May Manufacturing: Pause or Peak

Morris Segall      consumer spending, Economic Growth, economic recovery, economy, manufacturing, slowdown, stock market, trends

The ISM national manufacturing survey for May fell precipitously from April levels, confirming the trend seen in regional manufacturing surveys released over the past two weeks. For a number of reasons, the economy, including manufacturing, is slowing as we proceed into the second quarter. This looks very much like the pattern in economic activity we experienced last year as economic growth peaked last March-April and receded over the summer before reviving in the fall and winter. The reasons for the slowdown this year are primarily related to the surge in inflation since last summer, led by huge jumps in food and energy prices. This has been a restraining factor on consumer discretionary spending and has put pressure on corporate profit margins. It appears the rising level of prices is causing businesses to reduce spending to a greater extent than consumers as the experience of the recent recession has taught businesses to move quickly to cut spending to protect profitability.

Another factor hurting manufacturing currently is the dislocation of orders and shipments from and to Japan as a result of the earthquake and tsunami that has devastated that nation and created havoc with its industrial production and shipments.

In addition, the contraction in economic growth in Europe and ongoing sovereign debt issues are suppressing exports to the weaker economies in the Euro zone.

The unrest in the Middle East and North Africa has dislocated business orders and shipments from that region.

Lastly, the huge decline in shipments reported in the regional and national manufacturing surveys in May, reinforce our belief that a significant factor in May’s manufacturing weakness is due to the severe storms experienced in April and May in the Eastern U.S. and particularly the Midwest. In all of the manufacturing surveys production measures experience some of the biggest declines in the month of May.

It is noteworthy that the category of “No Change” increased significantly in many of the regional and national surveys in May. The increase in this category in May raised the absolute readings in this category to levels that far overshadowed the levels of weakening responses in the surveys. We interpret this that more of the weakness in these manufacturing diffusion indices is due to a “flattening” in the key metrics rather than massive deterioration. In addition, employment in virtually all of the manufacturing surveys remained positive. We acknowledge that employment is a lagging indicator and further weakening in orders, shipments and backlogs will result in weakening trends in employment going forward. Surprisingly, in many of the manufacturing surveys, including the national, respondents were generally positive regarding the future and expected key trends in orders and shipments to improve from May levels. If we are correct in our assessment of the impact of weather on the May surveys, we would concur. Finally, it should be noted that in the national survey, 14 of 18 industries reported growth in May with only 3 industries reporting contraction and those three industries were not major capital goods sectors.

It remains to be seen if the manufacturing growth trends rebound in June and beyond. If so, the capital investment cycle that has led the economic recovery will remain intact. If not, and the May surveys are signaling a weakening trend, then we will have to face the possibility this cycle may have peaked.

We are not optimistic that if such is the case, the federal government will resuscitate it with further stimulus as it did last year. The absence of further strong growth in manufacturing will lead to reduced overall economic growth this year and into next. Because of the flagging growth in manufacturing and net exports so far this quarter, we will be re-evaluating our economic growth projections for the second quarter and the rest of this year. We will evaluate the May employment report before we make our revisions.

The weakness in the May manufacturing report along with a forecast of weak employment growth by the independent payroll processing firm, ADP, caused a major sell-off in the U.S. equity markets on Wednesday that is being replicated by Asian markets Thursday morning and likely will spread to Europe. The world capital markets are nervous about the outlook for world economic growth and financial stability and have become very volatile. Those outlooks will dim further if the U.S. economic recovery stalls out. This is why we have emphasized private equity and the investment themes of merger and acquisition, infrastructure investment and business growth financing in our capital market strategy for the intermediate and longer term (See our website article of January 6, 2011 and our website Economic and Capital Market Presentation of February 2, 2011). Recent events overseas and the fragility of our own economic recovery plus our long term financial difficulties, reinforce this strategy.

Morris R. Segall

Osama Bin Laden is Killed and Risk Tolerance Rises For the Moment

Morris Segall      Al Queda, Capital Markets, consumer spending, debt ceiling deliberations, economic realities, Fed's QE 2 program, geopolitical changes, inflation, kudos to U.S. intelligence and military, obama, Osama Bin Laden, President's reelection, risk aversion, stock market

Last night’s news that U.S. military forces killed Osam Bin Laden is another unexpected geopolitical development in a year that is already seeing huge changes in the world’s political landscape. The news of Bin Laden’s death is causing an immediate reaction of relief and exultation which is seeing large gains in U.S. equity futures which will translate into large gains in U.S. stocks at today’s open. The very short term reaction in U.S. stocks will see a reversal in recent surges in safe haven investments led by gold and oil which are already trading down in Asian and futures markets. This reversal of risk avoidance will last in the very short term but economic and geopolitical realities will reassert themselves in fairly short order.

