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Thursday, May 14, 2015

Bad Things in the Midwest

Financial Review

Bad Things in the Midwest

DOW + 191 = 18,252
SPX + 22 = 2121.10
NAS + 69 = 5050
10 YR YLD – .04 = 2.24%
OIL – .77 = 59.73
GOLD + 6.30 = 1222.40
SILV + .35 = 17.55

The Standard & Poor’s 500 Index closed at an all-time high, taking out the previous closing high of 2117.69. The Dow is still about 36 points shy of its record closing high. The dollar is on track for its longest weekly losing streak since October 2013. The bond market rallied, just a little, which is at least a change from the past couple of weeks. The earnings season is winding down, and it was ugly, but it looks like there will be positive earnings growth coming from the first quarter numbers. The economic data has been tepid.

The number of Americans who applied for unemployment benefits in the first full week of May fell by 1,000 to 264,000. New claims have registered less than 270,000 for three straight weeks, only the second instance in which that’s happened since 1975. Continuing jobless claims, people already collecting benefits, were unchanged at 2.23 million in the week ended May 2.

Producer prices, or prices at the wholesale level, fell a seasonally adjusted 0.4% in April to mark the seventh decline in the last nine months, mainly because of lower gasoline and food costs. Core producer prices that exclude the volatile categories of food, energy and trade rose 0.1% last month; the increase was mainly due to higher prices for drugs. Over the past year overall producer prices have fallen a record 1.3% on an unadjusted basis. Yet the core rate has risen 0.7% in the same span.

U.S. corporate spending on capital projects could fall this year to the lowest level since 2011, with steep reductions by the energy industry and companies in other sectors cutting spending amidst broad concerns about global growth. Among the S&P sectors, only the materials and financials sectors expect to spend more in 2015 than they did last year. They’re not spending at a pace that would suggest a global recovery. According to data from Thomson Reuters, estimates from analysts show that total S&P 500 capex spending could dip to $641 billion in 2015 from actual spending of $718 billion for 2014, marking the lowest level since 2011.

And it’s not just businesses that are holding on to the purse strings; yesterday we had a report showing retail sales were flat last month. It was widely believed that lower oil prices would put extra money in shoppers’ wallets and they would rush out to spend. Oil prices remain more than 40% below the highs reached in mid-2014, which equates to a roughly $150 billion ‘tax cut’ to consumers.

One reason for the lack of spending might be middle class debt. According to the Federal Reserve, as of 2013, the average debt of middle-class families, those that fall within the middle three-fifths of the population by earnings, amounted to an estimated 122 percent of annual income. That’s down from 2010, but still higher than 2001. Consumers have been trying to save more because they realized that gas prices could go higher, and it is happening; consumers also realize that interest rates could go higher, and for a typical household, higher rates could spell disaster.

Futures contracts imply that traders see the fed funds rate at about 0.3 percent rate by December. That’s the lowest estimate of the year, and about half the forecast for the overnight lending benchmark that the Fed gave in March. Fed policymakers have been saying that a rate hike will probably happen this year, with the caveat that any move will be data dependent. The economic data looks soft right now but the Fed has another motivation for a rate hike: financial stability. With interest rates near zero, the Fed is limited in their ability to deal with financial instability. They don’t have many tools in their tool belt.

So the Fed says rate hike, the futures traders say no; and this is setting up for another market-wide tantrum. Former Fed Chairman Alan Greenspan, speaking yesterday, said: “Just remember we had the ‘taper tantrum.’ And we’re going to get another one.”

If for no other reason than a blind pig can find an occasional acorn, Greenspan is probably right about this; traders are almost certain to complain about higher rates, even if rates have been abnormally low for a very long time; which will then give them an excuse to trade with higher volatility. Higher volatility equates to bigger profits, or losses if they get it wrong. The start of a tightening cycle typically causes some rise in volatility, but rarely a bear market, provided the Fed doesn’t surprise the markets. The extent of the impact is likely to be influenced by two other conditions: changes in equity valuations and the direction of inflation.

