Thursday, January 23, 2014 - They Must Think We’re All Morons

They Must Think We’re All Morons

by Sinclair Noe

DOW – 175 = 16,197
SPX – 16 = 1828
NAS – 24 = 4218
10 YR YLD - .09 = 2.77%
OIL + .47 = 97.20
GOLD + 26.30 = 1264.10
SILV + .22 = 20.11

We have economic reports to cover, some interesting news out of China; lots to talk about today. But what is the top story on most major news outlets? Justin Beiber was arrested in Miami for DUI and drag racing his Lamborghini from strip club to strip club. Seriously. We could spend the whole hour talking about it…, if we were brain dead. That is the biggest story in the country, because they must think we’re all morons.

This has been a very quiet week for economic data but today we got a few economic reports.

Initial jobless claims held steady last week at a nearly 2-month low as 326,000 people filed for first time unemployment benefits.

The Markit Flash US Manufacturing Purchasing Managers' Index (PMI) fell to 53.7 for January, its slowest growth in three months. A reading of 53.7 still indicates growth in manufacturing, and the researchers say we shouldn’t read too much into the report because cold weather has to play into the results. According to the economist from Markit: "After allowing for companies that saw production and sales disrupted by the cold weather, the rate of growth of output and orders remained as strong, if not stronger, than seen late last year.”

In another consequence of the weather, natural gas prices jumped more than 5% during yesterday's session, pushing prices to levels not seen since late 2011. This morning, it's close to cracking $5. The government cut its gas inventory forecasts. Also, gas delivery to consumers in New York and Boston set records yesterday as the most recent snowstorm buried the Northeast. Nat gas is a common way to heat homes, especially in the Northeast, and we’ve had some serious storms this winter.

If you’re looking for ways to trade the move, there are funds and ETFs; among the best known is UNG, which is not to be confused with a trade on the oil sector in general. There is a tendency to chase anything that moves fast. I don’t know where the price of nat gas will go from here; I do know the storms will pass.

The Federal Housing Finance Agency reported home prices ticked up 0.1% in November, and were up 7.6% from the year-earlier period. The National Association of Realtors reports sales of previously owned homes rose in December for the first time in 5 months, and capping the best year since 2006. A total of 5.09 million U.S. previously owned houses were sold in 2013 compared with 4.66 million the prior year.

The index of US leading indicators rose in December. The Conference Board’s gauge of the outlook for the next three to six months climbed 0.1 percent after a revised 1 percent gain the prior month that was larger than previously estimated. The report noted progress in the labor market, rising equity prices, rising home values, continued strength in consumer spending, and rising orders to manufacturers. Five of the 10 indicators in the leading index contributed to the increase.

The biggest economic report today came from China. Activity in China's factory sector contracted in January for the first time in six months. Weighed down by weaker domestic and export demand, the flash Markit/HSBC Purchasing Managers' Index (PM) fell to 49.6 in January from December's final reading of 50.5, dropping below the 50 line which separates expansion of activity from contraction. The reading points to a further slowdown in manufacturing and the entire Chinese economy, which then has implications for the US economy. Chinese leaders have pledged to push reforms to unleash new growth drivers as the world's second-largest economy loses steam, burdened by industrial overcapacity, piles of debt and soaring house prices.

And this has been another area of concern about China. China’s growth model appears to be built on a mix of investments and exports and debt; the dependence on debt has been producing diminishing returns. Lending has in recent years been the driver of growth, but each yuan of new borrowing now produces 1/4 the amount of GDP increase that it did five years ago, and now there are concerns about an imminent default in its shadow banking system, or investments made off balance sheet.

The Chinese cabinet is seeking to increase government oversight of lending by companies that currently face little or no supervision. The shadow system has grown in recent years because the Chinese government has too tightly controlled traditional banking. It keeps the interest rates that conventional banks pay to depositors extremely low and gives out cheap loans to state-owned enterprises and favored companies that might not be able to repay the money.

And now it looks like one of those companies might not be able to repay. The China Credit Trust Company has told investors that it may not make a January 31 repayment on what would amount to the equivalent of about $500 million; that’s a big chunk of money but not a scary number, in itself. The problem is that nay significant defaults could shatter the widespread assumption that off-balance-sheet investments carry an implicit guarantee from state banks and their partner institutions. Regulators have warned that investors must assume the risks from high-yielding investments and not expect protection from losses unless such guarantees are explicit. Local governments have largely ignored these injunctions and have stepped in repeatedly in recent years with bailouts for local firms facing default on corporate bonds and trust loans.

The low rates, of course, have led savers to invest money in speculative real estate projects or dubious investments known as wealth management products offered by banks and finance companies that promise higher rates of return. Much of that money is then lent to private businesses and local governments, which cannot get conventional bank loans because regulated banks are required to give preferences to state-owned companies.

If there is a credit crunch, it would be very different from the Lehman contagion we experienced 5 years ago, and so we probably won’t see any Western style back crashes because the financial system is still an arm of the Chinese government. So, it will likely end in an entirely different way, and we’re not sure what that is.

Next week, the Federal Reserve FOMC meeting will take center stage. It will be Ben Bernanke’s final FOMC meeting. And although we see signs of an improving economy, (or as the Fed said: “cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions.")  We have also seen a wobbly start to the trading year on Wall Street; and this came on the heels of the December FOMC meeting in which the Fed announced the first stage of tapering, curtailing asset purchases by $10 billion per month to just $75 billion per month. There is consensus that the Fed will take the next step in tapering next week; announcing an additional $10 billion a month in asset purchases.

