Economic comments, week ending Aug. 5

By John W. Davidson | Aug 07, 2011

The July U.S. employment report surprised on the upside as one of the few exceptions to this week's otherwise soft economic releases. The debt ceiling compromised in Washington led to an agreement that avoided default on U.S. debt, but the brinkmanship and hardened positions on top of the weak economic releases caused a collapse of the equity markets across the globe. The S&P rating agency weighed in with a downgrade of the U.S. debt from AAA to AA+, citing both debt levels and political inflexibility. Government bond markets rallied in the face of economic weakness; credit spreads widened. The U.S. dollar and gold rallied, but energy and metal prices declined.



In downgrading the credit rating of the U.S. Debt, the S&P wrote: "More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policy-making and political, institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011."

The Congressional leaders and the administration reached a compromise at the 11th hour to avoid a default of the U.S. Treasury last Tuesday. The result was not perfect, but the theatrics and the partisan posturing that led to the agreement was unsettling to both the capital markets and the rating agencies. More disturbing was the minority of partisan Congress members on both sides of the aisle who still voted against the compromise even though the only remaining alternative was default. I was disappointed to find my own representative, Chellie Pingree, voted against the compromise, "because it's bad for the economy, hurts families, and should have been done in a more balanced way."

Congresswoman Pingree did not understand that a default of the U.S. debt would have been worse for the economy and hurt families more. Consider what happened following the default of Lehman! Understanding what is best for Maine and the U.S., the other Maine representative and both Maine senators voted for the compromise legislation.

I have never been a fan of the rating agencies. They have typically been late in downgrading credits; most bonds trade at the downgraded level before the rating agencies get around to downgrading them. Rating agencies completely missed the risks in the structured bonds whose credit problems contributed to the Great Recession in 2008. The Treasury Department criticized S&P's assumptions, claiming a $2 trillion error; some claim the downgrade was politically motivated. Nonetheless, given the political environment in Washington, I can't fault S&P for the downgrade.

This downgrade is a headwind to U.S. economic growth and job creation. It adds one more point of uncertainty to already hesitant job creation. 'All other factors held constant' (they are not) the downgrade should cause interest rates to be higher for all U.S. interest rates. Yet, recently interest rates have fallen because of weakening economic indicators. Nonetheless, over time interest costs will be higher than they otherwise would have been.

Bridging the divide to come together around a "Bowles/Simpson" solution would be too much to hope for, but the rating agency action should be a wake-up call for Congress and the administration. Unfortunately, so far, the downgrade has resulted only in partisan finger pointing.


Economic Releases

The July U.S. employment report surprised on the upside, making it an exception for the week. The chart below shows the history. Non-farm Payrolls (red) increased 117,000, near the high end of the range of expectations; June's Payrolls were revised up to 46,000. Private Payrolls (black) topped the range of expectations at 154,000; June's Private Payrolls were revised up 23,000 to 80,0000. The 4-week average of Initial Jobless Claims (green) dropped 20,000 to 407,800; the most recent week's Claims (not shown) eased to 400,000. Manufacturing Jobs (blue) increased 13,000 to 24,000 in July.


Source: Bloomberg LP

In other U.S. employment news, the Unemployment Rate dropped a tick to 9.1%, Hourly Earnings rose +0.4%, and the Hours Worked remained unchanged at 34.3 hours.

The Purchasing Managers' Indices (PMIs) are early indicators of economic activity as reflecting the opinions of those on the front lines of corporate earnings. The PMIs shown below all declined in July and trended closer to 50, the demarcation between expansion and contraction. US Manufacturing (blue) declined over 4 points to 50.9; U.S. Services declined -0.6 to 52.7. European Manufacturing (green) and Services (purple) declined about 2 points to 50.4 and 51.6. Not shown, UK Manufacturing broke into the contraction zone with a score of 49.1, but UK Services rose to 55.4. The Swiss Purchasing Managers' Index rose a tick to 54.5. Yet the Canadian PMI plummeted over 20 points to 45.4.




Other Economic Releases

U.S. Construction Spending in June inched up +0.2%; May's Spending was revised higher from -0.6% to +0.3%. Personal Income rose +0.1%, but Consumer Spending decreased -0.2% in June; the Core PCE prices increased +0.1%. June Factory Orders declined -0.8%.

The Unemployment Rate in Canada declined two ticks to 7.2%.

As expected the Reserve Bank of Australia (still AAA) left interest rates unchanged at 4.75% when they met this week. Retail Sales in Australia declined -0.1% well below consensus.

German Manufacturing Orders increased 1.8% in June, but Industrial Production declined -1.1%. Swiss CPI declined -0.8% in July; Retail Sales increased 7.4% YOY.


Equities Markets

Equity prices by record amounts this week, bringing YTD returns into negative territory across the globe.


Bond Markets

Government bond markets rose again this week in a flight to safety over worry about economic softness and the likelihood that Central Banks would keep interest rates at record lows for the foreseeable future. The fact that U.S. Treasuries declined in the face of a prospective downgrade was evidence of the the increased concern for an economic decline. U.S. mortgage rates hit new record lows. Credit spreads (over risk free U.S. Treasuries?) increased as investors demanded more yield to assume credit risks.



Currencies and Commodities

The U.S. dollar rallied against other currencies. Energy and Silver commodity prices declined, but gold rose in a flight to safety (could be creation of a bubble?).




Economic Sectors

No sector avoided the equity market sell-off, but Consumer Staples and Large Cap Growth sectors lost the least; REITs, followed by Energy, and Mid-Cap sectors suffered the worst returns.





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