World Events and Snow Can’t Deter Equities in January


By Rob Edel, CFA

Equity markets continued to rally in January with the S&P/TSX up 0.8% and the Dow and S&P 500 up 2.7% and 2.3% respectively. 

Stocks have been on a very impressive run.

Not only have they been going up, they have been going up nearly every trading session.  Except for a brief dip in late January, one would have to go back to early December to see the S&P 500 trading below its 10-day moving average. 

It’s been a one-way market that has resulted in indices closing in on some interesting milestones.  The S&P 500 is mere points away from hitting 1,333, which would mark a two-bagger (doubling) return off its March 2009 low of 666.79.  And if the S&P 500 accomplishes this in the next several days, it would be the quickest rebound and doubling off the bottom for the market since 1936. 

Pretty impressive stuff considering some of the events taking place in the world.  Inflation concerns in emerging markets, higher bond rates in the U.S. and political turmoil in the Middle East have not seemed to worry this market one bit.  Higher corporate earnings and signs that the economy may finally be turning the corner have enticed investors back into stocks. 

While we can’t argue that parts of the economy are looking better and corporate earnings have been robust, we are not sure how sustainable they are. 

The housing market remains weak and while the labor market is adding new jobs, it’s nowhere near enough to make up for the jobs lost during the recession. And this is with as much fiscal and monetary stimulus as the Federal Reserve and the Obama Administration can muster. 

Corporate earnings are strong but companies remain hesitant to hire new workers.  Without continued growth in private sector compensation, it’s hard to see how consumer spending can continue to grow.  Add to this, concerns of higher commodity prices and the resulting impact on profit margins, and future earnings growth begins to look less inspiring. 

Yes, a double dip recession may have been averted (for now) but a V-shaped recovery in the stock market doesn’t necessarily mean a V-shaped recovery for the economy.  Eventually monetary stimulus will need to be removed.  You can’t keep short term rates at zero forever, especially if the economy looks to be past the crisis stage. 

You also can’t keep fiscal stimulus unchecked indefinitely.  The Congressional Budget Office is forecasting the U.S. Federal deficit will grow about 14% in 2011 to $1.48-trillion before dropping to a still mammoth $1.1-trillion in 2012.  Even with the CBO’s optimistic prediction for tax revenue growth, the deficit is forecast to grow at an unsustainable pace. 

President Obama has proposed a five-year freeze on non-security discretionary spending, estimated to save $400-billion over 10 years.  Nice start, but it’s not nearly enough.  It’s entitlement spending such as Social Security and Medicare that needs to be addressed.  It’s no wonder bond rating agency Moody’s has warned that the U.S.’s triple-A rating may be at risk.  And why not?  Rival bond rating firm S&P recently downgraded Japan for the first time in nine years to AA-. 

Seems like it was a shot across the bow for Europe and the U.S.  Let’s hope they decide to alter course.

The U.S. Economy

GDP grew at a not too shabby 3.2% annual pace in Q4 2010, confirming views that the U.S. economy is gaining momentum. 

The consumer was the main driver, increasing 4.4% and accounting for nearly all of the growth in GDP.  Unfortunately, the personal savings rate declined to 5.4% versus 5.9% in Q3.  We are not sure if this is sustainable or just pent up spending delayed by the recession.  Consumers are still over leveraged and need to save more and continue paying down debt. 

Also contributing to GDP growth was manufacturing activity, which continues to heat up and should provide added strength in the short term.  Too bad manufacturing is only about 13% of the U.S. economy now.

The 3.2% growth in the fourth quarter meant that the U.S. economy has finally recovered output lost during the recession, moving the economy back into expansion territory.  It took 12 quarters to do so, however, compared to only eight quarters during the severe recession of the early 1970’s. 

Even worse, on a per capita basis, the U.S. economy is still below pre-recession levels. 

The employment situation was mixed and, quite frankly, a little confusing in January. 

On the positive side, the Household survey reported the unemployment rate plummeted to 9.0% in January, its lowest level since April 2009.  This jives with the Challenger job cuts report, which reported the lowest number of announced layoffs for any January since the survey was initiated in 1993. 

