Saturday, January 24, 2009

This Week in Review 1/23/09

Earnings drag stocks down

Earnings season is upon us again – and few are bringing good cheer. Financials in particular have resurfaced with greater vulnerability than expected. It turns out that improvement in the credit crisis has not been as much as previously believed. Meantime, inflation fears are making a comeback in the bond markets.

Stocks got no bounce from Obama taking office this past Tuesday. While there is considerable opinion that the new administration’s expected fiscal stimulus plan will speed up recovery, the latest earnings reports more than offset that optimism. Equities were pulled in particular by financials. Lowlights included huge losses at Royal Bank of Scotland. RBS warned that it may report a loss of $41.3 billion.

Also, equities were spooked by news that State Street needs to raise large amounts of capital. This raised fears that major banks are likely strapped for capital as well. Bank of America’s firing of CEO John Thain (formerly CEO of Merrill Lynch) left markets wondering about whether or not bank management in general is successfully dealing with the current financial crisis. For financials overall, sentiment definitely turned more negative.

Key tech companies were mixed. Apple dramatically topped expectations with its sales of Macs. In contrast, Microsoft continued to disappoint.

Broader based companies posted earnings that led equities to believe that more bad news is to come from more cyclically sensitive companies. GE had disappointing earnings.
Finally, a record low for housing starts in December was announced this past week, adding to negative sentiment in equity markets.
Equities were down this past week. The Dow was down 2.5 percent; the S&P 500, down 2.1 percent; the Nasdaq, down 3.4 percent; and the Russell 2000, down 4.7 percent.

For the year-to-date, major indexes are down as follows:
Dow down 8.0 %;
S&P 500 down 7.9 %;
Nasdaq down 6.3 %;
Russell 2000 down 11.0 %.

Current monetary policy and expected fiscal policy played key roles in the bond markets this past week. The Fed is keeping short-term rates extremely low with the fed funds target range of zero to 0.25 percent. Treasury bill yields remained not far from zero in sympathy with the fed funds rate. In contrast, with Barack Obama taking office this past Tuesday, credit markets have become more nervous about how much debt the U.S. government and governments world wide will be issuing to combat recession. Hence, the long-bond rose sharply this bond week with rising inflation fears also contributing to the boost in long-term yields.

For this past week Treasury rates were mostly up as follows: 3-month T-bill, down 1 basis point, the 2-year note, up 8 basis points; the 5-year note, up 15 basis points; the 10-year bond, up 28 basis points; and the 30-year bond, up 44 basis points.

Yields on long-term Treasuries jumped this past week. Key factors were a resurgence in inflation expectations and a fear of increased supply to fund fiscal stimulus plans and financial bailouts.

This past week, limited economic news was negative. Nonetheless, crude oil posted a strong net gain for the week. Boosting prices on Tuesday was the expiration of the February futures contract as the lower priced February contract converged with the higher priced March contract. A significant number of traders had been playing a “contango” situation in which current prices are low but are expected to consistently rise in coming months. But with the expiration of the February contract, there was considerable short-covering, boosting crude prices.

Not all factors lifted prices. Two geo-political issues keeping oil prices firm appear to have been resolved at least temporarily. Russia and the Ukraine have agreed upon a natural gas deal and Israel pulled its military out of the Gaza Strip. Government reports on petroleum stocks indicated that inventories were somewhat higher than expected but news of additional bailouts for banks helped boost prices.

But by the end of the week, oil industry consultant PetroLogistics Ltd. Indicated that OPEC will cut supplies by about 5 percent this month, which helped bolster crude prices. Even though crude rose notably this past week, prices are still relatively soft due to ongoing recession worldwide.

Net for the week, spot prices for West Texas Intermediate jumped $8.14 per barrel to settle at $44.65 – and coming in $100.64 below the record settle of $145.29 per barrel set on July 3.

The Economy
On the indicator front, it was a mostly quiet week – the only market moving indicator was housing starts. According to nearly all of the economic pundits, housing has to recover before the overall economy can. But the latest housing starts numbers indicate that’s not happening yet.

