Economic Update 6-29-2015

• Economic data for the week was dominated by slightly worse-than-expected durable goods orders, while several pieces of housing data surprised on the upside and the first quarter GDP figure was revised higher to just under zero.

• Both domestic equity and fixed income markets fell on the week, highlighted by concerns in Greece and higher interest rates; however, foreign markets (including Europe) gained.  Commodities managed an increase despite a stronger dollar, led by the agricultural group.

U.S. stocks ended the week lower, with concerns about the Greek situation weighing on sentiment.  Telecom (a small sector, so mostly AT&T-driven) and consumer cyclical stocks both gained on the week, while utilities was the worst performer, down over -2%—not expected, considering the rise in interest rates during the week.  Materials were also weaker, with weakness in paper pricing. Interestingly, and no one has probably noticed, but the S&P hasn’t ended up with more than a +/- 1% weekly move in two months, which hasn’t happened in 20 years.  As we also know, volume tends to drop dramatically during the summer months.  Could be a backdrop for  increased volatility?  Perhaps.

Despite a ~1% rise in the dollar during the week, foreign stocks ended up in the positive, although less in USD than in local terms.  European names rose, especially in the periphery, which was largely due to hopes for a Greek resolution as well as general PMI indicators moving above 50, showing accelerating growth (in fact, the strongest showing in four years).  While it didn’t affect markets during the week, the release of the Bank of Japan’s policy meeting minutes exposed a difference of opinion concerning the use of more aggressive monetary-easing policies, in terms of the creation of possible imbalances that could eventually undermine longer-term growth.  Such is the global debate about QE.

The handful of losing areas were focused in Russia and the Far East emerging market regions.  Local Chinese stocks fell another -7%, bringing the decline to almost -20% in the past two weeks—due to tighter liquidity and margin financing as well as higher valuations.  Interestingly, with this market being so limited in investor access, there seems to be limited contagion elsewhere.  However, to stem the damage, the Chinese central bank has reduced reserve ratios and cut interest rates by a half-percent for small business banks and 3% for finance companies.  There, the government continues to manage expectations and the divergent issues of a slowing economy yet bubbly local stock market.

U.S. bonds suffered as interest rates rose across the yield curve.  Long treasuries were among the biggest losers of the week, as was most developed market debt, notably in Europe, as spreads widened.  Domestic high yield bonds, however, were much less affected, while bank loans gained.  Foreign local bonds naturally performed better than USD-denominated debt.

Commodities gained on the week, as the agricultural group surged +9% as heavy rains in the Midwest threatened harvest activity—wheat, corn and soybeans all experienced sharp gains.  Precious metals fell by several percent, in keeping with higher interest rates, as higher-paying bonds are perhaps the primary competitor for gold assets.  West Texas crude fell about a half-percent, ending just under $60/barrel.

Speaking of Greece, as we all know from the news this morning, conditions intensified over the weekend.  Tuesday’s IMF payment is expected to be missed, and a referendum has been scheduled for July 5 that allows Greek citizens to vote on the terms of the proposed bailout agreement.  The Europeans didn’t allow a requested extension until that time, so it appears a partial default could be imminent.  (The fact that part of the disbursement from the ECB/European Commission/IMF under negotiations would have been turned right around and used to pay the IMF makes this situation even more convoluted, but that is beside the point for now.)  While the loan default applies to funds due to public rather than private sector entities—keeping this somewhat contained—Greek banks are experiencing capital problems.  Consequently, capital controls, bank and stock market holidays have been imposed this week to stem the damage, as depositors had been busily withdrawing Euros over the weekend.  German Chancellor Merkel has drawn a line in the sand, implying that the Greek vote will not just be one on the bailout terms, but whether or not they wish to remain in the Euro (the majority of Greek citizens still do, when surveyed).  This may sound dramatic, but does have some truth to it.

Global markets have experienced and may no doubt continue to experience more volatility from this (based on this morning’s response), but it’s important to remember that this is a continuation of the same drama—unfortunately, things have just come to a head now that an agreement hasn’t been reached by now as many hoped.  This isn’t unexpected, and the ECB has been considering this as one of the several possible scenarios.  We’ve been asked a few times about probabilities, but these are difficult to assign as they always are when the political dimension is involved—there are too many power dynamics involved in the short term (researchers who study ‘game theory’ attempt to unwind and postulate about each player’s motivations in situations like this, but this science is unavoidably imprecise).

By GDP standards, Greece is the size of Kentucky, and as much as we appreciate Kentucky, it doesn’t have the scale to bring down the global economy—although it doesn’t mean it can’t provide a scare to investors who prefer to avoid uncertainty at all costs.  Unfortunately, there is a precedent here.  According to research by economists Carmen Reinhart and Kenneth Rogoff, Greece has been in default for nearly half of the post-1800 period, with the earliest default allegedly in about 400 BC, so while many hoped Eurozone membership would open a new and financially healthier chapter for the country (and still could), old problems are hard to solve.

What happens now?  There still could be last-minute deal, although that’s unlikely.  The screws have been tightened, and capital controls now hit the average Greek citizen hard.  Whether this means a groundswell of support to make reforms needed to meet Euro demands, a change in political leadership or stubborn rejection of the Euro completely remains to be seen.  Or, perhaps the most likely scenario is another stopgap resolution to kick the can down the road again for another six months or a year, so we can revisit this all again.

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.                                                                        

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.