With the exception of the Russell 2000 small cap index, it was another week of negative returns for the major equity indices as they confronted credit market deterioration and rising oil prices.
1) Pillars of Mortgage Market Extremely Vulnerable: Former Fed Governor William Poole commented that Fannie Mae (NYSE:FMN) and Freddie Mac (FRE) were insolvent. Treasury Secretary Paulson and Fed Chairman Bernanke issued supportive statements contrary to Mr. Poole’s, but fears of another Bear Stearns (NYSE:BSC) type shareholder wipeout triggered massive selling in both stocks. Fannie and Freddie are admittedly too big to fail as such a scenario smacks of financial Armageddon. The real problem is that Fannie and Freddie are simply too big and their $5.2 trillion in mortgages expose an area of over-concentrated risk in U.S. economic infrastructure. Housing fuels the banking, consumer, and construction industries which are vital to economic growth. To address this vulnerability, some regulatory changes will need to occur. If these either of these agencies falters, the long awaited recovery in housing will be deferred even longer and only exacerbate the confidence crisis in the credit markets.
2) Uncertainty over 2nd Quarter Earnings: Alcoa (NYSE:AA) and GE (NYSE:GE) reported earnings this past week and easily beat their handicapped lowered estimates. It is estimated that 2Q operating earnings for the SP-500 in aggregate are expected to decline at -12%. Excluding financials, earnings for the SP-500 would rise at 9%. It just so happens that this week financial large caps such as Citigroup (NYSE:C), Comerica (NYSE:CMA), Capital One Financial (NYSE:COF), Wells Fargo (NYSE:WFC), U.S. Bancorp (NYSE:USB), and State Street (NYSE:STT) along with their mid and small cap financial brethren are scheduled to release results. Write-downs and losses have already been discounted into the sector’s share prices. Further negative surprises would not be well received by the market.
3) Geopolitical Instability Pressures Oil Prices and U.S. Dollar: Just when the idea of demand destruction actually seemed plausible, the tensions between the U.S. and Israel vs. Iran over its development of nuclear facilities and missle testing upstaged this theory. It will take time to defuse, if possible, the tensions between Iran and the West and its allies, i.e. Israel. In times of uncertainty, e.g. war or the threat of it, Gold shines its brightest and makes the dollar even duller to hold. It’s no surprise that some countries are seriously reconsidering monetary policies which are pegged to the dollar.
4) U.S. Trade Deficit Improving: There’s a silver lining in everything and one of the benefits of a weaker dollar is higher exports and a correction of long-term trade imbalances. Even in the face of higher oil prices, the overall U.S. trade gap narrowed to $59.8 billion from a revised $60.5 billion deficit in April. If global growth is sustainable, especially in emerging markets, then U.S. multinationals and companies deriving a signficant portion of their revenues internationally should fare better than domestic based business models.
5) Import Price Inflation on the Rise: Higher oil prices are the main contributor to import inflation which registered a 2.6% bump in June to reflect a year-over-year 20.5% rate. Ex-oil, import prices increased 0.9% and 7.3% year-over-year. This is clearly pressuring businesses as it is becoming more difficult to pass costs on to an already inflation bludgeoned consumer. As productivity peaks and capacity utilization drops, profitability is ultimately impacted. This inflation will not subside unless oil prices ease and the dollar strengthens. Neither of these are foreseen in the near future.
6) American Consumers in a Funk: Consumer Sentiment came in at 56.7, close to historically low levels not seen since 1979. Inflation is beating consumers mercilessly and the only thing going down is the optimistic spirit of the American consumer.
►Summary: The stagflation story remains intact. It is worth noting that Energy joined Financials and Consumer Discretionary as the three weakest performers week-to-date. Basic Materials, on the other hand, held its ground with a slightly positive percentage change. As reiterated last week, we are in the trough phase of the economic cylce and this past week defensive sectors such as Consumer Staples, Healthcare, and Utilities proved to be reliable shelters in the storm.
Weekly & YTD Performance
|Index||Start Week||End Week||Net Chg||% Chg||YTD Chg|
ETF Sector Patrol Weekly & YTD Performance
|Sector||% Chg Weekly||YTD Chg|
|(NYSE:TTM)||(1 Yr Ago)||(Fwd)||Yield||Yield||Book|
*Source: Birinyi Associates