Housing starts drop to new low
Indeed, housing starts in December continued to be pushed down by oversupply of unsold homes on the market. Starts fell another 15.5 percent, following a 15.1 percent plunge in November. The December pace of 550 thousand units annualized was down 45.0 percent year-on-year and was sharply below the consensus forecast for 615 thousand units. December’s pace of new construction was the lowest since the starts series began in 1959.

For the latest month, the fall in starts was led by the multifamily component which dropped 20.4 percent while the single-family component fell 13.5 percent.

By region, the decline in starts was led by a monthly 24.5 percent drop in the Midwest. Starts also declined in the South, down 22.2 percent, and the West, down 2.2 percent. The Northeast rose 12.7 percent.

Permits also continued in freefall in December, posting a 10.7 percent drop, following a 15.8 percent falloff in November. The December pace of 0.549 million units annualized for permits was down 50.6 percent year-on-year.

Other housing news out last week point to continued weakness or even further deterioration. The housing market index, compiled by the National Association of Homebuilders together with Wells Fargo, fell 1 point in January to a record low of 8 -- a level indicating that nearly all respondents are reporting month-to-month contraction. This index compiles respondents’ views on present sales of new homes, sales of new homes expected in the next six months, and traffic of prospective buyers in new homes.

Overall, the picture for housing continues to be bleak. But the silver lining is that homebuilders are facing the reality that inventories of unsold homes must be worked off before starts pick up. Meanwhile, construction jobs will continue downward and there will be collateral damage to spending for the likes of appliances, furniture, and other home improvement purchases. Not only is the fourth quarter looking very negative, but the direction for the first quarter is clearly down for the overall economy.

Looking ahead at the Fed
This coming week, the highlight may well be the Fed’s FOMC statement. Given that at the December 15-16 FOMC, the Fed cut the fed funds rate target to a record low range of zero to 0.25 percent, the Fed can’t cut any further. Importantly, the FOMC went out of its way to emphasize that the effective fed funds rate is likely to remain low “for some time.”

Indeed, the fed funds futures market was paying attention to the statement. Based on fed funds futures, traders expect the effective fed funds rate to stay below 0.25 percent at least through mid-2009 and below 0.5 percent for the rest of 2009.

Since we will not be seeing a statement from the Fed saying that the fed funds target is going lower, what can we expect? The Fed is now focusing on quantitative easing or credit easing as stated by Fed Chairman Bernanke. Without a doubt, the Fed has expanded its balance sheets immensely over the last few months.

Over the past decade from 1999 until late 2008, Reserve Bank credit outstanding had been slowly rising from $500 billion to $1 trillion. But credit outstanding surged from $894 billion this past September to an astonishing $2.2 trillion in December! Now, the focus is expanding credit into specific segments of the credit markets that will have the most impact on economic recovery. The Fed emphasized this targeting of credit in the December FOMC statement.

“As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.”

So, at this FOMC meeting, we may see more specifics about what the Fed may be purchasing to expand credit. There now is an unusual intra-Fed political angle. The FOMC – which is a committee comprised of Fed governors and Fed regional bank presidents - is charged with making decisions on setting the fed funds rate. But the regional presidents are not involved with the official decisions on new lending facilities – just the Fed governors. It will be interesting to see what role the regional Fed presidents will be playing while the fed funds target is stuck on hold. The debate will likely continue over whether the Fed should set numerical targets for balance sheet items. Separately, any FOMC comments on to what degree the economy may be worsening could move markets.

The bottom line
The latest economic numbers not surprisingly confirm that the recession is more than just a mild dip and fourth quarter earnings are falling in line with that view. It’s going to be a while before any significant fiscal stimulus will be coming out of the new administration and Congress. So, it is still up to the Fed to loosen the credit markets and specifically to begin restoring faith in mortgage markets. Wednesday FOMC meeting statement likely will give new details on the Fed’s plans.

courtesey Econoday

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