The ADP employment report further heightened expectations with a reported increase of 187,000 private sector jobs, only to have the Establishment survey report a disappointing 36,000 non-farm new jobs in January with hours worked falling slightly. 

So what are investors to believe?  The bulls will tell you that weather was a major reason the payroll numbers disappointed, backed up by the household survey indicating 707,000 workers took a “snow day,” claiming they were unable to find work because of the weather; twice normal levels for January. 

They point to the 32,000 job decline in the construction industry as further proof of their claim.  We would point out that the construction industry doesn’t need bad weather as an excuse to lay off workers.  We also find it strange that retail sales (as discussed below) didn’t seem to be impacted by weather.  There was too much snow to go to work but not enough to prevent shoppers from taking advantage of the post-Christmas sales? 

The bears would also point out the reason the unemployment rate fell was because 504,000 workers left the labor force, most likely because there are no jobs.  We suspect weather was a factor and employment in February should benefit from some of January’s “shut ins”, but the employment picture remains cloudy at best. 

Even as new jobs are created, they have tended to be lower paying jobs.  According to the Labor Department, between 2007 and 2009, 55% of workers finding full-time employment accepted lower paying jobs with 36% taking more than a 20% pay cut.  While the Labor Department’s Employment Cost Index reported U.S. wages overall continued to grow at a 1.5% pace during the 12 months ending in September 2010, this compares wages in the same job and doesn’t factor in workers switching careers and accepting lower paying jobs. 

Columbia University economist Till Marco von Wachter believes the loss in earnings is partly due to the fact that workers’ accumulated skills may be outdated and rather than gaining new skills to find higher paying jobs, workers take what’s available, namely lower paying jobs.    

  

Inflation was a little higher in January with headline inflation increasing at its fastest pace since June 2009. 

So far, energy is the main culprit with food costs up only 0.1% during the month.  Despite the increase, CPI remains well below the Fed’s 2% inflation target, but for how long?   Wholesale prices (PPI) surged 4.1% during the month, increasing pressure on suppliers and retailers to pass price increases on to consumers. 

Higher prices are in the works, the only question is how much.  Commodity prices have moved disturbingly higher, but they are not the only input costs for manufacturers.  Labor, marketing and processing costs are factored into the final cost.  Typically, the greater the processing required, the less impact higher commodity costs have on retail prices. 

Also, manufacturers and retailers are still hesitant to increase prices.  Smaller package sizes and in the case of clothing, a lower percentage weight of cotton, are also strategies that can be utilized to give the perception that prices have not increased.

Outside of the U.S., inflation has already started to hit consumers.

Especially in emerging market economies where food comprises a larger percentage of a typical consumer’s budget.  According to the U.N., global food prices increased for the seventh consecutive month in January to a record high.  Many governments are imposing price caps and export bans while at the same time cutting import tariffs. 

Even parts of the developed world are feeling the impact with inflation in the Euro zone increasing 2.2% in December, above the ECB’s 2% target for the first time in more than two years.  While most central banks loathe the idea of increasing interest, many will be forced to begin tightening in order to battle inflation. 

They loathe hungry citizens rioting in the streets even more.  Case in point: Egypt.

A rebound in the Conference Board’s Consumer confidence index confirms a moderately strengthening job market and economy. 

There were surprisingly strong January sales on the heels of a generally lackluster, but acceptable, Christmas shopping season. 

While December retail sales recorded their smallest increase since July, it was still the strongest Christmas shopping season since 2006, with luxury brands fairing particularly well while apparel needed to be heavily discounted.   

January same store sales are pointing to further gains as consumers seem to have braved the winter storms and hit the malls en masse.  Not only were they back spending, consumers were apparently back borrowing as well.  Revolving credit (credit cards) increased for the first time in 27 months in December as consumers rang up $2.3-billion on their charge cards and $6.1-billion in total consumer debt.  It’s enough to bring a tear to Ben Bernanke’s eye. 

I guess if you hold interest rates at practically zero percent long enough, people will eventually feel compelled to borrow.  Too bad they eventually have to pay it back.

