Macro Factors and Their Impact on Monetary Policy, The Economy and Financial Markets
Written by Jim Welsh, with the co-authors David Martin and Jim O'Donnell
By keeping the federal funds rate near zero percent for five years and suppressing long-term Treasury yields through quantitative easing (QE), the Federal Reserve has intended to help consumers, corporations and all levels of government lower their financing costs. Household debt service payments as a percent of disposable income have fallen from 14% in 2007 to 10.5% at the end of the first quarter. According to Sentier Research, median income has fallen from $54,218, when the recession ended in June 2009, to $51,500 as of May 31. Based on the U.S. Census Bureau's Current Population Survey, Sentier Research estimates that median income fell -0.3% from May 2012. Consumer prices increased 1.4% over the past year, so the majority of consumers have fallen further behind the cost of living. The reduction in debt service payments has helped consumers offset some of the persistent weakness in median income.
Corporations have lowered their cost of financing, which has contributed to record profit margins. According to independent researcher Brett Gallagher, companies paid 1.8% of sales to service their debt in 2012, down from a 15-year average of 3.9%, despite debt, as a percent of assets, rising to 14.2% from its 15-year average of 11.5%. Lower debt servicing costs contributed to increased earnings, and enabled corporations to buy back $97.8 billion of their stock in the first quarter, according to FactSet, a multinational financial data and software company. For the 12 months through March, companies retired a whopping 3.1% of their shares. Lower borrowing costs have kept the federal budget deficit from being larger, since interest expense is virtually unchanged from five years ago, even though outstanding debt has ballooned by more than $5 trillion to over $16 trillion.
The Federal Reserve understood that their extraordinary monetary accommodation would assist a recovery in housing, boosting home prices in the process, and lift the stock market. At the end of March, household and nonprofit organizations' net worth reached $70.35 trillion, eclipsing the prior peak of $68.06 trillion established as of June 30, 2007. The $2.29 trillion increase almost matches the increase in the Federal Reserve's balance sheet from $900 billion in 2007 to over $3.50 trillion as of June 30, 2013. The increase in net worth has been beneficial, especially for those with investment portfolios and homes. According to the U.S. Labor Department, the top 20% of wage earners account for 38% of all spending, which almost equals the spending of the bottom 60% of wage earners combined. Supporting the spending habits of the top 20% has sustained consumer spending, even as median income has fallen since 2009. One of the negative consequences of the Federal Reserve's monetary policy has been to exacerbate the problem of income inequality and wealth distribution in the United States. However, it is important to remember that the Federal Reserve has gone down the path of extreme monetary policy because all of their traditional policy tools were incapable of managing the fallout from the 2008 financial crisis. We are here by necessity, not by choice.
Since the end of 2010, existing home sales have increased from 4.27 million to 5.08 million in June 2013, a jump of 19.0%, according to the National Association of Realtors. New single family home sales have soared 52.4% since the end of June 2010 (from 326,000 to 497,000), according to the U.S. Commerce Department. This improvement is impressive, but here's a dose of reality. Existing home sales are still -28.5% lower than the 7.25 million homes sold in September 2005. From their peak of 1.39 million in July 2005, new home sales are down -65.7%. Since the end of 2010, the S&P/Case-Shiller U.S. National Home Price Index, which covers 20 metropolitan areas, has gained 8.9%, and is up 12.0% over the past 12 months. This has made those who have purchased a home since the end of 2010 feel good and has helped improve the psychology of homeowners and consumers in general. According to Thomson Reuters/University of Michigan's Survey of Consumers, the proportion of consumers who consider home-selling conditions favorable is the highest since 2006 while those saying it's a bad time to purchase a house is the smallest in 10 years.
Since the end of 2010, demand for housing has been buttressed by low home prices and mortgage rates, which lifted housing affordability to record highs. Large investment firms have spent billions of dollars buying homes in the most depressed housing markets. Blackstone, a real estate private equity firm, has spent $4.5 billion to buy 26,000 homes at an average price of $173,000. Colony Capital, a private, international investment firm, had acquired 12,000 houses as of May 17 at an average price of $150,000. Blackstone, Colony and other large investors have indicated they plan to rent and hold the acquired properties for years. Many small investors have different plans. Nationwide, the Campbell/Inside Mortgage Finance HousingPulse Tracking Survey estimates that 68% of the damaged homes sold in April were purchased by investors, while only 19% were bought by first time buyers. Real estate information company RealtyTrac estimates that nationwide 136,000 homes have been flipped - bought and resold within six months - during the last year, an increase of 19% from the prior year. In California, the number of homes that have been flipped reached the highest level since late 2005. According to Property Radar, a real estate data firm, about 6,000 homes have been flipped in California through April, or more than 5% of all homes sold. Flipping homes boosted prices when housing was on fire during 2004-2007, and has likely had the same impact in some markets over the last 12 months.
The supply of homes for sale has been low since 2010, held down by a number of factors. A significant portion of potential supply has been kept off the market since 20-25% of existing homeowners owe more on their mortgage than their homes are worth. These folks simply can't afford to sell their houses and are effectively trapped. According to CoreLogic, a provider of consumer, financial and property information, the number of homes in some stage of foreclosure declined in May to one million homes, down -29% from 1.4 million in May 2012. Less forced selling by banks has helped prices firm up in some of the most distressed areas. Although new home construction has increased, it is still down more than -60% from 2005-2006 levels.
The imbalance of supply and demand which has been so supportive since the end of 2010 is likely to weaken in coming months. The increase in home prices over the past year has priced some potential buyers out of the market, and forced others to buy smaller or less expensive homes. The increase in mortgage rates from 3.5% to 4.5% since mid-May (as measured by the Federal Home Loan Mortgage Corporation) is also a negative for demand. In May, the monthly payment on a $250,000 home with 20% down was $898. A mortgage rate of 4.5% increases the monthly payment to $1,013 or 12.8% more. Investment demand has been strong but that is starting to change. An early June survey of real estate investors by ORC International, a market research firm, found 48% of those surveyed planned to reduce their home purchases over the next year, up from 30% last August. Only 20% expect to buy more homes, down from 39% in August. This survey was taken before most of the increase in mortgage rates had taken place, so the demand from real estate investors has likely weakened further.
The S&P/Case-Shiller Home Price Index is simply a 12-month rate of change, comparing the current month to prices 12 months ago. The index made its low in January 2012 and by April 2012 had only risen 1.34%. Between April and October 2012, home prices as measured by the index rose 3.94%. Unless home prices increase by an additional 3.94% over the next six months, the 12-month rate of change will likely show less than a 10% year-over-year increase. Although still positive, the lower rate of increase could dampen some of the positive psychology generated in recent months and weaken demand from investors. Car and truck sales have also been an area of strength since the end of 2010. In 2011, total vehicle sales grew from 12.7 million to 13.9 million units, a gain of 9.4%. In 2012, sales rose 12.9%, climbing to 15.7 million. Although sales are running 6.4% ahead of 2012's pace after the first six months of 2013, they appear to be slowing. According to research firm R.L. Polk & Company, the average age of all vehicles in operation was a record 11.2 years at the end of 2012. This suggests vehicle sales should hold up in coming months as car and truck owners look to replace their old jalopies. A return to the double digit gains of 2012 seems unlikely, though.
According to Customer Growth Partners, a retail research firm, increased car purchases have tended to crimp other categories of retail spending. For instance, as car buying picked up in 2011 and 2012, back-to-school sales slipped from a gain of 6.7% in 2011 to 4.2% in 2012. Their estimate for this year is a weak gain of 3.4%. The squeeze from higher car sales may have already begun. In June, retail sales advanced 0.4%, which was less than expected, and May's tally was lowered from 0.6% to 0.5%. When car purchases and gasoline sales are excluded, retail sales actually fell 0.1% in June. Customer Growth Partners attributes the squeeze on non-auto retail sales to weak personal income growth. We have discussed how weak income growth has been almost every month, and last month we noted that disposable income had only grown a total of 10.5% over the previous five years ending March 31, 2013. This is the smallest increase since 1959, according to the U.S. Bureau of Economic Analysis.
According to the Labor Department, employers added 195,000 jobs in June, and increased the figures for April and May by 70,000 jobs. This raised the average monthly gain to 202,000 for 2013. Average hourly earnings improved slightly and are up 2.2% from a year ago. Despite the better headlines regarding job growth, there are details that paint a less heartening picture. More than half of the 195,000 gain was concentrated in relatively lower paying jobs, where the average weekly paycheck is $351. For example, retail had 37,000 new jobs and hospitality businesses added 75,000 new jobs. The total number of unemployed workers was unchanged in June from May at 11.8 million. More than 30% of those out of work have been unemployed for more than six months. The underemployment rate (U6) jumped to 14.3% in June from 13.8% in May. The number of workers who are working part time but want full-time employment has surged since March, from 7.6 million to 8.2 million. The increase in headline job growth is masking a less robust labor market. Total employee compensation from the trough of the recession in June 2009 through March 31, 2013, rose by just over 12%. The average improvement at this point following the last three recessions was 23%. While the number of jobs created each month is important, the quality of the jobs is just as important.