First, the U.S. markets will still have to deal with U.S. budget contentions that threaten to stall a rise in the U,S. debt ceiling that must be done to avoid a potential U.S. debt default. We continue to believe an eleventh hour agreement on raising the debt ceiling will occur but the cost in the form of higher taxes and decreased federal spending will be significant.

Second, the rise in inflation through the first quarter and extending into the current quarter threatens the growth of personal consumption and business profitability. Already more companies are announcing price increases necessary to pass along higher commodity, manufacturing and distribution costs. Unless, commodity prices collapse on an extended basis through the second half of this year, inflation will continue to be an economic headwind, not just for the U.S. but more importantly, for most economies overseas.

Third, the Fed’s QE 2 program will end at the end of June. What will the effect on the U.S. Treasury market be once the Fed stops absorbing the continuing large issuance of Treasury debt to finance this year’s large deficit.

Fourth, while the killing of Osama Bin Laden is a huge psychological victory over Al Queda, the reality is Al Queda has been operating independently of Osam Bin Laden for some time as witnessed by the vibrancy of the Al Queda operations in Yemen and Africa. The killing of Osama Bin Laden will not change that fact or the threats from local Al Queda chapters. In fact, these factions may intensify their threats in order to offset the psychological loss of Bin Laden.

So after a near term robust rally in U.S. and overseas equity markets, we expect euphoria to be tempered with economic realities. The impact of Bin Laden’s loss may have more mileage in the Arab world where people may feel a sense of relief and increased security that will empower them to further their fight for economic and political change in North Africa and the Middle East. In the dizzying pace of international events, it is difficult to forecast with clarity how political and economic developments will be shaped but major changes in both are underway and the status quo around the world is being altered.

Finally, we have been critical of President Obama in his handling of foreign policy including our recent website article on the Middle East. Despite critical diplomatic setbacks, we must congratulate the President and the counterintelligence agencies and the military for what appears to be first rate work in intelligence and military operations and decisive action on the part of the President to secure the prize. This will undoubtedly be a huge boost to the President’s reelection chances and deservedly so.

The Japanese Disaster and the Capital Markets

Morris Segall      Capital Markets, deflation, Economic Growth, Japanese reconstruction, nuclear meltdown, reflation, stock market, stock market correction, stock market volatility

What was already a cataclysmic catastrophe in last week’s earthquake and tsunami in Japan has become a calamity of potentially worldwide proportions. On the heels of the tsunami has been a series of hazardous nuclear system failures at the nuclear power complex at Fukushima Daiichi. These failures have been caused by the destruction of water cooling systems that are essential to maintaining the safety of nuclear power plants. The loss of this water cooling apparatus has resulted in dreaded nuclear fuel overheating and potential meltdowns that would release deadly radioactive gas into the atmosphere. What appeared to be a containable situation last Friday has become a seemingly out of control nuclear nightmare, rivaling the nuclear tragedies of Chernobyl and Three Mile Island. 

This ongoing nuclear misfortune has exacerbated the Japanese disaster into one of world consequences. World capital and commodity markets have declined substantially since the proportions of the nuclear threat increased.  The declines have been severe and precipitous as concerns that the impact of the Japanese national destruction would curtail world economic growth and cause another international financial crisis. After concerning ourselves with the rising tide of inflation in our March 7th website article, the Japanese crisis threatens to unleash deflationary forces, temporarily, from diminished demand from the world’s third largest economy. In addition, the spread of nuclear radiation to Asia and the Pacific Basin would impair economic activity in the important emerging industrialized countries in that region, further reducing worldwide growth.

In the long term, the rebuilding of the Japanese economy will stimulate demand for industrial commodities, raw materials and capital goods resulting in reflationary trends and accelerated worldwide economic growth. This should be reflected in rising capital and commodity markets after the near term corrections in these markets. However, the recent severe declines in equity prices threaten to derail the stock market recoveries began last September if they continue. As we publish this post, Asian markets are stabilizing from Tuesday’s sharp declines and we expect this will spread to European and U.S. markets on Wednesday.

If equity market recoveries are to continue, the Japanese nuclear threat must be removed so reconstruction can proceed. The disposition of Japan’s nuclear problems will determine the direction of capital and commodity markets in the short term. Those problems have become unpredictable and the uncertainty of that situation is causing public and investor consternation. At this time, we are maintaining our economic and capital market outlooks and allocations (See our website article of January 6th, “Great Expectations”),  but we are watching the Japanese situation closely to see if reevaluation is necessary. The recent public market declines and volatility from adverse overseas developments fortifies our capital market strategy emphasis on private equity investment in transaction and hard asset themes and cyclical recovery emphasis on the U.S.

