Choppy Action to Start Week

Charles Schwab: On the Market

Posted: 6/5/2017 4:15 PM ET

Choppy Action to Start Week

U.S. equities finished the first trading day of the week by posting only modest losses, as a plethora of political and geopolitical uncertainty appeared to keep investors in wait-and-see mode, including the upcoming election in the U.K. and European Central Bank monetary policy decision. Treasury yields and the U.S. dollar were slightly higher, along with gold, while crude oil prices were lower. Reports that U.S. services sector activity slowed but continued to show growth also may have also contributed to keeping investors on the sidelines.

The Dow Jones Industrial Average (DJIA) declined 21 points (0.1%) to 21,184, the S&P 500 Index decreased 3 points (0.1%) to 2,436, and the Nasdaq Composite lost 10 points (0.2%) to 6,296. In moderate volume, 699 million shares were traded on the NYSE and 1.7 billion shares changed hands on the Nasdaq. WTI crude oil declined $0.26 to $47.40 per barrel and wholesale gasoline was $0.04 lower at $1.54 per gallon. Elsewhere, the Bloomberg gold spot price added $0.64 to $1,279.81 per ounce, and the Dollar Index—a comparison of the U.S. dollar to six major world currencies—was 0.1% higher at 96.81.

D.R. Horton Inc. (DHI $33) announced that it has submitted a proposal to acquire 75.0% of the currently outstanding shares of Forestar Group Inc. (FOR $16) for $16.25 per share in cash. DHI said the proposal provides superior value to the existing merger agreement between Forestar and affiliates of Starwood Capital Group. DHI was lower, while FOR was up sharply.

Herbalife Ltd. (HLF $69) issued Q2 and full-year earnings-per-share (EPS) guidance that came in below estimates, despite raising its outlook for these periods, while lowering its sales outlook for the current quarter as it transitions to new Federal Trade Commission (FTC) rules. Shares were noticeably lower.

The markets payed close attention to the American Society of Clinical Oncology meeting, and Loxo Oncology Inc. (LOXO $70) surged after the company announced upbeat results from a clinical trial of its cancer treatment. However, Bristol-Myers Squibb Co. (BMY $52) came under pressure amid mixed results from the company's treatment for various types of cancer.

Growth in services sector activity slows slightly, factory orders dip

The May Institute for Supply Management (ISM) non-Manufacturing Index (chart) declined to 56.9 from April's unrevised 57.5 level, and compared to the Bloomberg forecast of a decline to 57.0. A reading above 50 denotes expansion. New orders and business activity slowed month-over-month (m/m) but remained solidly in expansion territory, while employment jumped 6.4 points to 57.8. Prices fell 8.4 points to 49.2. The ISM said comments from respondents continue to indicate optimism about business conditions and the overall economy.

The final Markit U.S. Services PMI Index was revised to 53.6 in May from the preliminary 54.0 level, where it was expected to remain, but was up compared to the 53.1 figure posted in April. The release is independent and differs from ISM's report, as it has less historic value and Markit weights its index components differently.

Services sector activity, which accounts for a majority of U.S. economic growth, continues to suggest expansion despite the festering political and monetary policy uncertainty. As noted in the latest Schwab Market Perspective: Unprecedented! Or Maybe Not?, both political uncertainty and Fed policy changes could contribute to increased volatility, but solid economic and earnings growth—both in the United States and globally—should help the bull market to continue. We suggest looking past the political rhetoric for the most part and focusing on economic developments and the long-term stability the United States provides. Read more on the Markets & Economy page at www.schwab.com.

Factory orders (chart) declined 0.2% m/m in April, in line with expectations, while March's figure was upwardly revised to a 1.0% increase. April durable goods orders—preliminarily reported two weeks ago—were adjusted to a 0.8% decrease from the preliminarily-reported 0.7% decline.

Final Q1 nonfarm productivity (chart) came in flat on an annualized basis, versus expectations of a 0.2% decline. Also, unit labor costs rose 2.2%, versus the forecast calling for a 2.6% gain.

Treasuries finished lower, as the yield on the 2-year note ticked 1 basis point (bp) higher to 1.30%, the 10-year note was up 2 bps to 2.18%, and the 30-year bond rate increased 3 basis points to 2.83%.

Today's data comes ahead of next week's Fed monetary policy decision, which is highly expected to deliver a Fed rate hike, while the potential beginning of the process of the Fed shrinking its bloated balance sheet later this year is also being eyed. Schwab's Chief Fixed Income Strategist, Kathy Jones discusses in her article, Will the Fed Reduce Its Balance Sheet? What Bond Investors Should Know on the Fixed Income page at www.schwab.com. Follow Kathy on Twitter: @kathyjones. Also, Schwab’s Chief Investment Strategist Liz Ann Sonders notes in her latest article, Gimme Three Steps … and a Stumble?, that reducing the gargantuan balance sheet is a form of tightening and the transition from quantitative easing (QE) to quantitative tightening (QT) begs the question whether we are heading into another period of heightened volatility. Read more on the Markets & Economy page at www.schwab.com and follow Liz Ann on Twitter: @lizannsonders.

Tomorrow's economic calendar will be light, with the only report of note being the Labor Department's Job Openings and Labor Turnover Survey (JOLTS), with economists forecasting that the measure of unmet demand for labor showed 5.73 million jobs were available to be filled during April, down slightly from the 5.74 million posted the month prior.

Europe, Asia lower on U.S. data and political and geopolitical uncertainty

European equities finished lower, though volume was lighter than usual as several markets were closed for holidays, including in Germany and Switzerland. The global markets continued to grapple with lingering geopolitical uncertainty in the wake of the weekend's deadly attack in London, while the political front also garnered attention ahead of this week's U.K. election as Brexit negotiations continue and votes loom in Italy and Germany later this year. Recent polls have showed the U.K. race tightening, causing some of the uncertainty to flare-up. For commentary on the political front check out Schwab's Chief Global Investment Strategist Jeffrey Kleintop's, CFA, and Vice President of Trading and Derivatives, Randy Frederick's video, Political Risk: How Should Investors Respond? on the Insights & Ideas page at www.schwab.com, where you can also find our article, Brexit Begins: What's Next for the U.K?., as well as another of Jeff's videos, What's the Current State of the Global Economy? The markets also await this week's monetary policy meeting by the European Central Bank. In economic news, U.K. auto sales and services sector output both disappointed the markets. The euro was lower and the British pound was higher versus the U.S. dollar, while bond yields in the region were mixed.

Stocks in Asia finished mostly lower as the markets digest Friday's softer-than-expected employment report in the U.S., which weighed on the U.S. dollar, while political and geopolitical uncertainty lingered. The U.K. is set for an election this week, on the heels of this weekend's deadly attack in London, while several Middle East countries cut ties with Qatar, citing terrorism-related issues. For analysis of the global front amid the backdrop of trade and geopolitical uncertainty, see Schwab's Jeffrey Kleintop's, CFA, articles, Missiles and Markets: An investor guide to geopolitical risks on the Markets & Economy page at www.schwab.com, as well as, Top Five Trade Issues Investors Should Be Watching on the International Investing page at www.schwab.com.

Japanese stocks finished flat, as the yen pared Friday's gain on the U.S. labor report, though financials weighed on markets in Australia ahead of today's Reserve Bank of Australia monetary policy decision. Mainland Chinese equities and those in Hong Kong declined, despite a relatively favorable read on the nation's key services sector output. Meanwhile, Indian securities ticked higher, continuing its record high run, while listings in South Korea dipped slightly.

Economic reports slated for release internationally tomorrow include retail sales from the U.K. and the Eurozone, as well as the Markit Services PMIs from across Europe.

Thursday, July 31, 2014 - Ugly Day, Ugly Logic

Financial Review with Sinclair Noe

DOW – 317 = 16,563
SPX – 39 = 1930
NAS – 93 = 4369
10 YR YLD un = 2.55%
OIL – 2.12 = 98.15
GOLD – 14.00 = 1281.50
SILV - .23 = 20.48

Well, this was just ugly. The worst day for the Dow Industrial Average in about 4 months. Back on April 10^th, the Dow dropped 267 points; that same day, the S&P 500 was down 30 points. Today wiped out the gains from July, with July marking the first negative month for the Dow and the S&P since January.

The S&P is still up about 5% for the year to date, but the Dow started the year at 16,576. All those record highs for 2014 have just been washed away. That’s how it goes; the markets scratch and claw, higher and higher, inch by inch it’s a cinch, until the cinch breaks. A couple of weeks ago, we talked about shorting, and the advantage of shorting is that the moves can be quick and severe. Sure enough. And while this might just be one bad day, long overdue, the Dow dropped below its 50 day moving average, which is one of the major measurements of a trend.

So, the question is why did the stock market nosedive today? One recurring theme I’ve been hearing is that traders are afraid the Fed will pull away the punchbowl. Yesterday’s GDP report showing better than expected 4% growth in the second quarter combined with today’s employment cost index, which rose 0.7% in the second quarter, made people nervous about the prospect of an improving economy and the possibility of wages pushing inflation higher.

Now wait just a minute; that doesn’t sound so bad; the economy is expanding at a 4% pace which is certainly better than a contracting economy which we saw in the first quarter; and workers are being paid a little more – not much just a little - and that’s certainly better than watching the middle class shrink into oblivion. If you look at this explanation for the market decline, it is an example of perverse logic, where the stock market traders are in opposition to economic prosperity and are only happy in the face of hardship; other people’s hardship, not their own.

There might be something to that interpretation. Beginning in 2008, the Fed cranked up a series of programs to stimulate the economy. Of course, the Fed didn’t really stimulate the economy but they did stimulate certain financial sectors, such as housing, and very clearly the stock and bond markets. During that time, the Fed added over $3.5 trillion to their balance sheet, which now holds nearly $4.5 trillion. The basic mechanics were that the US government borrowed money by selling Treasuries, and the Fed bought a large portion of those Treasuries with freshly printed money. Since 2013 the Fed’s balance sheet has grown even faster than government debt, which has leveled off, almost. Overlay a chart of the S&P 500 with a chart of the Fed’s balance sheet; the similarities are more than coincidental. A big chunk of the money the Fed was printing sloshed over into the stock market. When the Fed stops printing all that money, who is left to buy stocks?

The accumulated “surplus” of printed money will only last a couple of months. Sooner or later (probably sooner), the stock market will start to feel the pain of this monetary tightening. Of course the Fed isn’t really exiting the money printing business. They won’t sell off the assets held on their balance sheet; they will let those treasuries and mortgage backed securities mature and expire, maybe even roll over a few. And government debt hasn’t disappeared, so the Fed will continue printing money. We don’t know how the Fed taper and eventual increases in interest rates will turn out; neither does the Fed know. It’s a big experiment; the Fed might throw a curveball or two along the way; the stock market traders might throw a tantrum, knocking down your IRA in the process. The recurring theme today was that the Fed might pull away the punchbowl; the Fed hasn’t actually done that; they said this week they would not do that anytime soon. There has been considerable consideration given to a Fed exiting. Imagine when they actually do it.

The big institutional traders may already be headed for the doors. Last week, investors added $379 million into equity mutual funds, the kind that’s popular with retail investors. At the same time, exchange-traded funds focusing on equities; the kind of securities traded by institutional investors because of their liquidity and lower cost, saw a whopping $7.97 billion in outflows. That’s the biggest outflow seen since February.

Anyway, the Wall Street traders’ logic is flawed; the 4% growth in second quarter GDP really isn’t as good as it seems. The 4% growth implies the economy is on a very slow growth path when averaged in with the -2.1 contraction in the first quarter. Taken together, the economy grew at less than a 1.0% annual rate in the first half of 2014. That is hardly cause for celebration on Main Street or trepidation on Wall Street. Also, the strong growth in the second quarter was in direct response to the weak growth in the first quarter. Inventory growth was very weak in the first quarter, subtracting 1.16% points from the quarter's growth, and so a reversion to the mean, or a return to a more normal pace of inventory accumulation in the second quarter was a strong boost to growth, adding 1.66 percentage points. Final sales grew at just a 2.3% annual rate in the second quarter. Even that rate was likely inflated to some extent by the weakness from the first quarter.

But that wasn’t the only demon plaguing the stock market today. If it’s not one thing, it’s another. And there have been a lot of other things.

The bond market has its own demons. Fitch warns a jump in US high-yield default rates looms. There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. While most sectors remain relatively calm, the utilities and chemicals sectors are seeing huge spikes in defaults. Since the Fed pushed rates down near zero people have been chasing yield and that means the high yield market has become crowded, and that means the yield on risky debt has dipped to a little less than 6% on average, compared to a more typical yield of a little less than 9% for junk  debt. If or when the Fed starts targeting higher rates, who will be looking for the junk with the not so high yield? A reversion to the mean would result in big capital losses, and it could turn ugly if people start running for the exits and can’t find a bid.

And then we can’t forget the geopolitical problems of the world. A negative July in stocks was matched by a negative July in Ukraine, and Israel, and Gaza, and Iraq, and Syria, and Libya. Toss in sanctions on Russia, which will also hurt the European Union.  And then late yesterday, Argentina put a cherry on top.

Argentina has defaulted, or as S&P described it, a “selective default”. A quick recap: In 2001 Argentina defaulted on its debt and it forced most of its creditors to take a haircut, that is a lot less money than the face value of the bonds. After the default, Paul Singer, a hedge fund manager of NML Capital, bought a lot of the bonds at a big discount, pennies on the dollar, and then demanded the bonds be paid in full. Argentina refused to pay the vulture hedge funds. So Singer took his case to the courts – not in Argentina, but in the US. The case was heard by a judge who didn’t really understand all the fancy talk about bonds, and so he ruled against Argentina. About a month ago, the US Supreme Court said they would not interfere. So now, Argentina can’t pay off the bondholders who accepted the discount, unless they also pay off the hedge fund vultures who demand full payment; which basically negates the whole idea of the default in the first place. So, the US courts have essentially told the sovereign country of Argentina that it is more important to pay off the hedge funds, than it is to default and reboot the Argentine economy on a fresh start.

While Singer’s firm has yet to collect any money from Argentina, some debt market experts say that the battle may already have shifted the balance of power toward creditors in the enormous debt markets that countries regularly tap to fund their deficits. Countries in crisis may now find it harder to gain relief from creditors after defaulting on their debt.

The big question, however, is whether Argentina will ever pay Singer and his vulture fund fellows what it wants. If the firm fails to collect, that would underscore the limits of its legal strategy. There is no international bankruptcy court for sovereign debt that can help resolve the matter. Argentina may use the next few months to try to devise ways to evade the US courts. In dire economic crises countries need to be able to slash their debt loads. The idea is similar to bankruptcy for individuals, a chance to restructure debts and start fresh because we long ago learned that throwing people in prison for the debts didn’t help anybody. The legal victories of the holdouts may embolden creditors to drive harder bargains after future defaults, which in turn could prolong or postpone debt restructurings and extend the economic misery of over-indebted countries. So, the problem in Argentina is not unique to Argentina, it affects the global economic system, we just don’t know to what extent.