Managing Lower Momentum

by Jim Welsh with David Martin and Jim O’Donnell, Forward Markets

U.S. Economy

The slowdown in the U.S. economy continues to unfold as we expected, although the weather has accentuated the trend. For the third straight month retail sales fell, posting a 0.6% decline in February. Excluding the volatile categories of autos, gasoline, building materials and restaurants, sales were flat. Annual retail sales were up 1.7% from February 2014. Business sales were down for the sixth consecutive month, dropping 2.0% in January—the largest monthly decline since March 2009 when it appeared the world might be ending.

The Institute of Supply Management’s (ISM) overall purchasing managers index (PMI) dropped 0.7% to 51.8 in March and the new orders gauge is near a two-year low. Capacity utilization retreated for a third straight month to 78.9%. The weakness in the ISM’s New Export Orders Index and the lower rate of capacity utilization suggest business investment is not likely to improve much in coming months. Capital expenditures, which represent about 13% of GDP, will also be negatively affected by the decline in energy-related business investment.

The economy added 295,000 jobs in February, marking the twelfth straight month of adding over 200,000 jobs and the best streak since 1995. The official U3 unemployment rate fell to 5.5%, the lowest since May 2008, bolstered in part because more discouraged workers left the labor force. The participation rate remains at 62.8% where it has hovered for the past year, near the lowest level since 1978. The U6 unemployment rate, which includes part-time workers seeking full-time work and discouraged workers, dipped from 11.3% in January to 11.0% in February, narrowing the spread between the U3 and U6 rates to 5.5%.

As discussed in detail in last month’s Macro Strategy Review (MSR), since 1994 when the U3-U6 spread has been well above 3.85%, average hourly earnings growth has been weak. In looking at the U3-U6 spread since 2010, it’s easy to see why wage growth has been so slow in the past five years. This reality was confirmed in February as average hourly earnings only grew 2% from a year ago. The current U3-U6 spread suggests wage growth is unlikely to accelerate anytime soon.

According to the New York State Comptroller, Wall Street’s overall 2014 bonus pool was $28.5 billion, or an average of $172,860 for each of the 167,800 workers employed by Wall Street firms. This compensation was in addition to their annual salaries or wages. According to the Bureau of Labor Statistics, there are 1.03 million full-time workers paid an hourly wage of $7.25. If each of these workers work 40 hours per week for 52 weeks, their combined earnings would total only $15 billion. In other words, for these workers there was no bonus pool.

GDP growth is likely to remain under 3% as dollar strength curbs export growth, low energy prices and excess capacity keep a lid on business investment, and weak income growth throttles consumer spending.

Federal Reserve

In the March 2015 MSR, we noted the following:

“There are more reasons to remain ‘patient’ even if they remove the word from the March FOMC [Federal Open Market Committee] meeting statement. The Fed’s own model suggests that a 10% appreciation in the trade-weighted value of the dollar shaves about 0.75% off the level of GDP over a two-year period. The trade-weighted dollar index has risen by 15% since last summer, which suggests a drag of more than 1.00% on GDP. Partly as a result of the rally in the dollar, the pace of GDP growth has moderated, core inflation is well below 2% and there is plenty of slack in the labor market. A stronger dollar in response to a rate increase would only strengthen the headwind already evident in the fall off in exports, decline in import prices and increase in the trade deficit.”

On March 16 we penned a note for advisors that addressed the challenge the Fed faced with so much attention on the word “patient”, which included the following statement:

“The Fed has labored over the past 15 years to make [its] communications more transparent in order to reduce market volatility when there is a change in monetary policy. In some respects the efforts [of Fed members] have made them prisoners of their own communication. They shifted from using the phrase “a considerable time” to “patient” to ease investors’ concerns. The consensus has concluded that the Fed will raise rates two meetings after the word patient is removed. If the Fed does remove patient, [it] will use many other words to soften the impact and attempt to create some flexibility.” On March 18, the Fed did remove the word patient from the FOMC statement, but as Fed Chair Janet Yellen emphasized, “Just because we removed the word patient from the statement doesn’t mean we are going to be impatient.”1 To back up her words, the Fed lowered its targets for both GDP and inflation for 2015 and 2016. Back in December 2014, the Fed estimated that GDP growth would be between 2.6% and 3.0%. The new forecast is for growth to slow to between 2.3% and 2.7%. The Fed’s new forecast is now in line with our view that growth is likely to slow in 2015—contrary to the expectations of most economists.

Wages comprise 65% of the cost of goods sold, so if the Fed is going to achieve its goal of increasing inflation to 2%, wage growth will have to materially accelerate from the 2% range of the past five years. We think wage growth will be the primary factor in guiding the Fed’s decision on when to increase rates. Our guess is that the Fed will need to see an increase in average hourly earnings above 2.5% and be confident that wage growth will continue to trend higher.

