Stronger economic data leads to taper talk

Basically, we were guessing on interest rates … what we’ve come to believe is that no one can guess interest rates. – Fred Henning, head of fixed-income investing at Fidelity Investments, LA Times, July 7, 1997.

Here we go again. Just when you thought that investors could finally put Fed tapering to rest, it reared its ugly head again and caused stocks to fall for the second consecutive week. From an economic standpoint, the news last week was actually fairly positive as retail sales (excluding autos) rose 0.5%, housing starts were relatively strong, inflation rose modestly and jobless claims were lower than expected. But it seems that we’re back to where good news is considered bad news as a stronger economy only means one thing: Fed Reserve stimulus will probably end sooner rather than later. This mindset caused jitters among investors and gave them an excuse to sell, even though a stronger economy would ultimately be good for stocks in the long run. The sizable drop in initial claims for unemployment benefits was probably the biggest single reason that the yield on the 10-year Treasury note rose to 2.8%, the largest increase since June. The magnitude of the jump spooked the stock market, which is becoming increasingly uncomfortable with rising interest rates. The 10-year Treasury yield is now up 75% since May, even though inflation is running at about 1.1% on an annualized basis, unemployment is still high at 7.4% and GDP growth has been about 2%. No one can accurately predict where interest rates are going, but the data seem to suggest that the 10-year Treasury yield should range between 2.5% and 3.0% between now and year-end. But, then again, who really knows.

Last Week 

The week began on a positive note as U. S. retail sales rose for the fourth straight month and June sales were revised higher. But this news did not manifest itself in the quarterly earnings reports of major retailers, who reported disappointing results across the board. At the high end, Nordstrom reduced its earnings outlook going forward; in the midrange, Macy’s reported weak sales and a cautious outlook and at the low end, Wal Mart Stores announced a drop in sales and was not optimistic about its prospects for the rest of the year. To add insult to injury, Cisco Systems, the dominant maker of computer networking equipment, lowered its earning guidance and announced their plan to cut 4,000 jobs.

The recession officially ended in Europe in the second quarter as France and Germany reported better growth, but the increase in GDP was only 0.3% and followed six consecutive quarters of contraction. But Japan reported weaker than expected growth as its GDP grew at an annualized pace of 2.6% in the second quarter, less than the 3.6% that was expected. Closer to home, activist investor Carl Icahn announced that he has a large stake in Apple Computer stock and believes that the stock is extremely undervalued.

For the week, the Dow Jones Industrial Average fell 344 points to close the week at 15,081, a decline of 2.2%. The S&P 500 shed 36 points, or 2.1%, to end the week at 1,656 and the Nasdaq finished the week at 3,603, falling 57 points or 1.6%. 

This Week

This week’s economic calendar is very light and is in keeping with the summer doldrums. July existing home sales are expected to improve modestly from last month but show significant improvement from last year’s total. July new home sales are also expected to be better than expected and indicative of a housing market that continues to exhibit strength. Leading economic indicators for July are predicted to rise 0.5% and confirm that the economy continues to expand, albeit at a modest pace. The most important news next week could come in the form of minutes from the Federal Reserve meeting in July as they will be studied for evidence of the timing, size and scope of the monthly bond purchases.  

Among the companies scheduled to report earnings this week include home improvement retailers Home Depot and Lowe’s, retailers JC Penney, Best Buy and Target and technology companies Hewlett Packard and Analog Devices.

Portfolio Strategy

Although stocks have declined for two consecutive weeks, it’s important to note that volume and liquidity have been light, which can exacerbate moves in the stock market. The S&P 500 is now down 3% from its high of 1,709 but is still up about 18% on a year-to-date basis. That being said, there are worrisome signs with regard to the consumer which could prove to be problematic as consumer spending accounts for about two-thirds of GDP. The University of Michigan consumer sentiment index confirmed this trend as it fell in August following weak results from major retailers. With higher mortgage rates, higher gasoline prices and higher payroll taxes, consumers have less disposable income to spend. While the employment data has been encouraging, it also paints a picture that is misleading, as most of the new jobs being created are part-time and not full-time.

The market’s obsession with Fed tapering seems misguided as time and time again they have said that it will only occur if economic data is such that it is warranted. Although the Fed may signal its intention at its September meeting, it is by no means certain that any reduction in its stimulus will take place then. Fiscal matters dealing with the debt ceiling and government spending also are on the calendar this fall and any protracted fight could weigh on confidence, adversely affecting consumers. The economy still seems fragile, especially with the unwelcome rise in interest rates, and the Fed does not want to risk taking the punch bowl away prematurely. These conditions would argue for reduced bond buying at a later date, possibly closer to year-end.