Although the markets will be mainly focused on this week’s FOMC meeting (and the crazies intent on using violence and force of arms to achieve their aims), Tuesday’s economic data is much-watched by fixed income market participants.
Pocket Full of Kryptonite (Superfluous Worker and Capacity Blues)
The Empire Manufacturing Index (the New York Fed’s index of manufacturing activity in the New York, southern Connecticut and Northern New Jersey region) came in at 19.28, up somewhat from a prior revised 19.01 and significantly higher than the Street consensus of 15.00. Readings over 0 indicate improving conditions.
Most of the index’s components were indeed solid:
• General business conditions were 19.01 in the prior month, according to the New York Fed
• Prices paid fell to 17.2 vs 19.78 last month
• New orders rose to 18.36 vs 10.44 last month
• Work hours rose to 9.68 vs 2.2 last month
• Inventory rose to 9.68 vs 2.2 last month
However, two components gave us cause for concern:
• Number of employees fell to 10.75 vs 20.88 last month
• Six-month general business conditions fell to 39.84 vs 43.96 last month
Of these it is the drop in the “number of employees” component which most concerns us as it indicates that businesses can increase production without adding a commensurate number of workers.
TIC Flows (foreign purchases of U.S. securities) data indicate that Net Purchases of Long-Term U.S. securities fell in April, coming in at -$24.2B versus a prior revised +$4.1B (up from +4.0B). Total TIC Flows came in at +136.8B versus a prior revised -$122.3B (up from -$126.1B). The biggest decline came in the area of Treasury Bills. According to the Treasury Department’s press release:
“Foreign residents decreased their holdings of U.S. Treasury bills by $41.6 billion.”
The decline in T-Bill holdings was mainly due to China letting Bills mature and not reinvesting the proceeds in the U.S.
May Industrial Production increased 0.6% from a prior revised -0.3% (up from -0.6%) and higher than the Street consensus of 0.5%. Capacity Utilization came in at 79.1% versus a prior revised 78.9% (up from 78.6%) and higher than the Street consensus of 78.9%. Manufacturing Production rose 0.6% versus a prior revised -0.01% (up from -0.4%) and was in line with the Street consensus estimate. Auto manufacturing led the way in May, rising 1.5%. Capacity Utilization improved, but was below its longer-term averages. However, this is somewhat misleading:
Historical Capacity Utilization (source: Bloomberg):
As you can see, the overarching trend for the past 40+ years has been toward lower capacity utilization. We have been of the opinion that, because of greater efficiencies (Technology, etc.), some of the “excess” capacity is probably superfluous. As such, the economy is probably closer to normal than one might believe. If we are correct, this would mean that wage growth and long-term interest rates are probably closer to normal than one might believe. We are in the camp that believe “normal” interest rates should be lower than in the past. We see little pressure for higher wages, inflation or interest rates. In fact, a flat world for production costs (and labor) could have the effect of narrowing the spread between interest rates and inflation. Whereas a neutral Real Fed Funds Rate was around 2.00% in the past (Ex: CPI is 2.00% and the Fed Funds Rate is 4.00%), a Real Fed Funds Rate of 0.00% to 1.00% (2.00% to 3.00% nominal), might be the new neutral.
The NAHB Housing Market Index surged to 49 from a prior 45 and above the Street consensus of 47. Readings over 50 indicate more builders view conditions as positive versus builders who view conditions as negative. This is the biggest gain since the spring of 2014. The last time the index was positive was January 2014 (56). The data indicate that builder sentiment is recovering after a harsh winter.
This is Municipal Monday. We will start of by discussing everyone’s favorite large city, Detroit Michigan. Bloomberg News is reporting that Detroit has reached an agreement with creditors that hold Limited Tax General Obligation (LTGO) bonds. According to a statement filed in court by mediators, details are being put into written form. Mediators did not comment as to what (how much) bondholder recovery might be. Bond insurers are eagerly awaiting details as it could determine how much they would have to pay holders of insured Detroit LTGO debt. In a statement, mediators said:
“The settlement recognizes the unique status and niche of the LTGOs in the municipal finance market.”
We hesitate to comment on what recovery might be. In the past, Detroit’s emergency manager, Kevyn Orr, has commented that LTGO holders might receive very low rates of recover. However, mediators have apparently taken into account the potential for negative consequences for GO debt throughout the municipal space. We caution investors against becoming too optimistic regarding LTGO recovery. A “better” deal still could result in investors taking significant
As for the far reaching effects from Detroit; we believe that Detroit is a unique situation and is not representative of the LTGO or GO sector as a whole. We would caution readers against selling LTGO and GO debt of other municipalities in a knee-jerk fashion without know the credit story of their particular bonds. We are willing and able to provide assistance in this area.
Municipal bond credit spreads have tightened in recent months and continue to do so as retail investors return to the asset class. This is changing the value dynamic in municipal bonds. First, whereas investors in low tax brackets could find attractive values in municipal debt last year, the municipal bond space is fast returning to a place for high-tax-bracket investors.
Secondly, tighter credit spreads mean that there is less room left for credit spread compression when and if long-term rates rise. We believe that municipal bonds are now most appropriate for income-oriented investors in high tax brackets. The price appreciation/spread narrowing story appears to be drawing to a close. We still find value out in the 8 to 15 year area, but investors need to be able to buy and hold. Investors who are sensitive to interest rates should probably stay inside the 10-year area of the curve. (3)
The Second Cut is the Deepest
The IMF lowered its 2014 estimate for U.S. GDP to 2.0% from a prior estimate of 2.7%. The IMF blamed a harsh winter and a slowing housing industry for its downward revision. IMF managing director, Christine Lagarde, stated:
“Extreme weather occurrences have a serious effect on the economy.”
The IMF forecast for U.S. GDP in the second-half of 2014 is to run at 3.0%. The IMF expressed concern that U.S. wages could remain stagnant and long-term unemployment high. The IMF also focused on the difficulty the Fed might have in unwinding accommodation as Fed policies have greatly influenced borrowing, spending and investing. The IMF suggested that the Fed should consider expanding the number of post-meeting press conferences to six from four in order to improve communication and transparency.
The IMF projects that the United States won’t reach a level of employment that would meaningfully lift wages until 2017 and that inflation pressures will stay muted until then. It believes the Fed might consider keeping rates near historic lows longer than some market analysts expect. The IMF is the latest entity to lower growth and interest rate forecasts. Last week, the IBRD also lowered its Global and U.S. growth estimates for 2014.
As long as the Fed remains accommodative, risk asset valuations should be supported. However, when the Fed begins to truly tighten policy, risk assets could experience significant volatility. We believe that now is probably a good time to take profits in the riskiest assets.
Keep an eye on any Fed comments discussing geo-political events. Rather than the popular belief among hawkish pundits, rising oil prices due to geo-political events would more likely to slow the pace of tightening rather than speed it up. Although higher energy prices add to headline inflation pressures, saddling already constrained households with higher borrowing costs on top of higher fuel and food prices (agriculture is the largest consumer of petroleum in the U.S.) could be detrimental to the U.S. growth story.
Dare to be Different
Our discussion of junk bonds and loans sparked questions among readers. Apparently, our view of junk debt (bonds and loans) differs from the salespeople making their rounds among branch offices. We will leave you with this:
If you wish to get an accurate answer as to the performance and quality of the new Chevrolet Corvette, should you read “Car and Driver” or ask the sales staff at your local Chevy dealer?
By Thomas Byrne – Director of Fixed Income – Investment ConsultantThomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets. Employment
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY