Volatility returned to the markets this week with the S&P 500 declining by about one percent as investors followed political events in Washington, D.C. Interest rates were lower with the 10-year U.S. Treasury declining in yield from 2.36 percent to 2.22 percent.
Today the Federal Reserve released the September change in nonfarm payrolls which came in at 142,000 jobs versus the estimate of 201,000 jobs. Also, August data was revised down from the originally reported 173,000 jobs to 136,000 jobs. This data was seen a disappointment and the bond market reacted negatively. According to Bloomberg data, the Federal Funds Futures Market, which is a market in which traders can speculate on the direction of the Federal Reserve raising interest rates, shows only a 2 percent probability of the Fed raising interest rates this month. The probability of the Fed to raise interest rates in December has dropped from a 40 percent probability early this month to a 29 percent probability as of today.
It is important to remember that the U.S. has created an average of 200,000 jobs for the last six months. Since the depth of the financial crisis, the unemployment rate has gone from over 10 percent to around 5 percent where it is today. We prefer to take the long view as opposed to changing opinion on every incremental piece of economic data. Payroll data is notoriously volatile and is a backward-looking indicator. U.S. consumer spending accounts for nearly 70 percent of our GDP or national income and continues to be robust despite a couple of months of job creation that does not meet expectations.
One of our research partners, Cornerstone Macro, published a note this morning with some facts about the U.S. consumer that are worth sharing:
- Consumer income growth has been a solid 4 percent for the past five years
- Real income expectations are rising for the first time in 20 years
- Consumer confidence is trending higher across all income levels
- Small businesses are having a hard time filling jobs
- Increasing construction spending is a major support to construction employment
- Increasing manufacturing construction is a support for manufacturing employment
- Average hourly earnings is in a rising trend for finance, business services, construction, health and education
- Auto sales came in at a seasonally adjusted annual rate of 18.2 million units, the most in more than 10 years
We still believe that the domestic economy and the U.S labor market are continuing to heal from the Great Recession. The headwinds from emerging market turbulence and a strong dollar are not large enough to derail this economic expansion.
Our Takeaways from the Week
- Job creation for September and the negative revisions for August did not meet economists’ expectations; however, the equity markets largely ignored the data finishing up modestly for the day
- The bond market reacted more with the 10-year Treasury bonds finishing the day below 2 percent
Don’t Look Back!
As investors question the underlying strength of the U.S. economy, stocks are consolidating gains and bonds are defying Wall Street expectations for yields to rise. Like drivers gawking at a car wreck as they drive past, market participants once again revisited the surprisingly poor economic start to a 2014 that most thought would bring faster economic growth instead of the worst quarterly performance since the depths of the Great Recession. Reasons for the 2.9 percent contraction in first quarter U.S. GDP have been widely discussed, but the cold, inclement weather and late Easter don’t negate the math of such a poor start to the year, and its impact on full year estimates that economists are now scrambling to reduce.
Back on Track
Relatively healthy payroll growth, rising retail sales, and healthy manufacturing indicators bely the wreckage of first quarter GDP, but this week’s surprisingly poor May personal consumption numbers prolong the debate about how strong the economy really is. Few indicators are as simple as they first seem and this number is no exception, being dampened by accounting for the Affordable Care Act that economists first thought would boost healthcare spending. As it turns out, this component of consumer spending actually fell in May, and with the Fed’s preferred inflation measure ratcheting up to 1.8 percent year-over-year, real consumption spending used to compute the GDP number actually dropped sequentially. So what’s an investor to believe? Notwithstanding the disappointing May number, we expect Q2 consumption spending to increase at a faster pace and look for better capital spending and housing investment to produce GDP growth somewhere in the 3-4 percent range. If achieved, this level of growth will be the best in a couple years and should go a ways toward allaying concerns about the pace of economic expansion. In this environment, we expect bond yields to rise.
Clear as Condensate?
