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Following some reassuring movement on the European front, the market's attention has shifted to the other major question it has been grappling with lately global growth (or lack thereof). And on that front, this holiday-shortened weeks economic calendar promises to provide plenty of fresh information about the economy's health.
Recent economic data, both domestic and international, is pointing towards a synchronized slowdown worldwide. Europe's well known problems have pushed the region's economy into a recession, which seems to be contributing to the ongoing slowdown in China.
The overall tone of U.S. economic data has been relatively better compared to other developed regions of the world. But if this morning's very weak ISM report is a sign of things to come, then we may have to recalibrate our growth expectations. The focus now shifts to the labor market, with the June non-farm payroll report coming out on Friday. Another jobs report along the lines of what we got in the last three months will confirm that the economy is slowing down.
My feeling is that the market will take all negative economic readings in stride, hoping that it will trigger the long-awaited fresh quantitative easing (QE) program from the Fed. I can see those hopes keeping the market from getting nervous, but I can't see how more monetary easing could turn the economic tide.
Has Europe Turned the Page?
Europe is by no means fixed. But the announcements last Friday following the two-day Eurozone summit have finally put the region on course to a banking union. A lot will depend on follow through in the coming weeks and months, but it seems like the Spanish banking crisis that threatened to push the country into bailout has subsided, at least for now. The positive stock market reaction last Friday and the downtrend in Spanish and Italian bond yields show that investors broadly approve of what the leaders were able to achieve. But is there a basis for the all-around optimism or is it another instance of premature euphoria?
As is discussed here: Is Europe Fixed Already?, the market's optimism is justified. This is the first credible move towards a unified banking market and the first tentative step towards mutualizing the region's debt. But these are long-term goals and the details will take a very long time to work out and implement. One could almost guarantee that there will be disappointments and slip-ups along the way that will have a bearing on the market.
But the hope is that these political agreements will provide the European Central Bank (ECB) with enough cover to implement easing measures along the lines of the two liquidity operations (called long-term refinancing operations or LTROs) that could help sustain market confidence and smooth out the ride. With the region's economy in a recession and even Germany showing signs of deceleration, the ECB will most likely come through with a rate cut in its meeting later this week.
The Fed & The Economy
Unlike the central banks in other countries that are solely responsible for keeping inflation in check, the U.S. Federal Reserve has a dual mandate from Congress price stability (controlling inflation) and ensuring full employment. While some argue that these two mandates contradict each other, the Fed had nevertheless been quite successful in making headway on both counts up until the Great Recession came along.
No one can accuse the Fed of being cautious in coming to the economy's rescue. After exhausting the conventional monetary tools at their disposal, they resorted to a number of unconventional tools to conduct monetary policy. They relied heavily on their enormous balance sheet, which has expanded from under $1 trillion before the downtrend to almost $3 trillion now. They conducted two rounds of quantitative easing and are currently implementing the so-called Operation Twist, which in its last meeting was extended to the end of the year. But while announcing the extension to Operation Twist following its recent meeting, the Fed went to great lengths to assure the markets that they stand ready to 'do more' should conditions deteriorate further.
Given these repeated assurances, is it surprising that investors will start looking to the Fed again as they see negative or weak economic data? I think the market has been 'trained' to behave this way and will continue to do so in the coming days, as seems to be the case following this morning's disappointing ISM report. I would think that if we get a particularly weak jobs report on Friday, say a print of around 50K, the pressure will start building on the Fed to come through. The funny thing is that the Fed doesnt like to 'disappoint' the market and will likely come through with 'something' in the days ahead.
It is far from clear, however, if any fresh action from the Fed will have any traction in the underlying economy. In fact, there is little evidence to prove that more Fed QE will do anything to economic output, particularly given where interest rates are already. Given the global economic slowdown and the fiscal policy nature of the hurdles facing the economy later this year (fiscal cliff, etc.), one could easily argue that more QE may juice up the market temporarily, but will be irrelevant to jobs and the economy. That realization will eventually sink in as well.
Putting It All Together
As I mentioned on this week's Roundtable Review, the recent run of soft economic reports confirm that the all those talks of U.S. economic growth decoupled from the slowdown in China and turmoil in Europe were premature. The U.S. does not operate in seclusion to the outside world and does have trade linkages with the rest of the world, howsoever small relative to the size of its economy trade may be. The sharp drop in the New Orders and Exports sub-indexes of the June Manufacturing ISM survey confirm these global headwinds.
And we will likely start seeing more evidence of that in the coming days as the second quarter reporting season gets underway. Pre-season expectations for earnings growth in the second quarter are not much different from where we stood at this stage ahead of the first quarter reporting cycle. In the end, earnings growth in the first quarter turned out to be better than expected. A replay of that performance will make the coming reporting season a non event. But the risk of more negative guidance from management teams as a result of the global economic slowdown is there. A deterioration in the earnings outlook will become another headwind for the market.
Focus List Update
We made four changes to the Focus List this week adding and deleting two stocks each. Exiting the portfolio are Ryder Systems (R - Analyst Report) and T.Rowe Price (TROW - Analyst Report) and they get replaced by Hain Celestial (HAIN - Analyst Report) and ProAssurance Corp. (PRA - Analyst Report).
Hain Celestial is a market leader in the production, distribution, and marketing of various natural and organic foods, with brands like Earths Best, Celestial Seasoning, etc. Hain is a play on the positive demand outlook for healthy foods, which is reflected in the company's attractive growth attributes. This Zacks #1 Rank (Strong Buy) has been a strong performer this year, but it has plenty more room to go given its secular growth drivers.
ProAssurance Corp. is a property and casualty insurance company, with a focus on professional liability insurance for physicians, dentists, and other healthcare professionals. The company has an established track record, solid competitive market position, prudent operating and financial leverage, responsible loss reserve practice and conservative investments. ProAssurance also pays a stable dividend, currently yielding approximately 1.1%.
Both the deletions this week, Ryder Systems and T Rowe Price, were triggered by stock downgrades to a Zacks #4 Rank (Sell). We strictly stay away from stocks that have Zacks #4 Rank or Zacks #5 Rank (Strong Sell) as the companies are experiencing negative estimate revisions. And we know from experience that it is more than a mere mechanical process. Negative estimate revisions mean that the business outlook for the companies is turning south and the Zacks #4 Rank tells us exactly that.
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