Good Night, Irene
Federal Reserve (Fed) Chairman Ben Bernanke’s widely anticipated speech in Jackson Hole, WY last Friday (August 26) apparently struck just the right tone for markets. The speech allowed market participants to look ahead to several key economic and policy events this week, including the impact of Hurricane Irene in the economy and markets, the August reports on ISM manufacturing, chain store sales, vehicle sales and most importantly, employment, as well as key data on China (August ISM) and Japan (July industrial production, retail sales, and vehicle production).
On the policy front this week, the Fed will release the minutes of the August 9 FOMC meeting, and perhaps more importantly, German Chancellor Angela Merkel holds a key policy conference with her own caucus as the market continues to wait for a policy response from Europe . Japan’s ruling party will choose a new Prime Minister from its own ranks, after the current Prime Minister resigned on Friday, August 26. As with elsewhere around the globe, the path of future fiscal and monetary policy in Japan is crucial to the outlook for the global economy.
Further out on the horizon for markets on the policy front is the now two-day long September Federal Open Market Committee (FOMC) meeting on September 20 and 21, some type of policy actions in Europe, a jobs proposal from President Obama, and ongoing work by the so-called congressional “super committee” tasked with finding at least $1.5 trillion in budget savings by the end of this year.
Potential Economic Impact from Hurricane Irene
Another, shorter term concern for markets is Hurricane Irene, which made its way up the East Coast over the weekend of August 27 – 28. As of Monday morning, August 29, damage estimates were in the $5 to $10 billion range. Although the damage from Irene was less than feared, it caused major disruptions in a very heavily populated area of the country, keeping businesses closed and consumers at home for several days in the key back-to-school shopping season. The high frequency economic data (i.e. initial claims, shipping and rail traffic, weekly retail sales, consumer confidence, auto production, etc.) we, other market participants, and policymakers track may be difficult to interpret for a few weeks due to the impact of the storm. This potential lack of clarity on the underlying health of the economy arrives at a particularly inopportune time, as markets and policymakers try to gauge the true underlying strength of the economy and the risk of recession.
Although several major public transportation systems from the Metro in D.C., to the MBTA in Boston were closed for all or part of the weekend of August 27 – 28 (and some remain partially closed as of Monday morning, August 29), it appears that most of the other major economic infrastructure (ports, roads, airports, railways, refineries, utilities, etc.) related assets in the path of the storm were largely spared. Flooding remains the largest concern in the aftermath of the storm, especially in New Jersey, New York, and Vermont. If authorities take longer than now expected to repair the infrastructure, the hurricane may have a longer lasting impact on the economy in the region, and would push the United States economy closer to recession. Prior to the storm, we placed the odds of recession at around one-in-three, up from a few weeks ago, but well below the odds financial markets seem to be placing on a recession.
As previously noted, very preliminary estimates put the economic cost of Irene at between $5 and $10 billion. In terms of economic damage (adjusted for inflation), at $108 billion, Katrina (2005) was the costliest hurricane ever to hit the United States. Andrew (1992) at $45 billion was next costliest, followed by Ike (2008), Wilma (2005), Ivan (2004), Charley (2004), Hugo (1989), Rita (2004) and Agnes (1972). These storms (again in 2010 dollars) caused between $10 and $20 billion in damage. Irene may end up in the lower end of that $10 to $20 billion category in terms of economic cost, although the true cost of the storm may not be known for weeks. Three storms that took the same track as Irene — up the East Coast — and were roughly the same magnitude as Irene: Floyd (1999), Bob (1991) and Gloria (1985) were the 14th, 30th, and 30+ most costly storms in history. For perspective, the size of the United States economy is around $15 trillion dollars.
A Key Week for Economic Data
Although the week is chock full of economic data in the United States and abroad, the key reports are likely to be the ISM report on manufacturing for August (Thursday, September 1) and the August employment report (Friday, September 2).
Based on weakness in various regional ISM and Federal Reserve manufacturing sentiment surveys already released for August (Philly Fed, Empire State manufacturing, Richmond Fed, Dallas Fed), the consensus expects the August reading on the ISM to dip below 50 (to 48.5), from the 50.9 reading in July. The so-called “whisper number” among traders (who often informally have their own forecasts for key economic data and events that differs from the consensus estimate culled from economists) is probably closer to 44.0 or 45.0. Thus, expectations for ISM are quite low. A reading below 50 on the ISM has historically corresponded with contraction in the manufacturing sector, while a reading about 50 suggests an expanding manufacturing sector. The last time the ISM was below 50 was in July 2009, the first month of the current economic recovery.
It is not unusual to see the ISM to approach, and dip below, 50 in the midst of an economic expansion. The index dipped below 50 in the middle of the long 1982 – 1990 expansion and did several round trips above and below 50 in the 1991 – 2001 recovery, notably in 1995 and again in 1998. In the 2001 – 2007 expansion, the ISM dipped back toward the 50 level in 2004, before reaccelerating in 2005. More recently, we point out that manufacturing activity/output — vehicle production, industrial production, durable goods shipments and orders, manufacturing employment etc., have held up much better than measures of manufacturing sentiment like the ISM and the regional Federal Reserve manufacturing indices.
A sustained reading of 42 or below indicates recession, and the ISM did get to that level in both the 1991 and 2001 recessions. It got as low as 33.3 at the worst of the 2007 – 2009 Great Recession.
