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A Lot Of Action In What Was Expected To Be A Quiet WeekPioneer Investments

By Sam WardwellAugust 20, 2013

Observations on the Capital Markets Week Ended August 16, 2013

Most of the U.S. economic data released last week was rather ho-hum, consistent withcontinuing slow growth, but markets werent boring. Maybe markets are thin because itsAugust, but the U.S. Treasury market had one of its worst weeks in a long time, and theselling spilled over into the U.S. stock market.The Fed has signaled that employment will be what drives its policy, and employment-related data has been strong enough for the Fed to begin to taper in September. Its not adone deal, but even the Fed doves seem open to the idea . . . so the big question is nowbecoming how fast will the Fed taper? Signs that Europe and China are strengtheninggave no comfort to bond bulls.Inflation remains restrained and growth remains muted, so we cant blame bond vigilantesfor last weeks sell-off. Instead, it seems increasingly apparent that Quantitative Easing(QE) did blow a bubble in the bond market (size unknown) and that bubble has now beenpunctured. (Note: this is not a market forecast: markets typically overshoot, so yields may

well fall back after this sharp rise, but its hard to see how bond prices return to their priorhighs.)

Executive Summary:

Last week in the capital markets: a Treasury sell-off takes U.S. stocks with it

Initial unemployment claims fell sharply 15k to a new cycle low of 320kThe National Federation of Independent Business (NFIB) Small Business Index, whichmeasures the optimism of small business owners, rose 0.6 to 94.1Somewhat soft data from the manufacturing sectorBusiness inventories were flat in June even as sales inched up.Retail sales werent awful, but investors werent pleasedConsumer Sentiment (Reuters/University of Michigan) surprised on the downsideGood coincident housing data, but still cause for concern about the impact of rising interestratesInflation and unit labor costs ticked up, but remain lowU.S. consumers continue to deleverage

Detroit falloutWashington watchFed watching: waiting for the September taperForeigners are selling TreasuriesThe Eurozone posted positive Q2 GDP growthOther Eurozone news was constructiveJapanese GDP growstax policy is in the headlines

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The Philly Federal Reserves report on manufacturing was softer than expected (after a bigjump last month), but the new orders component was ok.Comment: Despite headline weakness, the strength in the new orders and employmentcomponents is supportive of Fed tapering. Further, strength in the ISM PurchasingManagers Index, which compares prices paid with the prior months prices, suggests future

strength.

Business inventories were flat in June even as sales inched up

Comment: inventory/sales ratios remain low; this bodes well for the second half (no excessinventories to be worked off means no production cuts are needed)

Retail sales werent awful, but investors werent pleased

Nominal retail sales rose for a fourth consecutive month, up 0.2% in July; June sales wererevised up by 0.2%. Still, this was below expectations. Reports from Macys and Wal-Mart

added to the gloom.Excluding autos and gasoline, July sales rose 0.5%, the biggest gain in 7 months.Comment: retail sales account for roughly half of total consumer spending and one-third ofGDP.

Consumer Sentiment (Reuters/University of Michigan) surprised on the downside

The index, which measures how consumers feel about the economy, and had had hit a 6-year high last month, was pulled down by weakness in both the current conditions andexpectations components.Comment: The current conditions decline is surprising, given that jobless claims andgasoline prices have been falling and home prices have been rising. Im inclined to viewboth last months strength and this months weakness as possible statistical noise (thesurvey is based on a sample of only 500 households), especially given the decent retailsales number.

Good coincident housing data, but still cause for concern about the impact of rising interest rate

Housing permits and starts rebounded, with the volatile multifamily component driving bothJune weakness and July strength. Starts and permits had/have stalled just below 1 millionunits/year.The National Home Builders housing market index rose from 56 to 59, its highest readingsince November 2005, with strength coming from both current sales activity and builders

outlook.Mortgage applications for purchases fell 5% in the week ending 8/9, continuing a 3-monthtrend, and refinancing applications fell 4% despite a 5bp decline in 30-year mortgageratesand, of course, rates have risen since then.

nflation and unit labor costs ticked up, but remain low

Both headline CPI (which measures inflation) and core CPI (which excludes food and

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gasoline) rose 0.2 percent in July. Year over year, headline rose from 1.8% to 2.0%; Corerose from 1.6% to 1.7%.Import prices rose 0.2% on higher petroleum prices; ex- petroleum, import prices fell 0.5%.Year/year, ex-petroleum import prices were -0.5%.Export prices fell 0.1% on lower agricultural product prices. Year-on-year, export prices are

up 0.4%.Labor productivity rose at a 0.9% annual rate in Q2; unit labor costs rose at a 1.4% rate.Year/year, productivity was unchanged; both hourly compensation and unit labor costs rose1.6%

U.S. consumers continue to deleverage

Consumer debt declined 0.7% in the second quarter (Q2). The delinquency rate fell from8.1% in Q1 to 7.6% in Q2.

