Earnings, subprime, Bernanke whipsaw equities
By R. Mark Rogers, Senior Economist, Econoday
July 20, 2007
Last week saw the Dow set a new record close over 14,000 on Thursday, only to drop triple digits the next day. Earnings and subprime concerns ended up being the key factors pushing and pulling on stocks even though Fed Chairman Bernanke got his share of attention during his semiannual testimony before Congress. Interest rates dropped significantly from flight to quality moves while oil prices skyrocketed.
Crude spot oil prices continue to spiral upward. There was not much movement early in the week, but on Wednesday the spot price for West Texas intermediate jumped 91 cents per barrel to close at $75.05. The surge was due to an unexpected drop in stockpiles of crude oil and gasoline in the Energy Information Administration’s weekly petroleum report. What stood out was a jump in gasoline demand, pushing up gasoline prices and crude prices in turn. Refiners seem to be getting production back as capacity utilization was up for the week. Refiners are gearing up to meet the higher demand which is defying currently high gasoline prices. Crude jumped another 87 cents per barrel on Thursday over problems in Angolan oil fields and on data from China showing a jump in that country’s oil imports. Prices edged down on Friday with little news.
The spot price per barrel for West Texas Intermediate was up last week by $1.64 per barrel to close at $75.57 per barrel. Prices are near record highs set last summer.
Equities ended the week down significantly despite the Dow closing for a record high and over 14,000 on Thursday. The operative word last week was volatility as most indexes changed direction each day. Except for the Dow, most indexes started the week down as investors moved to the sidelines, waiting on inflation numbers, Bernanke’s congressional testimony and FOMC minutes. The Dow got a mild boost on Monday from news that British mobile phone group Vodafone might make a takeover bid for Dow component Verizon, which boosted that company’s shares. It was another record close for the Dow. Tuesday saw all major indexes post gains on a tame PPI report and strong earnings reports, notably from Coca-Cola and Johnson & Johnson. And the Dow crossed 14,000 in intraday trading but its record close fell short of that mark. Stocks headed down on Wednesday due to heavy subprime fears reignited by news from Bear Stearns that two of its hedge funds were essentially broke. Fed Chairman Bernanke, in congressional testimony, said mortgage defaults will get worse, comments that weighed further on equities. His focus on upside risks to inflation gave no indication of when rate cuts might happen and this lack of news on rate cuts was a negative for stocks. Earnings were the focus on Thursday as the Dow set a new record close, finishing over the 14,000 mark. Favorable earnings reports from IBM, Honeywell, and Bank of America gave the markets a good boost. The market seemed oblivious to Fed Chairman Bernanke’s concern over subprime losses and to the morning’s strong jobless report – a key concern of the Fed. Weak earnings from late Thursday and early Friday sent stocks tumbling on Friday. Google came out late Thursday with earnings below estimates. Dow component Caterpillar surprised investors with a sharp decline in net profits and Swedish cell phone maker Ericsson came in below expectations. Also, St. Louis Fed President William Poole stated that the subprime problem was large enough to notably weigh on the overall housing market. Poole’s comments added to negative market sentiment for the day.
Last week, all major indexes were down. Major indexes were down as follows: the Dow, down 0.4 percent; the S&P 500, down 1.2 percent; the Nasdaq, down 0.7 percent; and the Russell 2000, down 2.3 percent.
Year-to-date, the Dow is up 11.1 percent; the S&P 500, up 8.2 percent; the Nasdaq, up 11.3 percent; and the Russell 2000 is up 6.2 percent.
Interest rates were pushed down significantly last week and almost entirely due to flight to quality over subprime concerns. Treasury rates generally dropped 5 to 7 basis points Monday as a key subprime derivative index hit a record low. Yields actually edged back up on Tuesday as subprime fears eased slightly and Merrill Lynch came out with a strong earnings report. Rates also got a boost from a strong industrial production report. All said, Tuesday’s nudge up in rates was mild relative to the economic news. Rates fell back on Wednesday on huge flight-to-quality demand on Bear Stearns' announcement that two of its hedge funds were basically worthless. Rates were little changed on Thursday as Bernanke’s testimony before the Senate had little news compared to Wednesday’s testimony before the House. One new item, however, was his comment that losses from subprime problems were believed to be between $50 billion and $100 billion. Friday’s significant dip in rates was largely due to flight to quality both from equities and from higher risk bonds. Flight was driven by subprime fears and by weak earnings reports. The 10-year Treasury fell below 5 percent.
The Treasury yield curve was down last week except for the near end. Yields were down as follows: 2-year T-note, down 16 basis points; 3-year, down 16 basis points; 5-year, down 17 basis points; the 10-year bond, down 15 basis points; and the 30-year bond, down 13 basis points. The 3-month T-bill was unchanged.
Flight to quality pushed Treasury note and bond rates down significantly last week.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
Last week’s economic data showed moderate inflation, continuing weakness in housing, and generally strong manufacturing.
