Financial Review


Financial Review

DOW – 238 = 16,804
SPX – 26 = 1946
NAS – 71 = 4422
10 YR YLD – .10 = 2.40%
OIL – .43 = 90.73
GOLD + 4.30 = 1214.00
SILV + .20 = 17.28

Yesterday, we talked about third quarter results. Most of the stock indices were down in September but still slightly positive for the third quarter. Today wiped out the third quarter gains. Why? Well, that’s always fun; the headlines offer a plethora of reasons, including “global worries” or maybe it’s a “market top” or “geopolitical hotspots” or “commodity crash” or maybe it’s just the start of a “rocky October”. I don’t claim to know why the markets dropped today, or any given day. I can read a chart, and I can identify patterns, but there are no guarantees. We follow macroeconomics and we analyze company P&Ls, but there are no guarantees. We do not get stuck in cheerleader mode like the talking heads on TV business shows, nor do we follow the perma-bears.

Markets fluctuate; to paraphrase a line from J.P. Morgan, or maybe John Rockefeller. “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” That’s a quote from Warrant Buffet. We don’t yet know whether this is folly or a trend. We’ll just have to listen to the markets.

The Institute for Supply Management’s index of national factory activity dropped to 56.6 last month, its lowest level since June. A reading above 50 indicates expansion. The gauge of new orders fell to 60% from 66.7%, but that’s still very strong. Production edged up a tick to 64.6%, marking a four-year high. Fifteen of the 18 industries tracked by ISM reported growth in September. A similar survey put out by the private-research firm Markit was just slightly off a four year high in September.

And compared to the rest of the world, American manufacturing is red hot. The JPMorgan global manufacturing index edged down to a four-month low of 52.2% in September while the rate of expansion was the weakest since April. Growth was near-stagnant in the Eurozone and Asia, and the global index is being propped by the United States.

On Friday, we’ll get the monthly jobs report from the government. I always consider this one of the most important economic reports. The warm-up for the report comes from ADP, a private payroll processing firm. Each month they gather data and make their own estimate about the labor market. ADP is not always a good predictor of the Labor Department’s report; for example, last month ADP predicted the economy added 202,000 jobs, and the official number came in at 142,000. In defense, the government numbers for August are typically subject to upward revisions, more than other months; so after revisions, ADP’s estimate might turn out to be pretty close.

That’s a fairly long setup to let you know that today, ADP estimates the economy added 213,000 private sector jobs in September. Most estimates call for the government’s report to show that total nonfarm employment rose by 220,000 jobs in September. Weekly readings on jobless claims are near lows hit before the recession, signaling that employers are laying off few workers. And if the economy continues to add about 200,000 net new jobs each month; it would be consistent with about 3% GDP growth. Not shabby.

Job growth has been steady since 2009, but it has also been uneven. The Labor Department reports today nearly a quarter of the metropolitan areas in the country had fewer jobs in August than 5 years earlier; 92 regions have experienced net job loss since August 2009. The Tucson region recorded the largest total decline with 23,500 fewer jobs there in August compared with the same month in 2009. The Pine Bluff, Arkansas region saw the steepest decline, down 9.4% from 5 years earlier. The hardest hit areas are more lightly populated; indicating rural America has not really recovered. Los Angeles added the largest total amount of jobs during the five-year span, almost 390,000; Houston, Miami and Dallas followed.

In a separate report, the Commerce Department says construction spending dropped 0.8% in August to a seasonally adjusted rate of $961 billion. Looking at private outlays, spending fell 1.4% for nonresidential projects and dropped 0.1% for residential projects. For overall public construction projects, spending fell 0.9%. In addition, July’s rise was revised lower to a 1.2% rise from an initially reported 1.8% gain.

Fannie Mae and Freddie Mac are the giants of mortgage financing; they are government sponsored entities that issue and guarantee mortgage-backed bonds. Between those companies and Ginnie Mae, which guarantees loans insured by the Federal Housing Administration, the government backs nearly 97 percent of US mortgages.

And today, they crashed. Fannie and Freddie shares each dropped 37%. And preferred shares were down more than 60%. A federal judge on Tuesday threw out a lawsuit brought by Fannie Mae and Freddie Mac investors to stop the government from seizing most of the profits at the mortgage finance twins.

