FMX | Connect – www.fmxconnect.com - (Reported 10/21/2010)

Excerpt from MARKET MUSINGS & DATA DECIPHERING

WHILE YOU WERE SLEEPING

The risk trade is back on with Tuesday’s sharp sell off in equities either a distant memory or a classic case of Tepper “buy-the-dip” on QE hopes. Hope is not a strategy, in our view, but it sure has lured in a lot of players over the near-term.

Equities are up quite robustly in Europe and emerging markets advanced 0.6%; though the action in Asia was a little more mixed. Nothing going on in bond-land worth reporting. Corporate bond risks, as per CDS spreads, are declining. And, of course, as is typical when risk appetite is back on track, the U.S. dollar is treading softly — despite the fact that a Spanish 10-year bond auction went poorly today and Greek-German bond yield spreads gapped up 16 basis points to 677bps.

In the FX market, nobody seems to care about default risk in the periphery or what the future holds as far as the euro is concerned. Investors ostensibly believe they are buying the D-mark and not the peseta or drachma. Germany looks like a bastion of stability, notwithstanding how weak their banks are from a capitalization standpoint — the government there just lifted the country’s real GDP growth forecast to 3.4% from 1.4% for 2010, and to 1.8% from 1.6% for 2011 — quite a standout at a time when other countries are lowering their economic projections. France’s Insee business confidence index also posted a healthy gain and there was a positive set of Eurozone manufacturing data just released as well.

However, the numbers out of China were not that encouraging. Growth “slowed” to its softest pace in a year in Q3, to 9.6%, while inflation ticked up to a two-year high of 3.6% (both roughly matching consensus estimates). These data points will undoubtedly add to external pressure on China to revalue ahead of tomorrow’s G-20 meeting in Korea. In any event, the People’s Bank of China (PBOC) rate hike coupled with the moderation in growth will likely trim some of the speculation in the commodity complex, which we highlighted on Monday when we mentioned the high level of non-commercial interest in the latest Commitment of Traders report.

NORTH AMERICA LOSING SOME SERIOUS MOMENTUM

The U.S. economy may in fact be contracting again. The monthly data from Macroeconomic Advisers showed that real GDP contracted 0.6% in August. While this did follow a red-hot +1.25% gain in July, this does mark the third decline in real activity in the past four months. And, as an exclamation mark to the overall deflationary backdrop we are in, nominal GDP also fell 0.4% in August and has contracted now in three of the past four months. Maybe the bond market does not need the Fed’s help after all — the super-soft economic environment is all the Treasury market really needs to sustain the downward trend in yields.

And, talk about taking a knife to the forecast — to both growth and inflation. That is what the Bank of Canada just did as it signalled a deep pause in what has turned out to be a brief interest rate cycle. As the Bank indicated, “the global economy is entering a new phase”, a “time of transition” that involves “a weaker U.S. outlook, constraints beginning to moderate growth in emerging-market economies” and “domestic considerations that are expected to slow consumption and housing activity in Canada.” Wow. All it took to bring the economy to its knees were three rate hikes (okay, and the loonie back at par too!).

Is there anything in these numbers and comments that would otherwise support this crazy notion that there is a bubble in bonds? Could it be that the fixed-income market is telling us the same thing about the economic outlook that the Bank of Canada is — maybe, just maybe, it is the equity market, liquidity-craved as it is, is the odd man out?

INVESTORS INTELLIGENCE BULL-BEAR SPREAD AT FIVE-MONTH HIGH

The U.S. Investors Intelligence Sentiment Poll just came out for this past week. The bull camp dipped a tad, to 45.1% from 47.2% , but the bear camp continues to dwindle to 22% from 24.7% .

The bull/bear spread widened further, to 23.1 versus 22.5 in the previous week. The spread has not been this wide since the week of May 4th. This is not a forecast as much as an observation but the last time the spread was this wide the Dow was down 9% in the next 4-5 weeks.