Last week, Fed Chairman Ben Bernanke gave his semiannual testimony to Congress and the minutes for the June 27-28 FOMC meeting were released. The bottom line is that the Fed has budged very little in terms of keeping its anti-inflation stance. Still, the Fed sees economic growth picking up from a weak first quarter but remaining a little below trend until 2008 when growth should be at trend. Key concerns about inflation remain a tight labor market and high energy prices.
The markets were disappointed to hear Bernanke describe the recent improvement in core inflation as still suspect. "Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences.”
Bernanke sees a leveling in oil prices as critical for inflation to ease. “However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower, on net, over the remainder of this year and next year. . . If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters."
The tight labor market is still a key concern – what the Fed chief refers to as “resource utilization.” "Although inflation pressures seemed likely to moderate over time, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected."
Bernanke’s concern that the recent improvement in core inflation might not be sustained was repeated in the latest FOMC minutes: "While total inflation was expected to slow toward the pace of core inflation over time, a number of participants noted that recent elevated readings posed some risk of a deterioration in inflation expectations."
The bottom line is that the FOMC sees the improvement in core inflation as likely temporary, that the economy is still on the strong side, and that labor markets are still tight. Inflation remains the Fed’s primary concern.
Consumer price inflation in June came in at a moderate pace for both the overall index and for core. The overall consumer price index in June slowed to a 0.2 percent increase, following a 0.7 percent surge in May. Energy prices actually helped the overall CPI in June as most had expected. Energy prices dipped 0.5 percent, following a 5.4 percent boost in May. Food price inflation accelerated to 0.5 percent in June from 0.3 percent in May. The core CPI inflation rate firmed slightly with a 0.2 percent increase in June, following a 0.1 percent rise in May.
But how do the latest numbers fit in with the Fed’s concern that the recent improvement in core inflation may be temporary' First, let’s just look at the changes in the “trend.” Monthly numbers certainly are volatile but a 3-month-ago annualized figure smoothes some of the volatility. Even by this measure, June’s monthly 0.2 percent rise in the core has boosted this annualized rate back up to 2.3 percent from 1.6 percent in May. “On the margin” the core rate has been between 1.6 percent and 2.6 percent annualized over the last six months. Looking at the numbers coldly, it is no wonder that the Fed states that the improvement in the core CPI is not yet convincing.
Indeed, some of the components that have held the core rate down recently are volatile and cannot be relied upon to stay down. For June, it took a 0.6 percent decline in apparel prices to keep the overall core rate at 0.2 percent and a flat component for education & communication. The latter had jumped 0.6 percent the month before. While core inflation is not worsening, there is reason to believe that improvement to the Fed’s satisfaction is a while off.
Year-on-year, the overall CPI was unchanged at 2.7 percent in June. The core rate declined to up 2.2 percent on a year-on-year basis in June from up 2.3 percent in May.
Overall producer prices in June edged down while the core PPI strengthened. The overall PPI fell 0.2 percent in June, following a 0.9 percent jump in May. For the overall PPI, softness was in both energy and in food. Energy slipped 1.1 percent in June, following a 4.1 percent jump in May. Consumer food prices fell 0.8 percent in June, following a 0.2 percent decline in May. In contrast, the core rate firmed in June to a 0.3 percent increase, following a 0.2 percent rise in May. Within the core, both capital goods and consumer goods excluding food and energy posted a 0.3 percent gain for the month.
The year-on-year rate for the overall PPI declined to up 3.2 percent in June from up 3.9 percent in May. The year-on-year core rate stood at 1.8 percent in June, up from 1.6 percent in May.
Today’s report reflects the volatility of the energy component but possibly a mild firming of the core number. Markets will likely hold back on any significant reaction until after tomorrow’s CPI release and Fed Chairman Bernanke’s testimony before Congress.
Housing starts in June improved slightly but remain soft. Housing starts in June rebounded 2.3 percent, following a revised 3.4 percent decline in May. But June’s 1.467 million annual rate was mainly propped up by apartment construction. In June, single-family starts edged down 0.2 percent while multifamily starts jumped a monthly 12.5 percent.
Housing permits, however, fell 7.5 percent in June, following a 4.3 percent rise the month before. Housing permits were at a 1.406 million unit annual pace, compared to 1.520 in May. Single-family permits slid 4.1 percent while multifamily permits dropped 15.3 percent. On a year-on-year basis, overall permits were down 25.2 percent in June, down from down 20.8 percent in May. Housing permits are at the lowest level since the 1.402 million pace in June 1997.
Further pointing to weakness in housing last week was a drop in the homebuilder sentiment index which fell to its lowest level since January 1991. This coming week, we will get an update on housing sales and housing supply. Starts and permits are not going to strengthen until supply of unsold homes is back down.
