Wednesday, May 28, 2014 - Reflecting the Economy

Reflecting the Economy
by Sinclair Noe

DOW – 42 = 16,633
SPX – 2 = 1909
NAS – 11 = 4225
10 YR YLD - .08 = 2.43%
OIL – 1.03 = 103.08
GOLD = 4.70 = 1259.60
SILV - .01 = 19.13

The major stock market indices were lower, but it wasn’t a big move, and we’ve been 4 up days, so today’s pullback was nothing but a pause. What was interesting today was the move in the bond market. The yield on the 10 year treasury dropped all the way to 2.43%; that’s the lowest rate in almost a year. The 10 year treasury has dropped 22 basis points this month, meaning treasuries are on track for the best month since January. Now, remember that the Federal Reserve is supposed to be tapering, cutting back on large scale purchases of treasury bonds.  

What’s fueling the move? It’s hard to pinpoint one thing. Europe is facing some sort of monetary stimulus package from the ECB next week; meanwhile, a report showed German unemployment rose and that pushed yields on the 10 year bund to 1.28%; that trade then spilled over to the US markets, toss in end of month window dressing and there was likely a short squeeze. There are some big short positions on treasuries right now; more shorts than longs.

At the end of the day, the bond market is supposed to reflect the economy; not an exact image but rather a mirror image. And the US economy is probably not as strong as expected. Tomorrow, we’ll get a revised look at first quarter GDP. The initial estimate on GDP showed just 0.1% growth; a pathetic rate blamed on bad weather; the revision is expected to show the economy contracted by 0.6%, maybe worse. Since the recession ended in June 2009, US GDP growth has dipped into the red only once: the first quarter of 2011, when economic output contracted at a 1.3% rate. It appears likely to happen again. The economy was repeatedly disrupted by cold and snowy weather in the first quarter and much of the activity that did not take place then is occurring now during the warmer spring months. Wall Street expects second-quarter growth to snap back with a 3.8% gain.

But where will the springtime burst of growth come from? Exports? Not to Europe and not to emerging markets. The initial GDP report said net exports subtracted 0.83 percentage point from the GDP growth rate in the first quarter. It may be a bigger drag on growth in Thursday’s update. Construction? A bit, yes, but we continue to see the housing market looking soft. Construction lending is seeing a slow, steady recovery, but it remains 66% below its boom-era peak of $631 billion in outstanding loans in early 2008. Companies restocking their shelves? Not likely. Inventories subtracted 0.57 percentage point from GDP growth, according to the first estimate, and that could grow with this week’s revision; inventories remain high and consumer spending sluggish. Corporate profits? Yes sir that is an area of strength but it’s also a two-edged sword.

The Commerce Department is starting to release a new report on corporate profits. Pretax profits adjusted for depreciation and the value of inventories climbed 1.9% in the fourth quarter to a record $2.13 trillion on a annualized basis. Corporate profits as a percentage of GDP stood at 10.2% in the fourth quarter, just a touch below a record high. Corporate profits are now higher than they’ve ever been before.

Here’s the problem; whenever profit margins reach a high, they tend to peak and then rollover, with the stock market and the economy dragging behind in like manner. It’s tough to keep pumping out record profits, in part because profit margins often depend on cost cutting, not just revenue; there are limits to how much fat a company can trim and there are limits to how much a company can increase sales while simultaneously cutting back on R&D and capital expenditures. Right now, stocks are priced to reflect very high corporate profits. Any disappointment would shake that pricing structure and translate into big stock market losses.

Like any individual indicator, this is not an absolute. Corporate profit margins can remain at elevated levels anywhere from a single quarter to multiple years and don’t typically present an imminent warning threat to the stock market or economy until forming a major peak and sudden decline. Profit margins peak on average before the stock market by more than a year and before recessions by more than two years. It doesn’t work out this way all the time; in the early 70’s profits peaked with the market, and in the early 80’s profits peaked after the stock market, and it is possible that the lag time stretches out so far as to make the indicator more or less worthless.

The point is that there are other factors that must be considered. Think of profits as one measurement of the business cycle. So, despite the Fed taper, there is increasing likelihood that interest rates will remain low and possibly decline a bit; if rates decline, stocks are likely to move up with bonds, as we’ve seen can happen; and if falling long-term yields flatten the yield curve, that would increase the risk of a market crash. In a low-yield, low inflation environment, there is a good opportunity to grow profits and so those crashes tend to be preceded by periods of very strong returns. So the current bull market is likely to remain in place until inflation picks up or low-flation/deflation drags down profits.

Falling yields tend to be somewhat more bullish than bearish, but it’s a poor indicator for how the stock market will react. Falling yields are good especially when we are in a bull market, but they can be dangerous if they should drive down the yield curve spread to an unusually low level and then there is the lag effect I mentioned earlier. When the long end of the yield curve comes down that is good for stocks for a while; it can even result in parabolic increases in the short term, but it also indicates bad news for the broader economy, and eventually the bill comes due.

Yesterday we talked about the proposed new EPA regulations on coal fired power plants. Today we’ll talk about the backlash to those proposals; which, by the way, have not been officially proposed yet. It’s anticipated that the new EPA guidelines will try to reduce the percentage of US electricity generated by coal to 14% by 2030 from about 37% right now. Coal is the single biggest source of electricity generation in the US and has been for more than 60 years. The amount of electricity generated by natural gas would rise to 46% by 2030 from about 30% now under the EPA plan. That would make it the biggest generator of the nation’s electricity.

Meanwhile, opponents of the plan say it will increase the cost of electricity and cost jobs. The US Chamber of Commerce released a study showing it would cost the economy $50 billion a year and destroy a quarter million jobs. Sometimes they just pull numbers out of the air; these reports tend to overlook the externalities associated with a dirty fuel like coal, and also overlook the positive impact of cleaner fuels. Anyway, the mudslinging has started.

And a follow-up on the Detroit bankruptcy story. A task force has issued the most detailed study yet of blight in Detroit and recommended that the city spend at least $850 million to quickly tear down about 40,000 dilapidated buildings, demolish or restore tens of thousands more, and clear thousands of trash-packed lots. It also said that the hulking remains of factories that dot Detroit, crumbling reminders of the city’s manufacturing prowess, must be salvaged or demolished, which could cost as much as $1 billion more.

If carried out, the recommendations by the Detroit Blight Removal Task Force would drastically alter the face of the nation’s largest bankrupt city. They would also cost significantly more than the approximately $450 million that the city already plans to spend on blight, raising questions about the feasibility of the vast cleanup effort, which is part of its larger campaign to emerge from bankruptcy by fall and begin remaking itself.

The blight study, which is perhaps the most elaborate survey of decay conducted in any large America city, found that 30% of buildings, or 78,506 of them, scattered across the city’s 139 square miles, are dilapidated or heading that way. It found that 114,000 parcels — about 30% of the city’s total — are vacant. And it found that more than 90% of publicly held parcels are blighted. The report also made several recommendations for preventing blight in the future, including changes to property tax and foreclosure laws, and heavy fines for scrap metal theft.

The basic plan is to clean up the city, but nobody really knows how to go about the task. Do you clean up by tearing down or do you clean up by building or rebuilding? For years, some have contemplated consolidating some of the city’s neighborhoods to allow the city to provide services to a smaller area, more suited to its shrunken population; Detroit has gone from 1.8 million to about 800,000. And if they don’t get this right this time, it will likely revert to farmland.