Economic Notes for the Week of July 9th

The ISM manufacturing index figure on Monday was certainly a disappointment, as it fell from May’s 53.5 down to 49.7—certainly larger than expected and below the critical ‘50’ mid-line of the diffusion index.  This is now at its weakest point since the summer of 2009.  Most of the components in the index were individually poor, with the new orders, production and export orders pieces all significantly down.  The employment measure was flat, however, and represented one bright spot in an otherwise dreary report, and the prices paid piece was also down—a good thing in this case—as commodity input costs fell, providing less of headwind for manufacturers.  Also, the level of the index itself, at around 50, is not especially low from a historical standpoint, is on par with about where we are at below 2% GDP growth is nowhere near recession levels.


The ISM non-manufacturing index on Thursday fell as well, but to a lesser degree than the manufacturing survey, from 53.7 to 52.1—so it stayed above the ‘50’ level.  The general business index and new orders declined, while the employment component edged up a few points—again, inconsistent with broader economic slowing.  Prices paid also fell, which is a positive for businesses.


In other news, construction spending rose +0.9% in May, which was higher than expected and annual benchmark revisions to the series offset a bit of the good news.  Factory orders for May were up (by +0.7%), which offset some of the ISM disappointment to some degree, and were higher than expectations of an unchanged number.  Core durable goods (non-defense, ex-aircraft) figures were up, while inventory accumulation was down.  All-in-all, a fairly neutral result.


On a much more positive note, new car sales were strongly higher as June results were quite robust from a year-over-year standpoint.  American automakers GM and Ford had strong months, as did foreign makers VW and Toyota, among others.  VW, in fact, is experiencing its best year since the early 70’s.  While at first glance, this might not be seen as necessarily that relevant to the U.S. economy, but there has been a steady trend over the last few decades of foreign brands being built in the U.S.—specifically, the American South, where labor costs have historically been lower.  So, at a deeper level, these gains for foreign-domiciled firms might not help S&P earnings, but do provide an economic plus domestically. 


The ADP private employment number from Thursday morning showed an increase of +176k jobs, much more than the +100k expected.  ADP is often looked at as a precursor to Friday’s ‘official’ jobs figure—even though the correlation between the two can vary.


Initial jobless claims fell by 14k to 374k for the last week of June, which was a larger drop than expected, and the four-week moving average was largely unchanged at 386k.  Continuing claims were close to 3.3 million, close to expected and largely unchanged.


Friday’s employment situation report was expected to be somewhat negative, at +100k or even fewer jobs added.  The +80k number that actually came in was certainly a disappointment, and the unemployment rate was unchanged at 8.2%.  The slowing came mostly from private sector job growth in the ‘trade, transport and utilities’ area (which includes retail).  There were some other positive pieces, though such as a longer average workweek and higher hourly earnings; so the year-over-year growth rate (at +2.0%) was a bit above consensus.  


How do we interpret these ISM and employment figures?  We’re certainly slowing, but individual data from month to month can be inconsistent.  For example, firms seem more cautious, but employment has grown (which is somewhat counterintuitive).  


This isn’t the first mid-cycle slow patch we’ve encountered during the past several years, so it may be premature to suggest further extreme slowing.  It could also be as simple as the fact that we’ve already rebounded from extremely low levels since the recession lows, so there is less extreme upside available.  The very slow ‘muddle through’ economy has been and continues to be a prudent base case for where we appear to be.  Because of the very low level of activity in certain sectors (homebuilding, construction, certain manufacturing), there isn’t much slack that would amp up recession risks, but there isn’t really a very good case for a high-growth catalyst, either. 


Risk assets look attractive; if for no other reason than the lack of attractive alternatives in a period of low interest rates and fairly ‘normal’ inflation measures.  While still volatile, these continue to appear to be investors’ best opportunity to earn a positive ‘real’ return looking ahead.