For now, inflation remains moderate but that can change; and one big factor will be energy prices. The fact that equity multiples have been rising suggests that markets are at greater risk for at least a modest correction; not a crash but enough to get your attention. And when we talk about rising multiples, we generally think of momentum stocks, and the usual suspects in this area would be biotech and social media stocks. The flip side to this line of thinking is that stocks climb a wall of worry. Momentum stocks typically represent areas of growth in an otherwise stagnant economy.

For now, volatility remains at low levels, the VIX, or volatility index is trading just under 13, almost half the level from back in December. It kind of feels like the calm before the storm.

Bad things are happening in the Midwest.

Deadly avian flu viruses have affected more than 33 million turkeys, chickens and ducks in more than a dozen states since December. On Tuesday, agriculture officials confirmed that the bird flu outbreak that has spread throughout the Midwest for months had reached Nebraska, making it the 16th state affected. Today, South Dakota reported its first possible infection on a chicken farm with 1.3 million birds in the eastern part of the state. The Iowa Poultry Association says there is no food safety risk for consumers. Chickens, turkeys and other poultry infected with bird flu will be destroyed and will not enter the food supply. Still, Iowa Governor Terry Branstad declared a state of emergency on May 1 due to the avian influenza outbreak. The virus may pose no risk to humans, but it is already having an impact on prices at the grocery store.

Iowa, where one in every five eggs consumed in the country is laid, has been the hardest hit: More than 40 percent of its egg-laying hens are dead or dying. For now at least, the biggest impact of the virus is on egg prices. It is estimated that prices will rise 1.6% for every million chickens destroyed. About 90 percent of the more than 25 million chickens that are being destroyed in Iowa produced liquid eggs, and already the wholesale price for those eggs nationwide has nearly doubled from late April. Liquid eggs are used in everything from mayonnaise to cake mix and are a major product of Iowa’s poultry industry.

According to the Associated Press, the price of a carton of eggs at supermarkets has increased 17% over the last month, hitting an average of $1.39. Bulk prices paid for eggs by cake mix and mayonnaise manufacturers, meanwhile, have spiked 63% over the past two-and-a-half weeks. Turkey prices are up as well, with breast meat at delis rising 10% since mid-April. So far, chicken prices appear to be unaffected.

Certainly the avian flu affects chicken farmers but from there it ripples through the Midwestern economy to the support businesses, ranging from bank lenders and insurers to trucking operations, feed mills and farmers. It hasn’t hit corn and soybean farmers yet, but it means a smaller market for part of their crops.

Next stop:
“Hog butcher for the world,
Tool maker, stacker of wheat,
Player with railroads and the nation’s freight handler;
Stormy, husky, brawling,
City of the big shoulders.
They tell me you are wicked and I believe them.”
City of Junk.

Moody’s Investors Service dropped two other hammers on Chicago taxpayers today, downgrading debt on both Chicago Public Schools and the Chicago Park District to junk levels. For the schools this will apply to $6.2 billion in general obligation debt.

The action won’t necessarily prevent CPS from borrowing more. But it will make that more costly, and comes at a particularly sensitive time, as the district seeks to renegotiate hundreds of millions of dollars in currently-losing swaps contracts. Beyond that, the district faces a deficit of well over $1 billion in its budget for the school year that begins on July 1, and is in negotiations with the Chicago Teachers Union, which says the current financial woes are “manufactured.”

At the parks, $616 million in outstanding general obligation debt is affected. Yesterday, Moody’s downgraded the city’s credit rating to junk status. Moody’s said Chicago’s options for curbing its $20 billion unfunded pension liability “have narrowed considerably” after last week’s Illinois Supreme Court ruling invalidated a state pension reform law. Moody’s said spending cuts and tax increases may be needed, regardless of how the court rules. The state could force the city to pay retirees directly, possibly leading to another rating cut. Moody’s on Tuesday also cut ratings on Chicago’s sales tax, motor fuel tax, and water and sewer revenue bonds.

Cities don’t get to play by regular bankruptcy rules. Cities don’t really have the choice of liquidating and going out of business. So when they can’t keep up with pensions, payrolls, services, and other obligations, they get temporary bankruptcy protection under Chapter 9. But they know that sooner or later they need to come up with a plausible matching-ends-with-means plan for coming out of bankruptcy. How will this all play out? I don’t know. But I’m guessing there might be a new nickname for Chi-town. City of big haircuts.

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