Optimism for the economy is not, unfortunately, filtering down to the housing market. 

While existing home sales increased in December, hitting a seven month high, prices continued to decline.  A Wall Street Journal quarterly survey reported prices fell in all 28 major metropolitan areas tracked in Q4 compared to year-ago levels with all but three regions reporting accelerating declines versus the previous quarter. 

Zillow.com reports that as of November, home prices had fallen 53 weeks in a row recording peak-to-trough declines of 26%, slightly higher than the 25.9% decline experienced during the great depression (1928-1933).  Zillow points out prices are presently at October 2003 levels.

The housing crisis has spared no one, not even God.  According to CoStar Group, nearly 200 religious facilities have been foreclosed on by banks since 2008 with hundreds more threatening to join them. 

Before the financial crisis, a default by a religious facility was practically unheard of.  Churches were traditionally seen as good credit risks due to relatively consistent monthly cash flows, but donations and tithing have declined as congregants have lost their jobs and seen their homes plummet in value. 

The trade deficit was practically unchanged in November as export growth narrowly outpaced import growth. 

While the trade deficit with China was flat versus October, it remains the largest contributor to the trade deficit and an obvious target in efforts to re-balance global trade.  While there is no doubt the U.S. purchases far more goods from China than they sell, the magnitude of the deficit is most likely exaggerated. 

Case in point: it is estimated the iPhone alone accounted for almost $2-billion of the U.S.’s trade deficit with China even though only the final assembly, accounting for approximately $6.50 of the $180 wholesale value, takes place in China.

 

 The Canadian Economy 

GDP grew at its fastest pace in eight months in November with oil and gas extraction, wholesale trade and retail spending leading the way. 

Leading indicators point to future growth, though only 5 out of the 10 indicators were positive.  Manufacturing continues to be the weak link as the strong Canadian dollar continues to take its toll. 

Canada’s job market is again the envy of the developed world as January saw a much higher than expected 69,200 jobs created. 

Yes, the unemployment rate increased to 7.8%, but that was due to more workers entering the work force.  This is the opposite of what is happening in the U.S. where workers are discouraged and quit looking for jobs.

Headline inflation over 2%?  That’s not good. 

Core inflation is still showing modest growth so we won’t panic yet, but this is a concern.  The Bank of Canada might need to be doing some rate-raising in the near future.  TD is forecasting a 2% increase in the over-night rates by the end of 2012.

A nice increase in consumer confidence and strong retail sales in November.

This is the sixth consecutive increase and largest since March.  Canadians have learned how to spend; now we have to re-learn how to save.  As mentioned last month, Canadian debt-to-disposable income continues to increase, bucking the deleveraging trend in the rest of the developed world.   If interest rates start to move higher, Canadian consumers are going to get crushed.

As with the job market, the Canadian house market continues to be a tower of strength compared to our developed world colleagues. 

Housing starts declined, but higher building permits point towards future construction.  Who wants to start building a house in December anyways?  Sales and prices remain firm with inventory of unsold homes at levels indicative of a balanced market. 

Finance Minister Jim Flaherty announced another tightening of the mortgage rules in January.  Effective March 18th, the maximum amortization period on government insured mortgages goes from 35 years to 30 years and the maximum refinancing percentage falls to 85% from 90%.  Effective April 18th, there will be no insurance backing on home equity lines of credit.    

The trade deficit declined in November mainly due to a 3.2% drop in imports. 

Weaker import demand could be the result of declining growth in the Canadian economy, though this isn’t evident by the strong retail sales growth reported above.  Export growth was due to strong resource sales as opposed to manufacturing goods, which declined during the month.  The percent of exports to the U.S. also declined to 70% of total exports compared 80% before the recession and is now at its lowest level since the early 1980’s. 

Overall, it’s a mixed picture for Canada. 

We are generating new jobs and the housing market remains solid.  On the other hand, the manufacturing sector continues to contract, threatening economic growth.  The Canadian consumer needs to deleverage and this process could provide further economic weakness in the coming months.