Some of the components of ISM bear close scrutiny, given the composition of the economic recovery thus far. The new orders index — which dipped below 50 in July for the first time since June 2009 is a decent leading indicator of future readings on the overall ISM. Some stabilization in the orders component near 50 would be welcome, although a sustained dip below 50 does not necessarily indicate recession.
Exports helped to lead the economy out of recession in 2009 and 2010, as signaled by the surge in the new export orders index to above 60 in 2009 and 2010, and the sustained stay above 55. The reading was 54.0 in August 2011, and although no formal consensus estimate is available for this component, the best bet is that the market is looking for this index to stay around 50 in August. The new export orders series does dip below 50 in recessions, but rarely gets below 50 during an expansion. The index did temporarily dip below 50 in 1998 due to the Asian financial crisis. One could argue that the turmoil in Europe might also push the export index lower as well.
Inventory restocking by businesses (and especially manufacturers) also played a big role in the economic recovery in 2009 and 2010. As noted in the nearby chart, the inventory component of ISM spends most of its time below 50, and dips well below 40 during recessions. It got as low as 31.3 in June 2009, the final month of the 2007-2009 Great Recession. The inventory component of ISM has spent much of the past two years above 50 as businesses have restocked inventories to meet increased final demand. It dipped to 49.3 in August 2011 however. A reading above 43 on this component of ISM suggests that the economy is still expanding.
The other key report due this week is of course the August employment report. The employment report is actually two reports in one. One part of the report surveys 60,000 households on their employment status, generating the widely cited unemployment rate figure, calculated as the number of people unemployed and looking for work as a percentage of all the people in the labor force. The other side of the report surveys 140,000 businesses, and generates the number of workers on payrolls, their wage rates, hours worked etc. Both surveys have huge nationwide sample sizes-far greater than the survey sizes (typically 1000 people) used in polling for national political races — and have been conducted for more than half a century. Although jobs are a lagging indicator of the economy (and the economy itself lags financial markets), the monthly jobs report is perceived by markets and the media as the most important economic report of the month.
The market is looking for the economy to create 103,000 private sector jobs in August, a deceleration from the 154,000 jobs created in July. As is the case with the “whisper number” for the August ISM report, at between zero and 25,000 jobs, the whisper number for the private sector job count is probably a lot lower than the published consensus. So, as is the case with the August ISM report, expectations are quite low for the employment report. State and local governments, which have shed nearly 600,000 jobs over the past three years, are expected to shed another 25,000 in August, so the overall economy (private sector and government) is expected to have added only 75,000 jobs in August. The whisper number here is well below zero, again suggesting that even an outright decline in overall jobs between July and August is somewhat priced in.
Weather, strikes, and other “one time” events often impact the monthly jobs report, and the August report is no exception. A strike at Verizon that impacted 45,000 workers will negatively impact the August job count, although the market should take this into account. The supply chain disruptions caused by the Japanese earthquake and the early (June instead of July) shutdown of auto plants for summer vacations may also wreak havoc with the August job count. Most importantly however, the dour mood that descended on the country in late July and early August as the debt ceiling debate raged, followed by a further dip in consumer, business and market confidence after S&P downgraded the U.S. debt rating on August 5 almost certainly curtailed hiring in the month. In addition, tightening financial market conditions (and very elevated readings on market volatility) also likely weighed on businesses decisions to hire in August.
Our Take on Fed Chairman Bernanke’s Jackson Hole Speech
Fed Chairman Bernanke’s speech in Jackson Hole on Friday, August 26 struck just the right tone for investors. As we expected, Fed Chairman Ben Bernanke did not hint at any new, immediate actions by the FOMC in the speech. Instead, Bernanke sounded relatively optimistic about the economy, especially in the long-term. In the short-term, Bernanke did note that the upcoming FOMC meeting (mid-September) has been changed to a two day meeting from a one day meeting. In our view, the extra day would provide the FOMC the additional time to:
A. Further refine the policies it has been discussing: extending the maturity of its Treasury holdings, lowering the rate it pays on excess reserves, or buying more Treasuries (QE3).
B. Come up with a completely different policy approach to address slow growth in the U.S. economy.
Bernanke also noted that the sovereign debt issues in Europe, as well as the fiscal situation in the United States were at the top of the list of FOMC concerns. Bernanke was unusually blunt in his criticism of Congress (his bosses) and its ability to make prudent fiscal decisions. Bernanke also reiterated his view that Congress should take into account the “fragility” of the economy when considering additional spending cuts as part of the debate to further address the long term budget issues faced by the United States.
Bernanke, a Republican first appointed by President George W. Bush, noted, “Fortunately, the two goals of achieving fiscal sustainability — which is the result of responsible policies set in place for the longer term — and avoiding the creation of fiscal headwinds for the current recovery are not incompatible. Acting now to put in place a credible plan for reducing future deficits over the longer term, while being attentive to the implications of fiscal choices for the recovery in the near term, can help serve both objectives.”
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IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Stock investing involves risk including loss of principal.
The ISM index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.
The Philadelphia Fed Survey is a business outlook survey used to construct an index that tracks manufacturing conditions in the Philadelphia Federal Reserve district. The Philadelphia Fed survey is an indicator of trends in the manufacturing sector, and is correlated with the Institute for Supply Management (ISM) manufacturing index, as well as the industrial production index.
Empire State Manufacturing Survey is a monthly survey of manufacturers in New York State conducted by the Federal Reserve Bank of New York.
This research material has been prepared by LPL Financial.
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