As we head further into the second calendar quarter, I find the stock market to be increasingly at odds with the economic data we have been getting thus far in the quarter. Despite the slowing growth rates in China, continued weakness in the domestic housing market, confirming signs that inflation has ticked up recently, slower consumer spending amid high gas prices and the move up in new jobless claims over the last few weeks, the stock market has continued to grind its way higher.
In my view, the latest rash of economic data has confirmed a soft patch in the domestic economy. Combine that with slower than expected growth in China and… well, let’s just say that when growth in the top two economies on the planet is slower than expected only a few months ago, expectations need to be adjusted.
And it is those expectations for certain commodities, such as oil, corn, wheat, soybeans and others, that are being re-adjusted from arguably overheated or frothy levels. Those expectations adjustments are behind the bumps in the stock market during the last two weeks.
Aside from the economic soft patch, what else is fueling the drop in commodity prices?
The recent build up in gasoline and oil inventories for one, and better than expected commodity crops is another. According to the U.S. Energy Administration, U.S. crude oil stocks rose 3.78 million barrels last week and gasoline stockpiles increased by 1.3 million barrels; this was head and shoulders above the 1.4 million barrel consensus increase for oil and the 200,000 barrel drop in gasoline inventories that was expected according to Reuters. That buildup, combined with growing indications of the aforementioned economic slowdown, resulted in oil prices falling earlier this week.
Also the USDA released its May World Agricultural Supply and Demand Estimates, which called for U.S. corn production to reach 13.5 billion bushels in 2011. Such a level would mark the largest U.S. crop ever, outdoing the record 13.1 billion bushel corn crop in 2009. Despite the favourable headlines associated with that production forecast and the ensuing price fall in corn and other commodities, deeper in the USDA’s forecast we find that despite the record production forecast corn stocks will remain in very tight supply.
All in all, this has resulted in a pullback for oil prices and other commodities, which translated into a rotation out of commodity fuelled names. More on that below.
Debt Ceiling and Manufacturing Data
The debt ceiling issue was trotted out over the weekend talk shows and that means…
Happy Debt Ceiling Day!
Yep, the authority Congress has given the Treasury to borrow money has now passed the borrowing allowed by the laws Congress has passed.
Hardly a surprise given the attention that this has been given over the last few months, but the key point is we have now passed that line in the sand and as yet there does not appear to be a workable deal on the table…as yet. That’s probably because Treasury Secretary Timothy Geithner has said that while he can juggle accounts for a time, he will run out of options for avoiding default by early August.
In terms of where the two sides stand – President Obama proposed a long-term deficit- reduction package of about $4 trillion over 12 years, which would include $2 trillion in spending cuts, $1 trillion in tax increases and $1 trillion in reduced interest payments. On the other side, Republicans are seeking spending cuts and no tax increases in exchange for supporting a higher debt limit.
While the President’s approval rating has rebounded following the recent killing of Osama bin Laden, Gallup data shows that Americans say they would want their member of Congress to vote against raising the U.S. debt ceiling by a 47% to 19% margin, while 34% don’t know enough to say. When we put the $14.3 trillion national debt into context per US Debt Clock.org, it’s understandable to see why most are against raising the debt ceiling:
- Debt per US Citizen: $46, 183
- Debt per Taxpayer: $129,109
Keep in mind the data set used shows a total U.S. population of 311.4 million people, and 111.4 million U.S. income taxpayers, which equates to 35.8% of the domestic population.
When we break down the revenue streams for U.S. Federal Tax Revenue, the largest components are income taxes, payroll tax and corporate tax. Given unemployment at 9.0 per cent and underemployment at 19.4%, the revenue stream has been battered over the last several quarters and is only expected to get modestly better near-term. With key spending programs such as Medicare, Medicaid, defence spending, income support programs, social security and net interest on the national debt accounting for the lion’s share of the Federal budget, it seems to me a combination of strategies – tax increases, program cuts and more – will comprise the eventual solution.
Whether or not we get innovative solutions that don’t kick the can down the road we will see, but at a minimum, the political manoeuvring to close a workable deal on the debt ceiling is going to make headlines near term. Those headlines and recent economic data that paints either a continued soft patch in the domestic economy or a more subdued recovery that was expected in 1Q 2011, in my view, will undermine an already concerned consumer amid. According to Gallup, three in four Americans name some type of economic issue as the “most important problem” facing the country today — the highest net mentions of the economy in two years. More specifically, general economic concerns (35%) and unemployment (22%) are the issues currently at the forefront of Americans’ minds. As I always say, the trend line is as important as the trend line, for the percentage mentioning the economy is up significantly from 26% in April, while unemployment is up just slightly from 19%.
Again, not all that surprising given the rebound in jobless claims, the bump up in the April unemployment rate and the pain at the gas pump. While commodity prices, including oil. are likely to reduce that pain at the pump, I see continued reasons for consumers to be wary even though gas prices are poised to fall in the coming weeks:
- Food prices remain at or near record levels according to the United Nation’s Food and Agriculture organisation Food Price Index;
- The winding down of QE2 as the Federal Reserve completes its $600 billion buying in U.S. Treasuries;
- Weaker than expected economic data across manufacturing (Institute for Supply Management and the Empire Manufacturing Index data), housing data and retail sales in recent weeks;
- Economic forecasts that have been reduced in recent weeks including that from the National Association of Business Economics, which reduced GDP expectations and increased its outlook for inflation.
All in all, this makes a recipe for a nervous consumer and a skittish stock market in my view.
Sector Rotation Toward More Defensive Names
That nervousness and skittishness has resulted in a shift in investor appetite at least for the near term. The pullback in commodity prices and commodity players, such as Corn Products International, Archer Daniels Midland Company and Bunge Limited, have taken the froth out of the commodities markets for now. At the same time, however, rising concern over the strength of the economy has caused investors to move from economically sensitive stocks toward more defensive ones. In the last week, shares of companies such as construction equipment maker Caterpillar Inc., Parker Hannifin Corp., and engine manufacturer Cummins Inc. are all down mid-single digits. By comparison, shares of more classic safety, slower growth companies, such as Kraft Foods, McCormick & Co., The Coca-Cola Company and others are up nicely. Up even more are Boyd Gaming Corp., Ameristar Casino, Inc. and others that fit into the Guilty Pleasure investing thematic I described a few columns ago.
Amid all of this we have to remember that we are still in the midst of corporate earnings and this week we will hear from Wal-Mart, Home Depot, Dell, Dicks Sporting Goods, BJ’s Wholesale Club, Deere & Co., Buckle, Abercrombie & Fitch, Ross Stores, Sears and others. With gas prices trending modestly lower, I’ll be listening for commentary not so much on the recently completed quarter but rather on the current quarter.
That said, my suggestion would be to do what a savvy and prudent investor does in times like this. Understanding that the current quarter could be a short-term soft patch, examine which economically sensitive sectors and corresponding companies are poised to rebound in the coming quarter? In more plain English, we might be able to use the recent weakness to get another bite at the proverbial stock apple. One such example is Trinity Industries, which has fallen from recent highs even though its railcar backlogs have surged and the outlook for rail traffic remains bright, particularly as gas prices remain well above year ago levels.