
Additionally, industrial production rose 0.9% in January, while during the past seven months it has increased 9.7%. According to ISI Research, that’s well above the rate of increase in the first seven months of the past four recessions.
The improvement in the manufacturing sector has played a part in the overall economic recovery, which continues as illustrated by the Index of Leading Economic Indicators (LEI). The index improved again in January, marking the 10th straight month of improvement—the most consecutive positive readings since 2004 and up 9% year-over-year, the largest annual increase since April 2004.
There are areas of the economy that are still lagging the recovery. Initial jobless claims (a leading indicator), after falling precipitously, have leveled off at a still-troubling level. We continue to believe a job recovery is pending, but renewed weakness in claims needs to be watched to see if it’s more than just weather, as has been suggested by the Labor Department.
Also, housing remains a concern, as building permits—which can be relatively volatile—were down 4.9% in January, and new home sales fell a surprising 11.2%, their lowest level on record. Although some of the weakness can be attributed to the original expiration of the government’s tax credit and its subsequent extension, we remain concerned about prospects of a new dip in housing.
Billions of dollars of "option ARMs" come due this year, which could put renewed pressure on foreclosures. We’re also seeing some "shadow inventory” come onto the market, as homeowners who’ve been wanting to sell step into the market after the recent stabilization, resulting in an increase in supply.
The nascent housing recovery is also threatened by the expiration of a couple of pillars of support. First, the aforementioned federal incentive program is scheduled to expire in the middle of the year. After the initial assumed expiration of the first government program a year ago, housing activity fell off quickly.
Second, the Federal Reserve is still set to end its support of the mortgage-backed securities (MBS) market at the end of the first quarter, which could push mortgage rates higher. The Fed could still opt to extend the program or step in thereafter to lend support if rates move too high.
RISING RATES CAN BE GOOD FOR FINANCIAL SERVICES, From Pablo Echavarria, security analyst; David Honold, portfolio manager/security analyst; Mark Turner, president; and Rick Wetmore, portfolio manager/security analyst, Turner Investment Partners
For a long time some security analysts and investors have thought they knew one thing for sure: rising interest rates are bad for the financial-services sector. We believe that rate hikes -- especially when they rise from a relatively low starting point -- can lead to enhanced fundamentals for select financial-services companies, especially for well-managed, well-capitalized banks, investment managers, brokers and investment banks. And as rates rise, the stocks of those companies can outperform. The potential impact of rising rates on the sector is relevant now, because U.S. interest rates may begin climbing sometime in 2010.
Below 5% is good
We’re struck by a Morgan Stanley study, which found that since 1980, when the 10-year Treasury yield was below 5% and started rising, financial-services stocks outperformed the broad market by an average of 2.8 percentage points. The shares of investment managers and brokers did even better, outperforming by more than seven percentage points.
The only times since 1980 when rising rates actually did prove bad for financial stocks were when the 10-year Treasury yield was initially above 5% and started to escalate. Then, financial stocks underperformed by an average of 2.9 percentage points. Even so, the stocks of investment managers and brokers still performed well, beating the market by 1.5 percentage points or more.
So, with the 10-year Treasury yield at 3.77% as of February 19 and the economy improving, we think security analysts and investors should know that today’s interest-rate environment is potentially bullish for financial stocks.
We think investors should know that today’s interest-rate environment may be potentially beneficial to the fundamentals of the financial-services sector over the next two years. The true believers in the rising-rates-are-bad-for-financial-services faith seem to overlook this: when rates increase, it typically signifies an improving economy. So we believe that when rates are rising and the economy is rebounding, three prospective benefits accrue to banks, investment managers, brokers, and investment banks in particular.
Benefit #1: For banks, rising rates in a reviving economy may result in declining credit losses, lower loan-loss provisions, higher net-interest margins, greater demand for loans, and more interest income for their bond portfolios.
• The yield curve today is relatively steep, with a differential of 2.92 percentage points between two-year and 10-year Treasury rates, as of February 19. We think the yield curve may remain relatively steep if rates rise. That would have two beneficial effects: 1) banks’ net-interest margins would widen, and 2) mortgage loans, which have a longer life than many other loans, would produce more interest income for banks over time.
Benefit #2: For investment managers and brokers, rising rates in a reviving economy may help stimulate much greater investor interest in stocks and eliminate profit-shrinking fee waivers on money-market funds.