Let’s set the stage. In 2008 Fannie and Freddie were placed into conservatorship to avoid bankruptcy. Congress originally authorized Treasury to collect 10 percent dividend payments from Fannie and Freddie every quarter as a condition of the government’s $188 billion bailout of them. Treasury amended the terms of the agreement in 2012 to make Fannie and Freddie give the government most of their profits, a move known as the “sweep amendment.” And earlier this year, Fannie and Freddie paid off their bailout, and taxpayers recouped the $187 billion that was used to prop up the two GSEs. A couple of big institutional investors in Fannie and Freddie, including Perry Capital and Fairholme Funds, sued, claiming that the dividend sweep was tantamount to a purchase of new securities, which Treasury did not have the authority to make. It also claimed the FHFA failed to conserve the assets of Fannie and Freddie by allowing Treasury to take most of their profits.

The hedge fund argued that Treasury’s arrangement caused irreparable harm to all private investors, saying they have been shortchanged as Fannie and Freddie returned to profitability. In its original complaint, the hedge fund said the government “maneuvered to ensure that Treasury would be the sole beneficiary of the companies’ improved financial position.” Basically, the hedge funds were upset that the taxpayers that bailed out Fannie and Freddie got paid back before they could suck out profits for their hedge fund.

In Tuesday’s ruling, the judge expressed sympathy for the plaintiffs, but it wasn’t enough to reverse course. He found that Treasury and FHFA were well within their rights, as dictated by Congress; and if the hedge funds didn’t like it, they could take it up with Congress. What’s still unclear is how and when and if Fannie and Freddie will emerge from conservatorship.

Bill Gross’s surprise departure on Friday from Pacific Investment Management Co., or Pimco, shook up the $42 trillion bond market. The most-traded assets quickly recovered but the less-traded ones are still feeling the effects. And it may have exposed an Achilles’ heel: the lack of liquidity in the bond market. When you get a dislocation like this, it tends to exacerbate price movements maybe more than what you’d have seen 10 years ago.

One person pushing around borrowing costs for nations and companies worldwide, however briefly, shows the increasing fragility of credit markets. Average daily trading in the US bond market fell to $809 billion in 2013 from $1.04 trillion in 2008, according to data compiled by the Securities Industry & Financial Markets Association. Debt still largely changes hands off exchanges, through telephone calls and e-mails. And in September Pimco’s Total Return Fund was hit with $23.5 billion in withdrawals, or right at 10% of assets.

Bill Gross does not rule the bond markets; any effect from him changing jobs will be temporary. The Fed will soon unwind QE, and that has been and will be a much bigger story. Gross’ departure serves as a reminder that fluctuation should not be confused with liquidity. Bond markets fluctuate all the time but things get scary when prices stop fluctuating.

We’re pretty sure the bond market will feel a bit uneasy about the end of QE, but what about the energy markets? And what is the connection between the end of quantitative easing and raising interest rates, and energy? The oil and gas industry is extremely capital intensive, with billions of dollars required in some cases to suck hydrocarbons from the ground. That means that companies need to sell a lot of debt to financial markets to finance their projects. But if interest rates rise, it will significantly raise borrowing costs for oil and gas operators.

Increasing interest rates should strengthen the US dollar relative to other currencies; and we’ve already seen the dollar at 4-year highs in recent trading. Higher interest rates makes holding dollars more attractive, which increases demand for the currency. Oil is priced in dollars, so a stronger dollar pushes down oil prices, along with other commodities priced in dollars. Lower oil prices mean lower revenues for oil companies.

Higher interest rates will make debt more expensive, making it more expensive to borrow money to drill an oil well. Moreover, the problem becomes worse still because so much of the oil growth in recent years has come from shale, which has rapid decline rates after initial production. Companies have to keep borrowing to drill new wells, but will run into trouble if the cost of debt rises too fast. So, high interest rates mean higher expenses and a stronger dollar means a lower price; and that means some of the marginal players won’t manage, and that means a pullback in production growth.

So far this year, oil prices have been moving lower; production is strong, inventories are high. The Fed says it will be a “considerable time” before they raise rates. Best guess is that sometime next year the Fed will end the era of easy money; they will tighten the spigot of stimulus, and that will tighten the spigot on oil and gas output, especially for companies that have high levels of spending. There are other factors at play, including global production and the impact of renewable energy, but the formula is in place. Higher borrowing costs will likely necessitate higher revenue and if oil prices don’t rise the industry will need to pare back production; not today, but over the next year or two, and America’s oil boom will fizzle.

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