Not only have sentiment indicators flagged a high level of investor complacency but also the equity market looks highly overbought right now. Looking at the internals, there is much less buoyancy than there is on the surface. As an example, back in April there were at least 600 stocks on the Big Board making new highs versus around 180 right now. Moreover, back at the April highs, we had well over 90% of the S&P 500 universe trading above their 200-day moving average and currently that share is barely above 70%. Keep these metrics in mind when judging the health and breadth of the overall market, and be sure to dust off Bob Farrell’s Rule 7: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”

BEIGE BOOK SYNOPSIS

The Fed’s Beige Book showed the U.S. economy to be growing, but at an anemic pace:

“Reports from the twelve Federal Reserve Districts suggest that, on balance, national economic activity continued to rise, albeit at a modest pace, during the reporting period from September to early October.”

The American consumer remains focussed on what they need, not what they want:

“Retailers said consumers are slowly regaining confidence, but remain price-conscious and were largely limiting purchases to necessities and nondiscretionary items.”

Even the lowest interest rates on record can’t revive the once interest-sensitive real estate market:

“Housing markets remained weak.”

“Conditions in the commercial real estate sector remained subdued.”

It’s hard to generate economic momentum with no job creation:

“Hiring remained limited, with many firms reluctant to add to permanent payrolls given economic softness.”

The commodity boom is a margin-crimper, not an inflation-generator:

“Input costs, most notably for agricultural commodities and industrial metals, rose further. Shipping rates increased, and retailers in some Districts noted rising wholesale prices. However, prices of final goods and services were mostly stable as higher input costs were not passed on to consumers. Wage pressures were minimal.”

As we have stressed in the past, the Fed’s Beige Book provides great insights into what is happening in detail at the sector level. Below we highlight the industries gaining momentum and those that are losing it:

Positive momentum groups:

•Semiconductors
•IT services
•Steel
•Agriculture
•Medical equipment
•Restaurants
•Food production
•Automotive
•Petrochemicals
•Hotels
•Travel/Tourism
•Mining
•Oil production

Negative momentum groups:

What really caught our eye are the two sectors that had been in the positive column for some time, but have now swung to the negative momentum group — staffing firms and transports. To wit:

“Reports from staffing firms were mixed. Staffing firms in the New York and Dallas Districts noted a slowdown in demand for their services, and contacts in the Cleveland District said new job openings declined. Richmond's report noted demand for temporary workers picked up slightly since the last report, and staffing contacts in the Philadelphia District said clients were adding positions as workloads increased. The Atlanta report noted a preference for increasing staff hours and using temporary help rather than hiring additional full-time staff.

Demand for transportation services appears to have slowed, although reports were mixed. Freight companies in the Cleveland District noted steady to declining volumes over the past six weeks, and Kansas City's report said transportation firms saw unexpected weakness. Rail companies in the Atlanta District reported positive, but slower growth of automobile and industrial goods shipments, while port activity in the Richmond District was mixed. Dallas' report said intermodal and railroad cargo volumes edged up, but growth in international container trade volumes flattened, and small parcel shipping volumes declined in September. San Francisco reported a pickup in demand for trucking services.”

BETTER TONE TO U.S. HOUSING DATA …

Both U.S. housing starts and the National Association of Home Builders Index (NAHB) released this week were better than expected, although some of the details of the housing starts report were mixed.

The most current reading of the housing market is the October release of the NAHB housing market index, which rose to 16 from 13 in September. While any improvement is encouraging, it pays to note that the October reading is now back to June 2010 levels and remains very depressed by historical standards.

The components were better with present, future and prospective buyers increasing; this, along with the single-family building permits, suggest that single-family starts could rise again in October.

Housing starts (data for September) were also better than expected, with starts rising 0.3% MoM (analysts were looking for a decline) and the prior two months were revised higher as well. However, the details were far murkier than the NAHB report.
Single-family starts rose 4.4% MoM after a 1.4% increase in August. These increases put a small dent in the large declines we saw in May, June, and July. On top of this, the gains were very uneven across the country, with a huge 66% jump in the Northeast, while two other areas reported flat-to-down starts.