When rates rise in an economic rebound, this sequence of events typically plays out: corporate profits grow and the stock market responds positively, which attracts greater money flows into stocks, which in turn increases the volume of business, fee income, and commissions of investment managers and brokers.
Also, if short-term interest rates rise from today’s abnormally low levels, investment managers would probably no longer need to pay fee waivers in support of their money-market funds (which yielded a record low 0.02% in February, according to The Wall Street Journal). Charles Schwab, for example, estimates that its fee waivers should end if the yields on its money-market funds rise by 1%. Eliminating the fee waivers would transform an expense into additional net income for Schwab and other providers of money funds.
Benefit #3: For investment banks, rising rates in a reviving economy may generate more merger-and-acquisition business. Our research has shown a high correlation between economic growth and M&A activity.
HOUSING—MORE BAD NEWS, from David Rosenberg, chief economist and strategist, Gluskin Sheff
Existing home sales followed the market for new homes and cratered in January. No doubt the weather will be blamed, although this doesn’t hold much water because the big snowfalls happened in February, not January, and every region, including the ones that had no snow, posted hefty declines (the South was down 7.4% MoM, for example).
In total, sales plunged 7.2% MoM after a December detonation of 16.2% in what was the worst two-month decline on record. At 5.05 million units (annualized), turnover was well below the 5.50 million units that the consensus was expecting and down to a seven-month low.
The median price of an existing single-family home fell 3.5% MoM, to $163,600 — breaking below the January 2009 low (when everyone thought the Grim Reaper was around the corner) to a new eight-year low. Look for the Case-Shiller home price index, which is calculated on a three-month average, to start deflating very soon.
All of a sudden, what looked to be a return to a balanced market in November when the inventory backlog got as low as 6.5 months’ supply has since ratcheted back up to a four-month high of 7.8 months. And, this is in advance of all the shadow inventory from the foreclosure pipeline that has yet to hit the market.
The U.S. is not the only housing market to be rolling over. The U.K.’s housing market appears to be doing the same. The Nationwide Building Society has published the February home price data, which showed a 1% decline — the first setback in 10 months. If this is an Anglo-Saxon trend, then there is no reason to expect it not to come to Canada, where housing values are overvalued from anywhere between 15% to 35%.
Avoiding the Fixed Income Whipsaw, from Stephen J. Huxley, Ph.D., chief investment strategist, Asset Dedication
In 2008 and 2009, individual investors flocked to the perceived safety of bond funds in hopes of avoiding greater losses. Unfortunately, many jumped out of equities at the bottom, just in time to miss the 2009 recovery. Now those investors may be facing a second round of bad timing, and they probably don’t see it coming. Nor do they perceive the impending risk to their portfolios. But bond fund managers do, and they are beginning to issue warnings to people who buy their products. These managers are anticipating that rising interest rates in 2010 will cause the NAV of their fixed income funds to fall at a time when many investors think bond funds are the safest place to be.
Bond funds do not function like bonds in rising-interest-rate environments. Bond funds are continually turning over their portfolios, which in a rising-rate environment will result in falling portfolio values. Individual bonds will suffer the same decline in price, but investors can immunize themselves from this market risk by simply holding the bonds to maturity. This simple distinction between bond funds and individual bonds can have a huge impact on portfolios, particularly for investors who are pulling out cash in retirement. They may need to take withdrawals at the wrong time, magnifying the effect of falling NAV. If they don’t reposition their portfolios now, bond fund investors may re-live the pain of losses; this time from a part of their portfolio they thought was safe.
REPORTS OF THE WEEK
Monday, March 1: January Personal Income & Outlays; February ISM Manufacturing Index; January Construction Spending
Corporate Earnings: H&R Block, MBIA
Tuesday, March 2: February U.S. Auto Sales; Same-Store Retail Sales (tabulated weekly)
Corporate Earnings: Hovnanian, Staples
Wednesday, March 3: Mortgage Applications (tabulated weekly); February Challenger Job Cut Report; February ISM Non-Manufacturing Index; Beige Book
Corporate Earnings: BJ’s Wholesale, Costco
Thursday, March 4: February Chain Store Sales; Initial Jobless Claims (tabulated weekly); January Factory Orders; January Pending Home Sales
Corporate Earnings: Wendy’s/Arby’s
Friday, March 5: February Employment report; February Consumer Credit
