For long-term investors, it is important to look past the knee-jerk reaction of markets to economic data and events and keep a focus on long-term trends.
-David Kelly, chief global strategist, J.P. Morgan Funds
For long-term investors, it is important to look past the knee-jerk reaction of markets to economic data and events and keep a focus on long-term trends. Domestically, a case in point was the bond market reaction to Friday’s new home sales report. New home sales, according to the Census Bureau, fell by 13.4% from June to July, dropping from an annual rate of 455,000 to 395,000. This contributed to an 8 basis point reduction in 10-year Treasury yields, presumably on the assumption that a rolling-over housing market might cause the Federal Reserve to postpone its phase-out of QE.
This is most likely an over-reaction. One key point, well-known among economists but not so clearly understood by traders, is that new home sales is the flakiest report issued by the government. The underlying source data – building permits – are pretty reliable because of a big sample for the survey. The Census Bureau announced on August 16th that single-family building permits fell by 1.9% in July, give or take 0.9% at a 90% confidence level. That is to say, they are 90% confident that permits fell by between 1.0% and 2.8%. Not nice but not a disaster.
However, they follow a small subset of this sample to calculate housing starts so they concluded that single-family housing starts fell by 2.2%, give or take 9.7%. Moreover, using an even smaller subset of houses that they follow through the sales process they concluded that new home sales fell by 13.4%, give or take 14.5%. To put it more simply, the government isn’t 90% sure that new home sales fell at all.
The truth is that, while weather effects and a bounce in mortgage rates are likely having a temporary dampening effect on housing activity, the pace of housing starts in the United States (at less than 900,000 units including multi-family starts), is almost 600,000 below its 50-year average and will need to rise to meet the demands of a growing population. Affordability remains extraordinarily good relative to any benchmark other than the last few years. Moreover, higher mortgage rates, although discouraging borrowing are encouraging banks to lend, while rising home and stock prices are making it easier to raise the down payments to make housing transactions a reality. Housing will not give the Fed a valid reason to postpone tapering.
Economic numbers this week are also unlikely to justify such a delay. Although Pending Home Sales in July may have fallen, they remain well up on a year-over-year basis, while the Case-Shiller Index should show strong year-over-year price gains. Durable Goods Orders (ex-the aircraft dominated and volatile transportation sector), on Monday and the Chicago PMI Index, on Friday should confirm recent strength in manufacturing.
Meanwhile, 2Q2013 Real GDP should see a modest upward revision to about 2% as better trade numbers more than offset slower inventory accumulation, setting the stage for somewhat stronger growth in the second half of the year. This pace of growth is not enough to excite anyone, a reality that could be underlined by declines in both the Conference Board and University of Michigan measures of consumer confidence. However, with very little productivity growth or labor force growth this modest pace of expansion should still be enough to tighten the labor market and thus keep the Fed on track to begin to phase out QE before the end of the year.
This prospect of higher interest rates in the United States is having a very negative impact on many EM currencies, with the Indian Rupee, Indonesian Rupiah, Brazilian Real and Turkish Lira all falling sharply early last week in response to rising U.S. rates and now down by 10-15% year-to-date. The oft-repeated theory is that rising U.S. interest rates are sucking money out of these currencies.
Strictly speaking, of course, this doesn’t make sense from an economic perspective. U.S. overnight rates haven’t risen from their near-zero levels and aren’t likely to before the end of next year at the earliest. Meanwhile, it is hard to see how global investors could find U.S. fixed income appealing, with a slow melt-up in interest rates imposing capital losses.
The problem for EM currencies is that investors have learnt to expect rising U.S. rates to have this effect and are thus selling out of EM currencies first and asking questions later. This inflicts serious losses on those who stick with the EM currencies. The risk isn’t in higher rates themselves but in the way markets react to them.
Falling currencies are, of themselves a significant problem for EM economies as they lead to higher imported inflation and central bank attempts to stabilize the currency by raising interest rates. This week should see another example of this with Brazil likely raising its Selic overnight rate from 8.5% to 9.0% on Wednesday.
However, even with these rate hikes and considerable domestic problems in many EM economies, markets may be over-reacting. In general, currency depreciation over the past year has been greater than inflation and should remain so, leaving these nations better able to improve their current account positions. This effort will be aided by the fact that the four biggest economies in the world, the U.S., Europe, China and Japan are all in growth mode. Moreover, for the most part government finances are in much better shape than in recent decades. For long-term investors, despite all the concern about reactions to higher U.S. rates, emerging market equities look relatively attractive given their long-term growth potential. Markets may over-react but investors shouldn’t.