Multi-starts, which are always volatile, fell nearly 10% after the 40% increase in August. For the Q3 tally, residential construction will still be deeply in negative terrain — our latest estimate is down 20% on the quarter.

Building permits (a forward-looking indicator) were much weaker, with total permits falling by 5.6% MoM. Single-family permits rose 0.5% after five straight monthly declines (but again, a very large regional disparity with an outsized gain in the Northeast) pointing to another increase in single-family starts next month. Multi-family permits were down 20%, the second decline in three months.

… BUT OVERALL, HOUSING IS STILL IN A DEEP FUNK

It is really quite remarkable that Ben Bernanke would claim that QE1 was a success, any more than the zero interest rate policy before it did. Maybe in the world of counter-factualism things would have been far worse without the radical Fed incursion, it can be said that success was achieved. Certainly mortgage rates and credit spreads have collapsed from their extreme highs in early 2009. Based on that narrow objective, QE1 may have worked but if the broader objective is to generate a sustained revival in the pace of economic activity, then it has been every bit as successful as President Obama’s fiscal plan, which was supposed to have pulled the unemployment rate down to 7% by now.

What we do know with certainty is that the record-low interest rates to date have failed to revive credit-sensitive spending because the debt deleveraging cycle, as it pertains to the household sector, continues unabated. Almost a third of the household sector have a sub-620 FICO score and as such are poor credits and the other two-thirds of the population are still scarred by the nightmare of the collapse in asset values and wave of defaults, delinquencies and foreclosures in the last three years.

So here we have this completely bizarre situation where even with market interest rates at historic lows, mortgage applications for new home purchases — the root of housing demand — slid 6.7% during the week ending October 15, on top of the 8.5% decline the prior reporting week and the level is back to its lowest in nine months, at 169.7. In “normal” times, the level of mortgage rates would have translated into a purchase index closer to 400, more than double where it is today. The Fed may well be able to drag bond yields and hence mortgage rates down even more, but the reality is that the central bank has no tools to deal with a total shift in household attitudes regarding debt, discretionary spending and homeownership.

As an aside, the purchase index is down 50% on a 26-week annualized basis, and from a year ago, purchases are down 37%. Incredible.

Moreover, refinancing activity is running dry and we will likely soon see activity being cut in half. Why? Because out of the total loans, 82.4% came from refis, which is near record highs (last week the percent of loans that were refis was 83.1% and the highest this got was 85.3% back in early January 2009).

SOFT PRODUCTION DATA

We saw a very bad U.S. industrial production report on Monday with total production falling 0.2% MoM in September versus consensus views of a 0.2% increase. This occurred even with a modest rebound in auto output. Manufacturing slipped 0.1% MoM — only food/beverage products (+0.7%) and technology (+0.3%) were bright spots.

Manufacturing production was especially soft, with over 80% of the sector down last month. This strongly suggests that the “diffusion index”, when it is released next month, will fall below 50 (was 52 in the latest August print) for the first time since the U.S. economy was struggling to emerge from recession in May 2009.

Capacity utilization rates (CapU) dipped slightly to 74.7% in September from 74.8%. While CapU has improved from the June 2009 lows, overall capacity is still about five-percentage points below long-run trends, suggesting that very few sectors have pricing power. The industries with the most spare capacity (and thus the weakest pricing power) include printing, wood products and plastics and rubber. However, there are a couple standout sectors where capacity is above long-term norms, suggesting strong pricing power and these include communications equipment and mining.

BANK OF CANADA — ON HOLD FOR NOW

As expected by both the market and Bay Street economists, the Bank of Canada left the overnight rate unchanged at 1.0% on Tuesday. The accompanying statement was quite dovish and was far more lengthy than September 8th statement, which accompanied a 25bps rate hike. Yesterday’s Monetary Policy Report added more colour to the statement and reinforced the message that the Bank of Canada is on hold for now — and given the large cuts to their economics forecasts, the Bank could be on hold well into 2011.