Morris R. Segall, CFA, CIC

June Unemployment: More Bad News

Morris Segall      recovery cycle, stock market, unemployment

Friday’s unemployment report for the month of June was weaker than economists had expected and weaker than the surface numbers show. It also was the latest in a series of weaker and disappointing economic data reported last week. Last week saw a continuation in weak consumer spending  in May for the second month in a row despite healthy gains in consumer incomes over the April-May period. The consumer savings rate increased in May for the second month in a row to 4% reflecting consumer caution. Also, last week, the Conference Board reported consumer confidence in June fell dramatically from 62.7 to 52.9. Clearly the stock market declines in May and June are depressing consumer attitudes but respondents are also again expressing difficulty in getting jobs and are increasingly pessimistic about both current conditions and future expectations. We have repeatedly stated in our economic presentations, since the economy began recovering last year, that the absolute level of consumer confidence in this survey have been well below levels normally seen in postwar economic recoveries and indicated to us a muted consumer reaction to the economic recovery.  Rounding out last week’s economic reports were: a greater than expected decline in the ISM purchasing managers index reflecting a pause in the upward trend in orders and shipments seen since last year and a decline in hiring  by respondents; an increase in first time unemployment claims for the last week in June, taking first time claims to over 470,000 for the third time since May and well above the level of 350,000 seen in previous economic expansions; and finally, factory orders for May dropped for the second consecutive month after rising steadily since last spring. 

But the June employment report contained cause for concern despite the expected decline in census worker jobs and a reduction in the unemployment rate for the first time this year. The number of discouraged workers at 1.2 million is up by over 400,000 from last year. The number of people in the work force, as measured by the Household monthly data,  is down by over 1 million workers since June of 2009 and despite that drop in the labor force, the employment participation rate is down to 64.7% from 65.7% in June, 2009. A full year after the economy began recovering, the average workweek is only at 33.4 hours versus 33.0 hours in June, 2009. Over the last twelve months, average hourly earnings are up by only 1.7%, less than the 2% annual rate of inflation as measured by the CPI through May of this year. The private sector created only 83,000 jobs in June, below an expectation of approximately 100,000+. Of that 83,000, approximately 21,000 were in temporary help services and 37,000 were in leisure and hospitality. A number of leisure and hospitality jobs, 28,000, were in amusements, gaming and recreation that may be seasonal hires to cope with a very active vacation season. Other professional and business services added another approximately 25,000 jobs and healthcare added approximately 17,000 jobs. Most of the remaining sectors in goods producing, services and governments cut jobs in June. The June numbers follow a downwardly revised estimate of 33,000 private sector jobs created in May and establishes a pattern of weak private sector hiring for the two month period when empirical and other evidence should be creating the opposite result.

Tomorrow we plan to publish our updated economic and capital markets analysis and forecast on our website, www.spgtrend.com. It will extend the theses we have articulated in our blog articles since May. That is the expansion cycle in the U.S. equity market has reversed because of the international credit alarms caused by sovereign debt issues in Europe and these developments are having a negative impact on the U.S. economic recovery cycle. The economic data of last week, particularly the monthly job report, lead us to believe the U.S. economic recovery is  pausing while businesses and consumers assess the outlook for the remainder of this year and next.  We are afraid businesses in particular are already starting to plan “cutbacks” in anticipation of a weaker economy going forward.

Morris R. Segall, CFA, CIC

May Unemployment Disappoints; So does Europe

Morris Segall      capital markets strategies, Economic Growth, European sovereign debt, May unemployment, stock market

Friday’s unemployment report for May was just what the stock market didn’t need- a disappointing jobs creation picture. Total nonfarm payrolls grew by a little over 400,000 in the month of May, but virtually all of that increase was due to temporary hires for the U.S. Census. Most of those workers will be terminated by the end of the summer. Only 41,000 jobs were created in the private sector in May according to the business establishment survey, well below the 150,000+ jobs expected. We have been commenting in previous blog postings about the increasing inaccuracy of the monthly business establishment survey in reporting job creation. Most of our criticism has been focused on the erroneous seasonal adjustments and the errors in reporting job creation in the small business sector. Most of the monthly reporting errors result in overstating job creation that are then reversed when the Labor Dept. makes its semiannual revisions in the winter and summer of each year. However, this time we believe the May jobs report is actually understating job creation. Empirical data and other employment measures point to a larger job creation in May than the 41,000 reported on Friday. We believe the May number will be revised upward in subsequent monthly reports over the summer. But that is where the good news on jobs ends. First time unemployment claims are “stuck”  around 450,000, far too high to indicate strong  job creation. In addition, other measures in the May jobs report continue to point to high levels of discouraged and underemployed workers and most discomforting,  a continued high level, nearly 50%,  of workers unemployed are jobless for 27 weeks and longer. We estimate that we are building a “hard core” unemployment rate of over 6% as a result of the recession and the historically weak economic recovery.