In our February commentary we discussed the impact the Affordable Care Act (ACA) was likely to have on the labor market, and concluded it would likely have some negative unintended consequences. The ACA effectively incentivizes companies to reduce hours for workers below 30 hours per week, since that defines whether a worker is full or part time, and part-time workers are not covered by the ACA. According to the Bureau of Labor Statistics there are 10 million part-time workers who work 30-34 hours per week. In April, research from University of California, Berkeley found that up to 2.3 million workers were at risk of having their hours reduced, and this appears to be what is occurring. According to the Labor Department, on average, employers added 171,000 full-time jobs and 31,000 part-time jobs each month in 2012. In 2013, employers have added 22,000 full-time workers, but hired a monthly average of 93,000 part-time workers. The recent decision by the Obama administration to delay the start of the employer mandate until 2015 is unlikely to cause a meaningful reversal in the trend toward employers hiring part-time workers.
Gross domestic product (GDP) growth hovered around 2% in 2011 and 2012, even though housing and vehicle sales improved significantly in both years. Gains in housing and vehicle sales are poised to be moderate in the second half of 2013, while job and income growth are not likely to accelerate. When all the pieces are put together, it's hard to see how growth is going to reach 3% by year-end as forecast by the Federal Reserve and many private economists.
In the June commentary we thought one of the reasons Federal Reserve Chairman Ben Bernanke discussed the tapering of the Federal Reserve's QE3 purchases in his May 22 Congressional testimony was to provide the markets a sobriety checkup. We noted that a number of Federal Open Market Committee (FOMC) members had publically discussed the activity in the market for leveraged loans, real estate investment trusts (REITs), the issuance of leveraged closed-end fund structures and the overall reach for yield by investors into more risky investments. On July 17, Chairman Bernanke appeared before the House Committee on Financial Services and stated that although the increase in interest rates since May 22 was "unwelcome," it had probably reduced some "excessively risky or leveraged positions," which eased concerns among some Fed officials.
We also discussed in our June commentary why the financial markets had likely overreacted to the Federal Reserve's comments regarding the tapering of QE3. Although Chairman Bernanke specified that the Fed's decision would be data dependent, market participants decided to sell first and clarify later. We thought this misperception would allow bonds and stocks to rally, with the S&P 500 Index at least approaching its mid-May peak. The financial markets were provided clarity, after a number of FOMC members assured everyone the Fed had no intention of immediately paring its $85 billion monthly purchases of Treasury bonds and mortgage-backed securities (MBS).
As noted last month, the debate within the Federal Reserve regarding QE3 has intensified this year, and, market gyrations aside, will likely become even more heated in coming months. The "hawks" have been opposed to QE3 from its inception. They are concerned about the negative unintended consequences from continuing QE3, and the ever-growing size of the Fed's balance sheet, which could be seriously dented by higher interest rates. The moderates from the FOMC have been supportive of QE3 as long as economic conditions warrant. We suspect they are also concerned about the size of the Fed's balance sheet and the difficulty the Fed may experience reducing its bond and MBS holdings in coming years. The "doves" are committed to QE3 until the labor market is stronger, unemployment much lower and the overall economy is clearly on a firmer footing.
In coming months we expect a consensus to form within the FOMC that agrees to gradually lowering the Fed's purchases. At some point, the financial markets must become less dependent on QE3, and the size of the Federal Reserve's balance sheet does matter. We would not be surprised if the Fed doesn't lower its purchases by $10 billion a month (or similar amount). This level of gradualism may be just the pacifier the markets need to avoid the "sky is falling" mentality that gripped some bond market sectors in June. Basically, the Federal Reserve needs to provide the financial markets a nicotine patch so investors can kick their QE addiction. Of course, this may prove easier said than done as most smokers who have tried to quit would attest.
It's been a year since the president of the European Central Bank (ECB), Mario Draghi, stated that the ECB "will do whatever it takes" to preserve the euro and revive the eurozone's economy. In the wake of his statement on July 26, 2012, the SPDR EURO STOXX 50 ETF (FEZ) rose from around $27 to over $36 at the end of January 2013. Since then, FEZ has traded between $32.50 and $36.50. Although the eurozone is likely to technically emerge from recession before year-end, growth is unlikely to exceed 0.7% in 2014. More importantly, little progress has been made in enacting the labor market reforms necessary to revitalize and improve productivity in Italy, France and several other countries, so politicians in these countries have squandered a year of opportunity. Political instability threatens to upend Portugal and Spain, while Greece remains mired in depression. According to Eurostat, the provider of statistical information to the institutions of the European Union (EU), the cumulative change in GDP since the end of 2007 through March 31, 2013, shows that as a whole, the eurozone's GDP is -2.7% lower, France's GDP is down -0.4%, Spain's has decreased by -6.5% and Italy is -8.2% smaller. Further, unemployment has soared in the eurozone, reaching 12.1% in May, and it is staggering at 17.7% in Portugal, 26.9% in Greece and 27.2% in Spain.