It’s clear the Bank took a long, hard look at their forecasts (we were very much surprised in the September statement that the Bank had said that “economic activity was slightly softer in the second quarter” after actual GDP missed their estimates by nearly a full percentage point). Cuts to forecasts were broad-based: the BoC trimmed most forecasts from the Canadian outlook, to the U.S. (taken down 0.7ppt to 2.3% for 2011) and even to emerging markets, which they had been previously upbeat on.

Canadian GDP forecasts were cut from 3.5% to 3.0% in 2010 and 2011 growth prospects were chopped to 2.3% from 2.9%. They did raise 2012 forecasts slightly from 2.2% to 2.6%. For the remainder of this year, we saw large cuts to the second half of the year — Q3 GDP at 1.6% now, which is much closer to current tracking of the incoming data than the previous 2.8%, and Q4 was taken down to 2.6% from 3.2%.

Another big change to the Canadian outlook was the much weaker tone to the outlook for domestic demand. The global and U.S. landscape is very much a worry for the BoC and has been for some time “the combination of difficult labour market dynamics and ongoing deleveraging in many advanced economics is expected to moderate the pace of growth relevant to prior expectations”. However, what was new to the October statement is that the BoC also stepped up the rhetoric on Canada’s domestic situation saying the “with housing activity declining markedly as anticipated and household debt considerations becoming more important, the Bank expects household expenditures to decelerate… ” In fact for next year, the Bank expects consumption to add 1.2ppts to growth (versus 1.4ppts prior) and for housing to shave two-tenths of a percentage point off growth (versus -0.1ppt)

On inflation, the Bank noted that inflation “has been slightly below” the Bank’s estimates. They trimmed both core and total CPI forecast — core is expected to remain below 2% until the end of 2012. The reason being is that “significant excess supply” persists and the output gap “is slightly larger” than they had thought, which is now expected to close by the end of 2012, about 12 months later than previously expected.

Another interesting addition to the statement was two mentions of the currency markets. The first was in relation to the global economy where “heightened tensions in currency markets and related risks associated with global imbalances could result in a more protracted and difficult global recovery.” They also noted that the “strength of Canadian net exports will be sensitive to currency movements”, acknowledging that the recent strength in the CAD could negatively affect exporters. Although the CAD has pulled back from parity recently, our fair value model continues to suggest that the loonie is overvalued by about five cents. While we remain long-term Canadian dollar bulls, in the short-term, we believe the CAD is due for a correction.

In September, the Bank concluded the statement very succinctly saying “any further reduction in monetary policy would need to be carefully considered in light of the unusual uncertainty surrounding the outlook”. While Tuesday’s closing was seemly less forceful (“unusual uncertainty” was dropped), given that the Bank went to great lengths to outline the risks and to reiterate them in the final paragraph, it is clear that they very concerned about the outlook and the uncertainty surrounding it, which suggests that they will be keeping rates steady for some time.

CANADIAN ECONOMY HOT IN AUGUST

We had another strong piece of Canadian data out in the form of wholesale sales, which beat expectations. August wholesale sales rose 1.2% MoM, more than double expected by economists.

For the real GDP tally, real wholesale sales were up 0.9% — impressive, especially after the large 2.1% gain in real manufacturing shipments. August real GDP is looking hot. Our tracking is for 0.3% MoM, much better than the 0.1% dip in July. Even so, the quarter won’t be that great and by our count, Q3 is around 1.4% QoQ annualized, close to the BoC’s fresh forecast of 1.6% (which they expect to be the low point over the next 18 months).

David A. Rosenberg
Chief Economist & Strategist Economic Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919

Source: Market Musings & Data Deciphering

http://www.fmxconnect.com/

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