What’s the deal with the LIBOR scandal?  First of all, a quick definition and explanation of LIBOR might help.  It stands for the London Interbank Offered Rate, which is regulated and published daily by the British Bankers’ Association (a trade group) based on quotes from almost 20 different banks.  Essentially, it’s the average rate for what banks will charge for short-term lending activities, and has turned into a popular baseline interest rate for companies seeking very short term lending (sometimes for periods as short as overnight).  Generally, loans are quoted at a ‘spread’ over LIBOR, such as LIBOR+50bp, LIBOR+300bp, etc. with higher risk loans being more expensive to finance.  Many longer floating rate loans, such as those owned in the bank loan asset class, are also quoted in this way, and allows the ‘floating’ of their interest rates in line with the market.  Even adjustable-rate home mortgages and credit cards use LIBOR as a base for calculations.  By Wall Street Journal estimates, perhaps up to $800 trillion of financial products are pegged to the base LIBOR rate (when notional value of derivatives are included)… so 1 basis point can mean a lot.


What started all this was news of a $450 billion settlement from Barclays Bank in London, payable to U.K. and U.S. bank regulators who claimed the bank ‘manipulated’ rates for the past several years, going back to 2005.  The alleged purpose of the rigging was to move rate quotes (those published and provided to regulators in order to determine LIBOR) up or down, based on what might have been more favorable to investment positions held within the bank.  The CEO, COO and chairman are now gone and further investigation is ongoing.


This may affect other banks and may result in more fines, but the true number of culprits is yet to be determined.  Much as with events during the financial crisis, somewhat lax and/or sporadic oversight resulted in an environment where traders, who are compensated by trading profits, were able to manipulate a system in their favor—since market ‘quotes’ are fast-changing and difficult to monitor.  Based on past episodes of manipulation, excess risk-taking, inappropriate risk hedges or just lack of common sense, this isn’t entirely surprising, although the ‘payoffs’ of a bottle of nice champagne or coffee seem a little ridiculous. 


But this does represent another hurdle in banks’ efforts to clean up their reputations in the wake of the 2008 crisis.  Scandals like this which affect the pocketbooks of everyday consumers don’t help, but do provide more ammunition for the pro-regulatory lobby.  Expect more news, lawsuits, and probably some type of large-scale settlement(s) at some point.


Market Notes


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Stocks were generally lower with the poor ISM results and continued concerns about slow economic activity U.S. and abroad, although emerging markets were up on the week.  Domestically, telecom and staples rode out the week in the best shape, while industrials and financials fared worst.  Small-caps lost a bit less than large-caps, so there was no real pattern of stock performance during the week.


In bonds, government and interest-rate sensitive debt performed best, while foreign bonds lagged with a stronger dollar.  Speaking of foreign rates, the Bank of England is restarting its asset purchase program/QE with an additional £50 billion and the ECB is expected to lower rates another 25 bps.  The People’s Bank of China reduced rate by another 31 bp, down to 6%, in an effort to keep stimulus flowing in a slowing economic scenario.


In commodities, agricultural contracts were up while most others were flat to negative.  Grains have been the biggest winners in recent weeks as the Midwest drought has become the worst since 1988 (and perhaps since the ‘dust bowl’ years of the Great Depression).  Corn and soybeans have undergone the biggest moves upward.  Oil remains weak, and perhaps could be oversold at this point, according to some analysts—and remain at levels only appropriate if we enter another recession.  So, a bounceback a bit higher here would not be entirely surprising.


Alcoa begins the 2nd quarter earnings race this week.  Revisions for companies in the S&P have been trending lower over the past several weeks as economic conditions slow further.  Whether these estimates have been lowered far enough to satisfy investors remains to be seen in the coming few weeks.  For the S&P as a whole, 2nd quarter earnings are expected to be roughly flat, with a 7-9% growth rate for 2012 as a whole.  However, P/E’s remain below 13, which is under the historical average.


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.  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.