The thinking has been that if things get bad, the Fed will simply ride to the rescue by postponing the taper and resuming or increasing asset purchases. We have to start by looking at what it means by “bad”. Economically speaking, it would be bad if unemployment were to spike; another credit collapse such as we saw in 2008 would be  bad; an economic  meltdown of any sort, domestic or international (think China, at least for today) – that would be bad. How about a 10% correction on Wall Street?

Stock market corrections are common, and we are overdue for some sort of correction, just based on past performance. The Fed’s taper announcement may very well serve as a catalyst or just an excuse for a correction. So, will the Fed jump in to clean up?

Not likely. The Fed has set a new course, and they will most likely have to stay the course, at least for the foreseeable future. There has been a concerted effort to emphasize forward guidance as the primary policy tool. Backtracking now would undermine the Fed's credibility. The Fed might like to talk about the importance of its independence and any reversal of taper would be seen as political. And any backtracking would be a serious blow to the Fed’s economic forecasting abilities and the Fed’s credibility.

And then there is the idea that the Fed’s balance sheet has grown too large, too fast. Increasing asset purchases would be seen as increasing the risks of future imbalances given the surge in stock prices that coincided with prior QE programs. In other words, there is the concern that QE could lead to bubbles, especially QE without an exit date would surely end badly. And a final reason, backtracking on taper and jumping back into the markets might not work this time. Each round of QE has resulted in slightly diminished returns. What if the Fed announced new stimulus and it failed to stimulate?

If the Fed is compelled to go back to the QE well, though, the cyclical sectors would be at heightened risk of underperforming as optimistic expectations get wrung out of stock prices. But this would only happen if things get bad (a subjective term) and we would likely see that coming.

The economic data have remained supportive of the Fed's tapering announcement in December. The December jobs report was weak, but it will be revised. Investor expectations are that the economy is stronger; not really strong but certainly not as weak as it was. So the Fed will likely continue with the taper, slowly and surely. And if the economy falters or something melts down, well they still have some other tools in the tool belt.

  

It’s still earnings reporting season and the big report today came after the close of trade as Microsoft posted net income of $6.5 billion, or 78 cents a share, compared with $6.3 billion, or 76 cents a share, in the year-ago quarter.  Revenue rose 14% to $24.5 billion, partly reflecting the release in November of a new Xbox videogame console and a fresh version of Microsoft’s Surface tablet computer ahead of the holidays. The results topped analysts’ guesses. No word on a replacement for CEO Steve Ballmer, who has announced his retirement.

Treasury prices rallied today. In part it was a safe haven move, with the weak data out of China; maybe some rebalancing or even an old fashioned short squeeze. Mortgage rates fell, decreasing borrowing costs for homebuyers. The average rate for a 30-year fixed mortgage was 4.39 percent this week, down from 4.41 percent and the lowest since November. The average 15-year rate slipped to 3.44 percent from 3.45 percent.

I mentioned earlier that we had a couple of reports on housing today. The Federal Housing Finance Agency reported home prices ticked up 0.1% in November, and were up 7.6% from the year-earlier period. The National Association of Realtors reports sales of previously owned homes rose in December for the first time in 5 months, and capping the best year since 2006.

Another report shows that the housing recovery has reached a level where it is increasingly unaffordable. You guessed it, California topped the list. The salary you have to earn to  be able to buy the median home in San Francisco is just over $125,000 as of November, and the median cost of a home in San Francisco is somewhere between $705,000 and $813,000, depending on what data source you look at; best guess is that home prices in San Francisco are up 24% over the past year. San Francisco tops the list of the most unaffordable cities. Next are San Diego and Los Angeles – the California trifecta – then New York City, where a mere $71,245 in income suffices to buy the median home. Households earning the median income of $51,000, well, forget it.

The reason San Francisco tops  the list is fairly simple, the tech bubble has attracted billions in fresh money, and one reason it has gravitated to San Francisco is past history and also tax incentives handed out to tech companies.

San Francisco may be extreme, but housing bubbles are now re-cropping up across the nation – and so are the very factors that helped inflate the prior housing bubble and then magnified the ferociousness of its implosion.

Helocs, or home equity loans, were up 30.8% in the first nine months of 2013 from prior year and are expected to reach $60 billion for the year, the highest level since 2009 when the market was in collapse mode. But it’s still a far cry from 2006, when such loans hit an all-time crazy record of $430 billion. Using the home as an ATM cranks up consumer spending. If the money is plowed back into the house, such as remodeling a bathroom, it adds some value to the house and lowers the risk of the loan. If it is used to buy gadgets, cars, or vacations, it still cranks up the economy in the US and other countries. But when home prices decline, homeowners and banks get slaughtered.

Also, the housing boom has seen the return of creative financing. Interest only home loans are back and they’re especially popular for jumbo loans. In a number of high-cost counties, including San Francisco, these are loans over $625,500 that banks can’t sell to Fannie Mae and Freddie Mac but have to keep on their balance sheets. Bank of America said that 36% of its fourth-quarter mortgages were jumbo loans, up from 23% in the first quarter. And adjustable rate mortgages, or ARMs made up 22% of all purchase loans in December, up from 11% in December 2012, the highest ratio since July 2008.

The result of higher prices has been slowing sales. In December sales volume was down 17.7% in San Francisco and 12.7% in the Bay Area from a year earlier. In California, volume dropped 12.1% to 34,949 sales, the worst December since 2007 – and 19.7% below the average for all Decembers since 1988.

In Palo Alto, at the center of the techie induced price hikes, home prices are now 40% above the prior bubble peak. But don’t call it a bubble, it’s a housing recovery, at least until it pops.