Also on Friday was news from Hungary that their fiscal situation was becoming dire to the point of possible debt default. The announcement was a surprise since it was assumed the IMF bailout of Hungary last year was sufficient to avoid default. The prospect of another European country sliding toward debt default was sufficient to break the euro below critical levels of $1.20 on Friday and raise the threat levels again of more widespread financial crisis in Europe. The Hungarian announcement created new strains on the financial system in Europe with lending spreads and costs of credit default insurance rising again. The situation in Europe is becoming more alarming as default risks spread from Southern Europe to Central Europe and likely to Eastern Europe next. The austerity programs being enacted by the governments in Southern and Western Europe and the U.K. will exacerbate the problems in Central and Eastern Europe that depend on exports to the Eurozone for much of their GDP growth. The financial system is now on heightened alert again to see where this latest emergency in Europe will lead. The outlook for containing the European sovereign debt problems is becoming more bleak.

The combination of a weak employment report and the dire news from Hungary, reversed a stock market rally that began before Memorial Day and carried strongly through last Thursday. The market decline on Friday eroded market technicals and has cast doubt on the view that the market decline in May was a correction and not more serious. We have stated in our most recent blog entries that we believe the market action in May signals a “Sea Change” in the international capital markets cycle. The market action on Friday confirms that view for us. We now believe we are moving towards a short-intermediate term trading range on the Dow 30 Industrials of between 9,000-11,000. We reiterate our belief that the market highs recorded at the end of April-early May, are the highs for this market cycle. While the U.S. economic news has been improving since last summer, going forward, the economic news becomes more problematic as Federal stimulus recedes and the stock market itself becomes the main story in the economy. It is estimated a trillion dollars of market value was lost in the month of May and June is extending that. The market decline is replacing risk assumption with risk aversion and when investors see their portfolio values at the end of May, there is the fear consumer spending will retrench just when the economy needs more robust consumer spending. We believe it is possible the pace of the U.S. economic recovery could be retarded by the current stock market decline. We  continue to stress defensiveness in our capital market strategies and emphasize U.S. dollar denominated assets.

Morris R. Segall, CFA, CIC

Ben Bernanke, the Stock Market and the Economy

Morris Segall      Ben Bernanke, economy, employment report, GDP, government, stock market, trends, unemployment

After playing politics with Ben Bernanke’s nomination in the wake of last Tuesday’s election loss in Massachusetts, the Democrats with help from the stock market on Friday, thought better of their populist pandering on Monday and began to rally around the beleaguered Fed Chairman. Criticism began late Friday with the stock market selloff and built up over the weekend. In our blog article of December 8, 2009, “Ben Bernanke: Hero or Goat“, we warned of the market ramifications of politicizing the Fed and its Chairman’s reappointment process. Congress got the message over the weekend and will now probably vote to reappoint Ben Bernanke.

Friday’s stock market sell off culminated a week that saw the market decline over 500 points and erased the gains accrued in the first two weeks of the year. After rising virtually non stop since its lows in early March of last year, the stock market entered 2010 strectched and overdue for a correction. Last week’s market decline could be the beginning of such a correction. Despite good news on corporate earnings and sound fiscal action on the part of the Chinese government to curb speculation in their economy, stocks sold off reversing their pattern of seeing the “glass half full” on virtually all economic and corporate news. It remains to be seen if this new pattern of stock price decline will revert to the short lived selloffs of last year or develop into a long overdue correction. Such a correction would be good for the stock and commodity markets longer term. The latter have been particularly ebullient over the last year with outsized gains that are ripe for profit taking.

In a couple of days we will get our first look at the fourth quarter GDP. Consensus estimates are for growth of 4%-5%. In our blog article, “Third Quarter GDP Revised Down“, November 25, 2009, we stated “strong contributions in consumer spending and business fixed investment would be needed from downwardly revised third  quarter GDP levels”.  After watching numbers “see saw” in housing, unemployment and retail sales in the fourth quarter, we believe fourth quarter GDP will be within consensus estimates led by large gains in business fixed investment, notably machinery and equipment, and government spending with a solid contribution from personal consumption and a positive contribution from net exports. Since the third quarter of last year the manufacturing sector is the strongest part of the economy with factory orders and shipments maintaining their recovery from depressed recession levels. However, the strength in fourth quarter economic data is not expected to be sustained in the first quarter of this year. Post holiday retail and housing sales are expected to dip leaving economic growth to the government and industrial sectors. Economic growth is still dependent on government stimulus in the face of continued high levels of unemployment and the improvement in unemployment is still the key to sustained economic recovery. At this time we do not expect a “double dip” recession when government stimulus ends in the second half of this year but the visibility of economic growth is clouded by the stimulus programs which have distorted the normal trends of economic recovery and have resulted in a “sawtooth” pattern of economic data since the recession ended in the third quarter of last year. We expect that to continue until the private sector can sustain this recovery on its own.

Morris R. Segall, CFA, CIC