The U.S. energy industry was jolted this week by surprise news that the Commerce Department has granted approval for two energy companies to begin exporting very light crude oil known as condensate. The U.S. energy renaissance has boosted domestic oil production by over 70 percent since the lows of 2008 and, owing to the nature of unconventional development, an increasing amount of the liftings are of the clear variety. The challenge for U.S. refiners has been to revamp their capital intensive facilities to accommodate this light production after years of gearing up for heavier Mexican and South American imports. The reaction on Wall Street was dramatic, as stocks of oil producers rallied and refining stocks tanked. If the first government approvals this week turn out to be a harbinger of additional exports to come, benchmark WTI oil prices should increase relative to the global benchmark Brent. Accordingly, the producers would realize higher prices at the expense of the refiners, which have benefited greatly from the discount at which they buy U.S. light crude. Only time will tell whether additional export approvals are granted, but the risk for refining investors is not only that their feedstock costs increase, but that investments made in recent years to process lighter grade crudes fail to pay off.
Our Takeaways from the Week
- Q2 comes to a close, with stocks hovering near all-time highs as investors assimilate disappointing headline economic news into full year estimates
- Energy stocks are in focus following initial government approval for light crude oil exports
Ascending to New Heights
Subsiding geopolitical tensions in Eastern Europe, tentative steps by Chinese policymakers to support slowing growth, and more deal-making domestically combined to send U.S. stock prices to new record highs this week. Investors expecting negative revisions to previously reported first quarter GDP numbers were undeterred by the latest numbers that proved surprisingly poor, buying shares of economically sensitive companies poised to benefit from a rebounding economy. The fact that benchmark U.S. equities are now up four percent for the year is less surprising to us than the observation that bonds have nearly kept pace. Until just recently, key fixed income indices were outperforming stocks, prompting no small amount of ink to be spilled by investment analysts attempting to explain why bonds have done so well at a time when economic growth domestically is accelerating.
Skating to Where the Puck Will Be
While somewhat shocking at first glance, the one percent first quarter GDP contraction reported by the U.S. Commerce Department earlier this week paints an unrealistically dour view of the US economy. By now, almost anyone who didn’t hibernate through the unusually cold and snowy winter knows what the inclement weather did to economic activity. We are encouraged by recent strength in reported payrolls, rising U.S. energy production and the health of key manufacturing indices that point to rising domestic investment. With retail activity picking up, we do not foresee inventory investment continuing to detract from GDP in the second quarter, and surprisingly low interest rates may very well end up providing a nice boost to the recently lackluster housing market. All told, we expect a strong rebound domestically, one that could produce upwards of four percent GDP growth in the second quarter.
We anticipated that a faster rate of economic growth, relatively low interest rates and high levels of cash on corporate balance sheets would stimulate merger and acquisition activity this year, and that is certainly what has transpired. Deal-making in the cable, telecom and drug industries that has dominated M&A headlines so far this year gave way to activity in the food aisle this week, as meat processors Tyson and Pilgrim’s Pride now find themselves in a bidding war for Jimmy Dean sausage and cold cut company Hillshire Brands. What started as an attempt by Hillshire to expand its grocery store presence by acquiring Pinnacle Foods (purveyor of Birds Eye frozen vegetables and Log Cabin syrup) has turned the hunter into prey. Pinnacle Foods, which soared 13 percent earlier this month on the Hillshire bid, has now given back almost all of its recent gains on the heels of Pilgrim’s Pride’s $45/share bid for Hillshire Farms. The presumption is that the poultry producer wouldn’t want Pinnacle in the fold, opting instead to vertically integrate with Brazil’s JBS, the 75 percent owner of Pilgrim’s Pride. Complicating matters, chicken and pork processing competitor Tyson entered the fray by offering a superior bid of $50/share for Hillshire.
How this game of chicken concludes is hard to tell, but what the frenzied deal making in the food business demonstrates is the industry’s slow growth and ultra-competitive dynamics. Key players are being incented to combine and eliminate duplicative cost structures, produce more favorable margins by vertically integrating from the meatpacking floor to the cold-cut aisle and dampen the cyclicality inherent in livestock production.
Our Takeaways from the Week
- Contraction in the US economy early this year should give way to stronger growth in the months to come
- M&A activity continues at a heightened pace as key players jockey for better industry positioning