Our analysis of the U3-U6 spread suggests the Fed is likely to remain patient beyond June even if the Fed doesn’t say so. In the aftermath of the 2007-2008 financial crisis governments around the globe ran huge Keynesian deficits that succeeded in stabilizing growth but did not return economies to precrisis growth rates. After six years of crisis-level interest rates just above 0% and three quantitative easing (QE) programs, the Federal Reserve is first in line to lift interest rates. As investors confront the consequences of the end of the Fed’s zero interest rate policy (ZIRP) at some point in 2015, there is a real risk that the bond market may not be as patient as the Fed would like and overreact with another tantrum. ZIRP has potentially pushed too many conservative investors to reach for income and assume more risk than they otherwise would. In 2007, a conservative retiree could earn more than 5% per year on a 5-year certificate of deposit (CD) compared to less than 1% now. The dearth of income from retirement savings has led many retirees to take part-time jobs to replace the loss of income they had planned on from conservative investments.

In 2014, corporations were able to sell more than $1.5 trillion worth of bonds, including $344 billion of junk bonds, as investors snatched up anything with a decent yield. However, the corporate bond market may be vulnerable since its level of liquidity isn’t what it used to be. There are far more corporate bond assets in exchangetraded funds (ETFs) now than in 2004, and ETFs make selling off very easy. As mentioned earlier, the last time the Fed increased interest rates was in 2004 and it did so at 17 consecutive meetings. If institutional investors and financial advisors become concerned that the Fed is planning to consistently increase rates through 2016, they may lower their allocations to ETFs and mutual funds that hold corporate bonds. As ETF providers and mutual funds liquidate corporate bond holdings into a thin market, their selling could lead to a quick plunge in corporate bond prices and further increase selling pressure. A decline in corporate bond prices could leave conservative investors with capital losses that far exceed their annual income stream.

Utility stocks recently provided a glimpse into the risk that could be awaiting corporate bond investors in coming months (see the following section on oil prices). Utility stocks have been a favorite of income-seeking investors as they offer a yield well above that of money market funds, are generally considered less volatile than the stock market and had been performing well. In December 2013, the Dow Jones Utility Average (DJUA) offered yields in excess of 3.00%, which caught investors’ attention. Between December 18, 2013, and January 28, 2015, the DJUA rose 37.80% compared to a gain of 10.57% for the S&P 500 Index. At its high of 657.17 on January 28, the DJUA’s yield was 2.17%, comfortably above the 0.80% annual yield for 5-year CDs and much better than the puny return provided by money market funds. From its high, however, the DJUA, in less than six weeks, fell -13.74% to 566.90 on March 11. It may take years of dividends for those unlucky investors to recoup their loss of principal.

Technical analysis can provide insights that fundamental analysis often overlooks since fundamental analysts are far more focused on the economy, monetary policy and corporate earnings. Although most of the content in each month’s MSR discusses fundamentals, behind the scenes we do incorporate technical analysis into our work, and the combination has been very helpful. The recent reversal and decline in the DJUA is a good example. In the week ending January 30, 2015, the DJUA experienced a weekly negative key reversal when it made a higher high, reached a lower low and closed lower than the prior week. Weekly key reversals are of particular value when they occur after an index has experienced a large rally or decline. The DJUA’s historical performance suggested a fall to at least the prior range of support between 585 and 605 was likely. During the week of February 20, the DJUA indeed dropped within the support range as expected to 588.63, bounced to 611.40 and then fell to 566.90. That bounce above the support range provided an opportunity to sell into strength before it fell again. Technical analysis can provide a level of risk management that is difficult to achieve with fundamental analysis alone.

Oil Prices

In the January 2015 MSR we included a section titled “The Disparate Impact of Lower Oil Prices.” We discussed our belief that the price of oil would fall until a new equilibrium between supply and demand could be established, which might take longer than expected since countries and companies dependent on oil revenue were likely to increase production to replace some of the lost revenue due to the recent decline in the price of oil. Until producers could agree to cut production, we thought oil was likely to remain under $60 a barrel and, in the short run, potentially fall to under $40 a barrel. Despite a sharp decline in the number of drilling rigs in the U.S. in recent months, U.S. production has continued to increase. According to federal data, as of March 6, total U.S. production hit a high of 9.4 million barrels a day, as producers have focused on their best fields to pump more oil. U.S. crude oil supplies are at their highest level in more than 80 years, according to the Energy Information Administration (EIA). The EIA estimates that 80% of excess oil production storage space in the U.S. is already filled, the remaining storage space likely to be filled by July. Commercial crude storage facilities in Europe may be more than 90% full while facilities in South Korea, South Africa and Japan are at more than 80% of capacity, according to Citigroup, Inc. Among industrialized nations, commercial oil and petroleum product stockpiles could hit an all-time high of 2.83 billion barrels by midyear, according to the International Energy Agency.