Detroit fallout

Moodys is inviting comment on a proposed methodology change which would raise theweight it gives to pension obligations from 10% to 20%.

Washington watch

Odds that Larry Summers will be the next FOMC chairman are rising. The Wall StreetJournal says the White House has moved to quiet Senate Democrats from pressing theclaims of Janet Yellen as the next Fed head, saying the President will not be pressuredinto an appointment. Comment: because Yellen is considered a major dove, the marketmay be pricing in a less accommodative Fed.The Justice Department moved to block the American/USAir merger. Most commentatorsfind the Justice Departments reasoning/logic/arguments pretty weak . . . the only place thecombined airline might seem to have excessive market share would be at Reagan (DCA)Airport . . .the one closest to DC.Higher tax revenues continue to shrink the deficit.No substantive progress on the budget or debt ceiling.

Fed watching: waiting for the September taper

Next Federal Open Market Committee (FOMC) meeting: September 17-18Fed speakers continue to guide the markets to expect a September taper.Chatter is now centering on the size/rate of the taper more than its start date: what is priced

in?

Foreigners are selling Treasuries

The Treasurys report has shown foreigners to be net sellers of Treasuries most of thisyear; net sales were quite large in June, hitting $67 billion. Both Chinese and Japaneseaccounts were large sellers in June.

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The Eurozone posted positive Q2 GDP growth

Flash Q2 GDP was +0.3% (-0.7% year over year) after a -0.3% Q1Germany (+0.7%) and France (+0.5%) drove growth. Portugal (+1.1%) was also solid.Spain (-0.1%) and Italy (-0.2%) remained in negative territory, but the rate of decline slowed

(the trend is improving).Comment: a positive Q2 number is a pleasant surprisethe end of the recession mighthave come a bit earlier than expectedbut one positive quarter is not enough for a victorydance.

Other Eurozone news was constructive

German investor confidence (the ZEW report) and industrial production surprised on theupside.Headline CPI was up 1.6% year over year; core was up 1.1%

Japanese GDP growstax policy is in the headlines

Q2 GDP rose for the third consecutive positive quarter, albeit more slowly than anticipated(0.6% quarter over quarter, 3.8% year over year).Real consumer spending is outpacing overall GDP growthbut is that rising confidence orbuying in anticipation of prices rising?On the downside, machine tool orders (an important indicator for Japan) was weakTheres lots of speculation/uncertainty about whether the government will seek to delay arise in the consumption tax and/or cut corporate tax rates.

China watchNew York Times watch

Economic data was generally encouraging, notably rising factory output, electricalgeneration/consumption, and demand for copperindications that growth is not collapsing.The government said it would accelerate the cutback of excess industrial capacity.A Friday New York Times article said that a credit crisis is spreading through China as theinformal lending called shadow banking system dries up, causing thousands ofbusinesses to close, mass repossession of luxury cars and street protests. Comment: itsunclear whether this is just another wall of worry story (journalistic sensationalism theNew York Times is not a China booster) or a valid warningtheres no independentverification of the story yet.

ndia tries (without success thus far) to stop the decline of the rupee

Facing a large current account deficit, and falling currency, India boosted import duties ongold and silver and banned the import of gold coins, while the Reserve Bank of Indiaimposed new capital controls. It didnt help last week: stocks fell and the rupee hit a new all-time low intraday Friday. Note: Indians were the worlds largest buyers of physical gold inQ2given the decline of the rupee, gold doesnt look bad in local currency terms.

Mexico announces plans to open its petroleum sector

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Mexican President Enrique Pea Nieto proposed changes to the constitution that wouldallow private investment in the development of oil and gas resources (currently theres astate-owned monopoly).

Egypt watch

The unrest is boosting both geopolitical fears and oil prices

The week ahead

New and existing home sales, FHFA house price indexKansas City Fed surveyJuly FOMC meeting minutesmay shed some light on taper plansFed Jackson Hole meetingBernanke wont attend: no notable Fed policy guidanceexpectedEurozone and China PMI

Data Sources: The Wall Street Journal, Financial Times, Bloomberg

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