Youth unemployment is 24.4% in the eurozone (ages 15-24), and, since it has been above 20% since the first quarter of 2009, it has become a chronic problem. In a number of countries youth unemployment is also an acute problem: Italy 38.5%, Portugal 42.0% and Spain and Greece comfortably above 55%. A generation of European youth may not have the opportunity to develop the skills and the experience to become productive contributors to Europe's future. It shouldn't come as a surprise then that fewer and fewer Europeans think the creation of the European Union has been a net positive for their country. A May survey from the Pew Research Center asked citizens throughout the European Union the following question:
"In the long run, do you think that your country's overall economy has been strengthened or weakened by the economic integration of Europe?"
In France, 77% thought it had weakened their country, versus just 22% who thought it had strengthened France. In Italy, Spain and Greece, 75%, 60% and 78% of citizens, respectively, thought it had weakened the country while 11%, 37% and 11%, respectively, thought it had strengthened their country. It's a good thing that in Germany only 43% thought it had weakened Germany, versus 54% who said it had strengthened the country, since Germany may be on the hook to contribute more bailout money if things should deteriorate again. The German federal election will be held on September 22, 2013, and Angela Merkel, the Chancellor of Germany, will do everything in her power to keep eurozone issues to a minimum. However, the Pew survey suggests there is a rising tide of disillusionment, frustration and anger building in many of the countries most adversely affected by high unemployment and dim prospects for improvement. We would be surprised if protests and social violence don't break out and disrupt economic activity in at least one country in 2014 or 2015.
As discussed in our June commentary, Japan has devalued its currency 25% against the euro since last November, which is a headwind for European countries heavily dependent on exports. We noted that Germany derives 50% of its GDP from exports, Portugal 37%, Spain 30%, Italy 29% and France 27%. Although much of these countries' exports are to other eurozone countries and the U.S., European companies will still have to compete with Japanese companies whose products have become 25% less expensive. In May, eurozone exports dropped -2.3% from April, and imports fell by -2.2%. The decline in imports is a reflection of softer domestic demand and economic weakness, and the falloff in exports of a tougher global export environment. Germany represents 30% of eurozone GDP, so what happens in Germany doesn't stay in Germany. Although Germany is the eurozone's locomotive, it still needs demand from other EU members to keep its economy humming. In May, German exports were off by -2.4%, led by a -9.6% decline to other EU countries, but exports to countries outside the EU also fell -1.6%. This isn't a new trend. Over the last year, exports have fallen -4.8%. According to the German Economy Ministry, industrial production fell by -1.0% in May, confirming the weakness in exports. The monthly economic sentiment poll by ZEW, which is an amalgamation of the sentiments of approximately 350 economists and analysts regarding the economic future of Germany, dropped to 36.3 in July from 38.5 in June, well below the forecasted increase to 39.6. We expect German growth to improve enough to pull the eurozone technically out of its recession before year-end, but it won't provide much solace to the millions who will remain unemployed throughout the eurozone.
As forecast last December, the eurozone recession has persisted through the first half of 2013, and has caused the erosion in home prices to accelerate. According to Eurostat, home prices throughout the eurozone fell at an annual rate of -2.2% in the first quarter, worse than the -1.7% drop in the fourth quarter of 2012. Some individual countries fared worse, with Italian home prices falling -5.7%, the Netherlands' off -7.2%, and Spain's plunging -12.2%. This isn't good for European banks, and we suspect many are facing additional mortgage write-offs and credit card losses due to the sustained high unemployment rates. European banks create 80% of new credit, so their health and lending is critical to any recovery. Lending to the private sector fell -1.1% in May 2013 from May 2012, and was weaker than April's -0.9% annual decline. Annual money supply growth slipped to 2.9% in May, down from 3.2% in April.
Mario Draghi can say the ECB will do whatever it takes, and say the ECB's monetary policy "will stay accommodative for the foreseeable future" as he did on June 26 (and that was a surprise?). But it has not translated into any measurable economic or structural improvement in the eurozone since July 26, 2012, when he made his famous "whatever it takes" comment. Even though the problems in Europe appear to have been delegated to the back burner by most investors in recent months, the risk is rising that another sovereign debt crisis may emerge in the next six to 12 months in Europe. A decline below $32 in the EURO STOXX 50 ETF (FEZ), and/or a close below €127 on the euro would represent a clear warning of coming trouble.
