Economic Notes for the Week of July 16th

It was a bit of a light week from an economic news standpoint.

The University of Michigan Consumer Confidence survey was weaker for July, falling from 73.2 to 72.0, which wasn’t a complete surprise.  The ‘expectations’ part of the survey fell by a few points, while the ‘current conditions’ component rose.  Consumers’ expectations for future inflation have fallen between 2.7-3.0% for almost every month for the past several years.  This is in line with current inflation, and historical averages.  Of course, as with many measures, the most-often guessed expected future figure is today’s number.

Obviously, this data is conditional, so should be looked at accordingly.  A critical piece, and what makes this useful, would be a pattern of increasing negativity, which could certainly lead to a self-fulfilling spiral of more negativity.  We’re not seeing that yet, and consumers seem surprisingly resilient, although still reactive to shorter-term conditions.

The trade balance, the difference/deficit between domestic imports and exports, improved a bit in May (fewer imports compared to exports) mostly due to cheaper petroleum, which is, by far, our largest imported item by volume.  Producer prices rose in June by +0.1%, which was a bit of a surprise, as consensus called for a decline.  The main factor was a rise in food prices which offset the already-anticipated energy price drop.  The core figure was up +0.2%, resulting in a year-over-year figure of +2.6%.

Initial jobless claims came in sharply lower than expected for the July 7 week, at 350k, as opposed to the expected 372k.  Continuing claims were generally as anticipated.  The main reason for the drop appears to be a rash of fewer auto factory shutdowns, which has affected the data somewhat.  It was also a short holiday week, which likely had an impact as well.

Lastly, the FOMC minutes from the June 19-20 meeting were released, with very few surprises.  The main point of interest from investors is how close/far away we are to another round of quantitative easing.  At the time of the meeting, several economic data points were mixed, and generally did not show a consistent trend of slowing; since that time, we have seen additional indicators decelerate.

It appears several members are open to the possibility; however, only ‘a few’ seem ready to ease at this time.  There are several issues here:  one, as additional easing costs money, the Fed is reluctant to head down this path unless it is absolutely necessary; and, two, there is debate as to whether such further easing would really be that productive.  The intended outcome of bond asset purchases is keeping rates low (and simulative) for a longer period.  It is debatable whether even lower rates, say a 1.0% versus a 1.5% 10-Year Treasury yield, would provide that much more of a benefit.  Other measures, such as the ECB’s action to lower the discount rate, providing banks with less of an incentive to hoard cash rather than lending, might be more effective in steering specific actions.  Another factor, which is unavoidable, is time.  Delevering from a financial crisis takes time…years, in fact, if not a decade…making the process a long one.  We have made progress, but are still in it.

What the Fed, and Chairman Bernanke specifically (based on his background as a student of the Great Depression), would like to avoid is a loss of momentum from low growth into a deflationary episode.  That is a more difficult scenario to crawl out of, since the downward spiral of delaying purchases and hoarding cash would make consumer spending and business efforts much more challenging.  This is not a likely scenario by any means, but this ‘worst case’ is where their thinking stems from.

The following news item was more related to specific bond markets than the economy, but the state of California has certainly experienced its share of bad news over the past few weeks.  First, the city of Stockton declared bankruptcy (the largest city ever to do so), vacation hotspot Mammoth Lakes was next, now followed by San Bernardino.

It’s important to remember a few things about municipal bankruptcies and how that affects the muni bond world.  Unlike the Treasury or even corporate markets, where economic conditions affect corporations more homogeneously, the municipal market in America contains 50,000 different issuers and several million unique bond issues.  This represents all types of debt:  general obligation (where payments are based on taxing power of the municipality/state/etc.), revenue (backed by a specific project/utility district) as well as more unique hybrid public/ ‘private activity bonds’ (the kind that sometimes don’t qualify as tax-free under AMT rules).  On top of that, every municipality/state is in a different financial condition, making the range of credit qualities quite large.

The evaluation of municipal bonds has become more difficult in recent years now that the pool of ‘insured’ bonds has shrunk in the wake of the financial crisis.  Regardless, defaults remain extremely rare—even for the quirkiest and worst-thought-out bonds—and often end up being more of a black-eye news event than a financial one.  In fact, according to Moody’s, there have only been 71 defaults from 1970 to 2011—and most of these have originated from the family affordable housing and non-profit healthcare areas.  Meredith Whitney’s prediction two years ago of massive defaults has not yet come to pass.  Most historical defaults have occurred for specific reasons:  fraud/corruption/bad business decisions (Jefferson Co., AL), a large lawsuit against a city that renders it insolvent (Mammoth Lakes, CA case most recently), bad investments (Orange Co., CA), or a budget deficit between costs and tax revenues that couldn’t be closed (Stockton and San Bernardino).  Unlike the Federal government, states and municipalities (with a few exceptions) are generally required to balance their budgets annually.  So, the depth of the recession and popping of the housing bubble (which caused anticipated property taxes to fall off dramatically) has affected many communities, but to different degrees.

Filing ‘Chapter 9,’ the special type of bankruptcy for cities/counties requires a judge to assign a trustee of sorts to handle the city’s affairs and ensure that essential services continue, like police and fire.  Other assets are rearranged (or sold in the worst case), and other city financial affairs, such as pensions and salaries, are often restructured, which requires union negotiations.  These don’t often go well.  Debt service may be suspended or stopped entirely, but this isn’t always the norm, and even if interest is suspended, recovery rates on defaults are a lot higher than we see for corporate bonds.  These end up being very unusual situations for many reasons, but the final outcome is often better than the initial headlines.

In cases other than the high-profile examples mentioned above, what you tend to find is that bankruptcies have catalysts of huge, overreaching urban renewal projects or similar financially ill-planned activities.  Also, public/private partnerships like stadiums and convention centers, or ‘land bonds,’ which are leveraged on future development that may or may not occur tend to be problematic.

Historically, net financial losses from municipal bankruptcies have been quite small compared to other asset classes.  What these do is create other collateral damage, such as a media frenzy, embarrassed politicians and a disenchanted citizen base and generally poor sentiment.  What they don’t do is necessarily direct affect anyone else in the market.  For example, while one particular city might suffer, a neighboring town right across the street might be humming along just fine.  So, while we might see more bankruptcies in coming months/years, an epidemic doesn’t have to be the result.

Market Notes

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Markets this week were mixed, as large-caps squeezed out a small positive return, and outperformed both small caps and foreign stocks.  Domestically, financials and utilities were the best performers on the week, while technology and materials lagged the most.

Emerging market stocks were down strongly on the week, as China’s growth slowed from 8.1% pace in the first quarter to 7.6% in the second.  Brazil was also down, due to their tie-in to Chinese exports.  Some surprisingly, considering the negative sentiment around Europe, the second-worst performing region this year in equities has been Latin America.

Long-government bonds were up with lower rates, as were most international bonds—both developed and emerging market.  Credit was mixed.

In commodities, agricultural contracts were up strongly again (+5% on the week, 15% for the past three months), as drought conditions in the Midwest raised concerns over harvest conditions.  Other commodities were all positive, but more moderately.

Have a good week.

Karl Schroeder, RFC, CSA, AACEP

Investment Advisor Representative

Schroeder Financial Services, Inc.


Sources:  FocusPoint Solutions, Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, Goldman Sachs, JPMorgan Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Thomson Reuters, Schroder’s, Standard & Poor’s, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research, Forbes.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.  Schroeder Financial Services, Inc. is a registered investment advisor.