Economic growth strengthened in the second quarter in no small part due to manufacturing. Overall industrial production posted a 0.5 percent gain in June, following a 0.1 percent dip in May. The manufacturing component was up a robust 0.6 percent, following no change in May. For June, utilities output rebounded 0.3 percent while mining output jumped 0.5 percent. Industries showing greatest strength in June were motor vehicles, primary metals, furniture, and nonmetallic mineral products. By market categories, consumer goods output advanced 0.7 percent in the latest month while business equipment was flat. Nonindustrial supplies rose 0.4 percent in June while materials output increased 0.6 percent in June.
While overall industrial production was robust in June according to the Federal Reserve Board’s measure, more recent manufacturing surveys were mixed. Notably the New York Fed’s survey for July came in strong while the Philly Fed’s survey softened. The Empire State manufacturing index held onto its big gain in June, at 26.5 in July vs. June's 25.8. In contrast, the Philadelphia Fed's business activity slipped back to 9.2 in July from 18.0 in June, indicating expanding conditions but at a slower rate than June. The Empire State report included a surge in new orders, indicating likely strength in August. The Philly Fed’s survey showed a slowing in orders.
On the inflation front, both surveys' prices paid indexes edged down but remain at somewhat elevated levels – primarily due to energy costs.
For prices received, the New York Fed index edged down while the Philly Fed index posted a gain. Both indexes remain in the moderate range.
As before, housing remains on a slow decline but now manufacturing may be picking up a little steam. Core inflation is moderate but the Fed remains concerned about the impact of higher energy costs and from a tight labor market. The Fed is likely to stay on hold for some time as a result. Nonetheless, the economy seems poised for continued moderate growth. Equities just need to price in moderate earnings growth with no decline in interest rates for some time.
Next week highlights housing sales – existing and new – and the initial estimate for second quarter GDP.
Existing home sales slipped another 0.3 percent in May to a 5.99 million annual rate to the lowest since June 2003 -- offering perhaps the clearest evidence of all of the housing slowdown. Sales are down 10.3 percent on a year-on-year basis. Most disconcerting is that supply, at 8.9 months and compared with 8.4 months in April, is at its highest since 1992. Supply overhang is weighing heavily on new construction as existing homes are a close substitute for new homes. Don’t get your hopes up for June sales as recent data on mortgage applications have dipped also.
Existing home sales Consensus Forecast for June 07: 5.87 million-unit rate
Range: 5.45 to 6.09 million-unit rate
The Beige Book being prepared for the August 7 FOMC meeting is scheduled to be released Wednesday afternoon.
Initial jobless claims fell 8,000 in the week ending July 14 to 301,000, pushing down the four-week average by 6,250 to 312,000. Initial claims have fallen in three of the last four weeks. Clearly, the labor market is tight and may be getting tighter. This is a major concern for the Fed. The claims data are pointing toward a stronger payroll gain in July and perhaps a tick down in the unemployment rate. Markets should be giving the claims numbers more attention as the Fed likely is doing.
Jobless Claims Consensus Forecast for 7/21/07: 312,000
Range: 305,000 to 315,000
Durable goods orders fell 2.8 percent in May but followed three consecutive increases, including a robust 5.1 percent surge in March. Excluding transportation, durables orders declines 0.4 percent in May, following a 2.3 percent jump in April. Recent manufacturing surveys have shown strong orders indexes – notably ISM and Empire State – suggesting that we may see the same in the Census data for durables orders.
New orders for durable goods Consensus Forecast for June 07: +2.0 percent
Range: +1.1 percent to +3.5 percent
New home sales reversed course in May with a 1.6 percent dip in sales, following a 12.5 percent the previous month. May’s sales pace of 915,000 units annualized is 15.8 percent on a year-on-year basis. New home sales are more volatile than existing home sales. As with existing homes, supply remains a problem. New homes supply on the market rose 7.1 months from 7.0 months in April -- not a favorable sign. Expect higher mortgage rates and tightened lending standards to keep sales soft in June.
New home sales Consensus Forecast for June 07: .890 million-unit rate
Range: .875 million to .925 million-unit rate
For the final revision, first quarter real GDP was revised up incrementally to an annualized 0.7 percent from the previous estimate of 0.6 percent. New GDP data will give us a broader picture for the first time for the second quarter. Most economists expect a notable improvement from the flat first quarter due to improvement in exports and inventory investment while consumer expenditures and business fixed investment continue healthy gains. We will also get to see annual revisions going back through 2004.
Real GDP Consensus Forecast for advance Q2 07: +3.2 percent annual rate
Range: +2.9 to +3.9 percent annual rate
GDP price index Consensus Forecast for advance Q2 07: +3.4 percent annual rate
Range: +2.0 to +4.0 percent annual rate
The Reuter’s/University of Michigan’s Consumer sentiment index firmed to 92.4 in the early July reading from 85.3 in June. Consumers have been getting mixed reports on factors more directly affecting sentiment. The jobs market remains tight and stocks have oscillated upward. High gasoline prices, however, remain a sticking point.
Consumer sentiment Consensus Forecast for final July 07: 91.0
Range: 89.0 to 94.0
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