Friday's employment report, showing an increase of 18,000 in non-farm payrolls and a jump in the unemployment rate to 9.2% was widely viewed as a "shocker." Frankly, I don't understand the surprise. Between February and April, weekly new claims for unemployment (4 week average) dipped below 400,000, which was associated with a few months of nice growth in non-farm payroll employment. Since then, weekly unemployment claims have moved higher, and have been running at an average near 425,000 new claims weekly. Historically, that's a level that's fairly well correlated to roughly zero growth in non-farm payrolls. The data is certainly very choppy from month-to-month, which is enough to produce surprises around that average, but the errors also tend to mean-revert, meaning that unexpected job growth figures one month tend to be corrected in the opposite direction (where the "expectation" is taken on the basis of the weekly claims figures).
So the payroll figures were bad, but from our standpoint, they were predictably bad. The notion that this is some sort of a misprint or seasonal adjustment problem is just not supported by the data. That said, the expected monthly non-farm payroll numbers are very sensitive to the weekly unemployment claims figures. If we can get the weekly unemployment claims figures down toward 375,000 on a 4-week average, it will be reasonable to expect monthly payroll job growth on the order of 200,000. That level is our "mean-reversion benchmark" assuming that we gradually close the gap between actual and potential GDP over a 4-year period. Clearly, recent economic performance is well below "benchmark" levels.
Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) was also well ahead of this apparent "surprise," noting last month that "You're not going to see the quarter of a million jobs on average anytime soon." Unlike the emergent weakness we saw in 2010, the recent weakening in leading measures of economic growth have been more in line with what he calls the "Three P's." Achuthan argues that the oncoming global economic slowdown is likely to be pronounced, persistent, and pervasive - "not a one or two month affair" - though the data is not sufficiently discouraging to warn of an outright recession at this point (and we would agree). ECRI suggests that "the broad economy is going to slow alongside the industrial sector... it's all going to be synchronized."
To some extent, the disappointment on the payroll figure was the result of high expectations last week that followed an uptick in the ISM Purchasing Managers Index, which got an enthusiastic response from investors. What was odd about that enthusiasm, from our standpoint, was that the individual components of the ISM report suggested little of the good news that investors took from it. By far, the strongest components of the report were growth in inventories among the respondents, and growth in their customers' inventories. Order backlogs actually fell significantly, and new orders were stagnant. So the picture from the ISM was one of inventory buildup and sluggish new orders, coupled with rear-view growth that has brought down previous order backlogs.
The overall effect of the incoming economic data is to suggest that while upcoming earnings reports may be reasonably good from a rear-view perspective of the second quarter, earnings guidance for the second-half of 2011 could tend to be either weak or non-existent.
Unlike 2010, there appears to be little latitude for a robust fiscal or monetary response to the weakening in leading economic measures. Not that we would view any of those responses - aside from facilitating debt restructuring - as promising in any event. Before contemplating a round of QE3, the hawks on the Fed are likely to ask what benefit QE2 provided to the real economy, aside from Fed sponsored speculation, market distortions, and commodity price inflation.
Moreover, as of Wednesday July 7, the Fed's consolidated balance sheet shows .87 trillion in assets, versus .7 billion in capital, for a leverage ratio that is now up to 55.6-to-1. This isn't getting any better, and is far beyond where Bear Stearns, Lehman, Fannie Mae or Freddie Mac were at just prior to their respective insolvencies. Of course, nobody is going to shut down the Fed just because it is approaching technical insolvency, but we ought to recognize that anytime interest rates rise, the interest being paid on Treasury debt is quietly being used to cover the Fed's capital losses.
The accounts for achieving this are on the liability side of the Fed's balance sheet. As of Wednesday, there was .3 billion in the Treasury general account (which is the account where the Fed books interest earnings on its Treasury portfolio, which is normally repaid to the Treasury for public use). Per recent accounting changes at the Fed, losses on its portfolio of Treasury securities are treated as a negative entry in that account, essentially covering the losses with funds that would normally go back to the Treasury. The "Treasury supplementary financing account" has another billion in liabilities to the Treasury. This is the account set up at the Fed's request where the Treasury issues a "special" series of Treasury bills outside of its normal funding requirements, and deposits those funds with the Fed. Given that the Fed cannot afford the embarrassment of a transparent balance sheet, the liability items to the Treasury presently amount to a .3 billion cushion that can be used to cover portfolio losses for the Fed. The concern here is not so much the risk of Fed insolvency per se, but the fact that the public is quietly being used as a backstop for what we continue to view as reckless Fed policy.
From a fiscal standpoint, there is little political latitude for further attempts at "stimulus," aside from a possible expansion of the payroll tax holiday. From a broad fiscal perspective, we have just passed the edge of the well-anticipated "cliff" where the bulk of prior Federal stimulus now rolls off. Analysts who regularly criticize Meredith Whitney for her concerns over state and municipal balance sheets don't seem to take account of the fact that nobody expected (or should have expected) much strain until we passed June 2011.
Globally, even with the approval of further austerity measures in Greece, yield spreads on government debt there continue to price in a 100% probability of Greek default (assuming 60% recovery) within about two years. The only material change with respect to peripheral European debt is that last week, yield spreads in Portugal and Ireland also shot to levels that imply 100% probability of default (again assuming 60% recovery), but within about four years rather than two.
Frankly, the recent low-volume short-sqeeze, still-tenuous market internals, and complacent level of the CBOE volatility index (VIX) are all a little bit unnerving. Like Wile E. Coyote holding an anvil just past the edge of a cliff, here we are, looking down below as if there is much question about what happens next. Yet even here, we continue to look for appropriate opportunities to accept market exposure - even on a modest and transitory basis, and even if it requires a line of put option defense underneath. If only the data would support even that.
What matters most to us is not one single factor such as Greece, or state/municipal balance sheets, or even the slowing in leading economic measures, but rather the overall profile of expected return and risk that emerges from a very broad ensemble of conditions that we can extensively test in historical data. Valuations remain rich in our view, with our projection for 10-year total returns for the S&P 500 presently at just 3.6% annually. Bullishness has backed off modestly, but advisory bearishness remains below 30% (which when combined with a Shiller P/E above 18, has historically been enough to drive near-term S&P 500 returns below Treasury bill yields, on average). Market action is mixed, with conditions overbought on short- intermediate- and long-term horizons, and relatively neutral internals looking across breadth, industry groups, and asset classes. Still, those factors can change over a fairly short horizon, so they don't constitute "long-term" considerations.
We've had very narrow windows of opportunity to accept market exposure in recent months, because declines sufficient to relieve overbought conditions have typically been sufficient to damage market internals, while advances sufficient to ease that damage have also re-established overbought conditions and overbullish sentiment. There are certainly market conditions that don't create such a minefield of unfavorable constraints, but they are likely to emerge from much deeper weakness than we observed a few weeks ago. Still, we are trying to be responsive even to small, transitory windows to accept exposure to market fluctuations as they emerge. Given valuations and economic concerns, a line of defense against significant market losses, using index put options, will remain important in any event. Presently, we are defensive, but we would prefer more frequent, if modest opportunities to accept market exposure, and remain alert to conditions that would periodically allow a more constructive stance.