China's GDP grew 7.5% in the second quarter, down from 7.7% in the first quarter and 7.9% in the fourth quarter. In June, exports fell -3.1% versus an expected gain of 3.4%. China's broadest measure of money supply (M2) was up 14.0% at the end of June, but down from May's annual growth of 15.8%. Urban household disposable income slowed to an annual increase of 6.5% as of June 30, down from 9.7% in the first half of 2012. Lower income growth resulted in a smaller increase in retail sales of 12.7% in this year's first half, versus a gain of 14.4% in 2012's first half. In recent months, the People's Bank of China (PBOC) has moved to slow the explosive growth in total social financing (credit), which increased an extraordinary 52% through May versus May 2012. If the PBOC maintains its effort to moderate credit growth in coming months, GDP is unlikely to accelerate before year-end.
According to recent analysis by Bloomberg, each $1 increase in credit during 2007 lifted China's GDP by $.83. Over the last year, each $1 of new credit only yielded $.17 in GDP growth. As stated last month, China could prove vulnerable to large capital outflows in 2014 or 2015 that could create a liquidity problem for Chinese banks, and deflate the credit bubble that has been expanding since 2008. Should Europe's debt problems reemerge in coming months, or some unexpected shock impairs global growth, the timing of China's banking problems would be pulled forward.
Technical analysis helps measure whether the stock market is gaining or losing strength. One of our favorite technical indicators is the advance/decline line, which is a running total of the number of stocks rising each day less the number of stocks that fall. When a net majority of stocks advance over a period of days and weeks, the advance/decline line shows that a market rally is being supported by a broad level of participation. Stock market tops are usually formed when fewer stocks participate and the advance/decline line fails to make a new high. When fewer stocks participate as the market rises, some of the market averages containing those weaker stocks often fail to make a new high, which creates a "divergence" between market averages. Divergences are a sign of stress, like pistons in a car motor not firing in sequence. The October 2007 high in the stock market was a "textbook top." As the Dow Jones Industrial Average and S&P 500 were reaching an all-time high, the advance/decline was below its July 2007 high, as were a number of major market averages.
We use technical analysis to corroborate our fundamental analysis, since technical analysis tends to lead to changes in the fundamental outlook as it did in 2007. When the market reversed on May 22, every major average had made a new high, as did the advance/decline line. We reviewed this in the May commentary and concluded the long-term trend remained up as long as the S&P 500 did not fall below 1,536.
For many months we have stated that the risk of a meaningful decline in the stock market was not likely until the second half of this year, since we would expect to see the market's technical health measurably deteriorate, before negative news and reasons to sell appear. Currently, the overall technical health of the market is still decent, although there has been some slight weakening. The Dow Jones Utility Average peaked on April 30, and historically has often been a leading indicator (three to six months) of an approaching market top. Various measures of momentum are still fairly strong, but weaker than they were in May. For the first time in many months, the advance/decline line has lagged as the S&P 500 made a new high in July. Volatility, as measured by the VIX Index, has been creeping higher since March 14 (March 14: 11.05; May 17: 12.26; July 22: 12.29), even though the S&P 500 is 8.4% higher. Volatility is likely to increase in coming months as investors attempt to discern when the Federal Reserve will begin tapering, reports indicate that the U.S. economy is not accelerating as expected, and more attention is paid to the lack of global growth. In our quarterly Macro Market Update webcast on July 10, we suggested selling into strength, if the S&P 500 approached 1,700 as we expected. As you can see, the S&P 500 is touching the upward boundary of the channel it has traded in since 2010, which is another reason to lower exposure. As long as the S&P 500 holds above 1,560, the long-term trend is still up.
Last month we showed a number of trend lines that converged near 2.7% on the 10-year Treasury bond, and used technical analysis to project that the yield would reach 2.74%. After touching 2.74% on July 5, the 10-year yield has drifted lower. Any rise above 2.74% and the down trend line from 2007 would be a significant negative and imply that the major trend in longer-term rates had turned up.
Definition of Terms
The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.
Quantitative easing (QE) refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.
S&P/Case-Shiller U.S. National Home Price Index is a quarterly composite of single-family home price indexes for the nine U.S. Census divisions.
S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.
SPDR EURO STOXX 50 ETF tracks the EURO STOXX 50 Index, a selection of the biggest companies from every sector of the European corporate sphere.
The VIX Index is a benchmark index designed specifically to track S&P 500 volatility.
Volatility is a statistical measure of the dispersion of returns for a given security or market index.
One cannot invest directly in an index.
Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.
This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.