MarketView for June 25

 

Summary 

 

The major equity indexes were lower at the open on economic data, but investors quickly moved on. The economy contracted in the first quarter at an annual rate of 2.9 percent, the sharpest drop in five years, though activity was affected by a harsh winter, and there are indications that growth has since rebounded. In another negative data point, orders for durable goods unexpectedly fell 1 percent in May.

 

Nonetheless, by late in the trading day the major equity indexes had rallied sharply, led by the pharmaceuticals, while a Supreme Court ruling lifted the shares of major broadcasters. Shares of Bristol-Myers Squibb rose 3 percent to $49.73. The rally came a day after the company stated that a late-stage trial testing its immunotherapy nivolumab in advanced melanoma patients was halted early after it was determined that the drug was likely to prolong survival. Meanwhile, Pfizer gained 1.7 percent to $29.80, Merck rose 1.6 percent to $58.86.

 

Shares of CBS were up 6.2 percent to $62.48 after the Supreme Court ruled that online TV startup Aereo Inc violates copyright law by using tiny antennas to provide subscribers with broadcast network content via the Internet. Comcast chalked up a gain of 1.1 percent to $53.21. Disney, which owns ABC News, was up 1.5 percent to $83.90.

 

The S&P 500's gains followed two days of losses, putting the index on track for a decline of 0.2 percent for the week.

 

Monsanto climbed 5.1 percent to $126.73 after the world's largest seed company raised the low end of its full-year outlook and said it plans to offer debt to help finance a $10 billion stock buyback.

 

More merger news also helped the healthcare sector. Medical Action Industries rose 93.5 percent to $13.68 on its heaviest one-day volume ever after Owens & Minor agreed to buy the supplier of disposable medical products for about $208 million. Owens rose 1.5 percent to $35.38.

 

On the downside, shares of refiners fell after officials allowed energy companies to export light crude oil, or condensate. Valero Energy, down 8.3 percent at $51.35, was the S&P 500's largest percentage decliner, followed by Marathon, down 6.3 percent to $80.97.

 

Approximately 5.7 billion shares changed hands on the major equity exchanges, a number that was slightly higher than the 5.6 billion share average for the month to date, according to data from BATS Global Markets.

 

Economy Contracts

 

The Commerce Department reported on Wednesday that economy contracted at a much steeper pace than previously estimated in the first quarter to record its worst performance in five years, but there are indications that growth has since rebounded strongly. According to the Department gross domestic product fell at a 2.9 percent annual rate, instead of the 1.0 percent pace it had reported last month.

 

Growth has now been lowered by a total of 3.0 percentage points since the government's first estimate was published in April, which had the economy expanding at a 0.1 percent rate. The difference between the second and third estimates was the largest on records going back to 1976. Revisions to GDP numbers are not unusual as the government does not have complete data when it makes its initial and preliminary estimates.

 

While the economy's woes have been largely blamed on an unusually cold winter, the magnitude of the revision suggests other factors at play beyond the weather. The latest revisions reflect a weaker pace of healthcare spending than previously assumed, which caused a downgrading of the consumer spending estimate. Trade was also a larger drag on the economy than previously thought.

 

Data on employment, manufacturing and services sectors point to a sharp acceleration in growth early in the second quarter. However, the pace of expansion could fall short of expectations, which range as high as a 3.6 percent rate.

 

Some estimates show that severe weather could have slashed as much as 1.5 percentage points from GDP growth in the first quarter. The government, however, gave no details on the impact of the weather.

 

Consumer spending, which accounts for more than two-thirds of economic activity, increased at a 1.0 percent rate. It was previously reported to have advanced at a 3.1 percent pace. Exports declined at an 8.9 percent rate, instead of a 6.0 percent pace, resulting in a trade deficit that sliced off 1.53 percentage points from GDP growth. Weak export growth has been tied to frigid temperatures during the winter.

 

Other drags to first-quarter growth included a slow pace of restocking by businesses, a sharp drop in investment on non-residential structures such as gas drilling and weak government spending on defense.

 

Businesses accumulated $45.9 billion worth of inventories, a bit less than the $49.0 billion estimated last month. Inventories subtracted 1.70 percentage points from first-quarter growth, but should be a boost to second-quarter growth.

 

A measure of domestic demand that strips out exports and inventories expanded at a 0.3 percent rate, rather than a 1.6 percent rate.

 

Durable Goods Fall

 

The Commerce Department said orders for long-lasting U.S. manufactured goods fell 1.0 percent in May. Orders for these items, which range from toasters to aircraft that are meant to last three years or more, fell for the first time in three months. They were dragged down by weak demand for transportation, machinery, computers and electronic products; electrical equipment, appliances and components; as well as a 31.4 percent plunge in defense capital goods orders.

 

Non-defense capital goods orders excluding aircraft, a closely watched proxy for business spending plans, increased 0.7 percent after declining by a revised 1.1 percent in April. The expectation had been  for these so-called core capital goods to increase 0.5 percent after April's previously reported 1.2 percent fall. The increase in core capital goods points to some pick-up in business spending, which should support second-quarter growth.

 

While the economy has rebounded from its winter-induced slump in the first quarter, data such as retail sales and housing starts suggest growth could fall short of expectations. Growth forecasts range as high as a 3.6 percent annual pace. The economy shrunk at a 2.9 percent rate in the first quarter.

 

Core capital goods shipments rose 0.4 percent last month. Shipments of core capital goods are used to calculate equipment spending in the government's GDP measurement. They had declined 0.4 percent in April.

 

Last month, orders for transportation equipment fell 3.0 percent as bookings for civilian aircraft fell 4.0 percent. Automobile orders increased 2.1 percent. Orders excluding transportation slipped 0.1 percent after rising 0.4 percent the prior month.

 

Fed Chair Janet Yellen Has Her Own Plan

 

Federal Reserve Chair Janet Yellen wants to see wages increase at a faster rate to increase consumer spending and help workers recoup ground they lost in the last recession, but she'll have to fend off policymakers who fear that could cause inflation to surge.

 

As she seeks to maintain a consensus at the central bank, Yellen will have strong arguments in favor of nursing the recovery for longer and should be able to counter any calls for an early interest rate hike.

 

Research from the Fed's staff and her own past academic work both suggest there could be greater slack in the economy than inflation hawks believe, and that businesses in recent years have been slower to raise prices than they were previously.

 

If that is the case, then interest rates could remain lower for longer and inflation could be allowed to increase beyond the Fed's 2 percent target without fear of it losing control. It's a policy Yellen has indicated she is willing to pursue to encourage wage growth and bring as many workers as possible back into the full-time labor market.

 

The connection between faster wage gains and a healthy jobs market is emerging as a core principle Yellen, who has said she expects pay to accelerate to something close to the long-run growth rate of 3 percent to 4 percent a year from the current level of around 2 percent.

 

"My own expectation is that, as the labor market begins to tighten, we will see wage growth pick up some to the point where ... nominal wages are rising more rapidly than inflation, so households are getting a real increase in their take home pay," she said recently adding: "If we were to fail to see that, frankly, I would worry about downside risk to consumer spending."

 

Yellen has balanced her concerns over a weak labor market and slow wage growth with a commitment to price stability in the long run. And for now, she contends, there is no tension between the two because there is so much slack in the economy. However, the debate may well test the limits of the Fed's tolerance for inflation. For some policymakers, that limit is already close.

 

In comments on Tuesday, Philadelphia Federal Reserve Bank President Charles Plosser said Fed policy had already become "too passive," and the central bank needed to better explain why another year of near zero interest rates is justified. However, it also touches on a fundamental issue: Can the United States again generate the jobs and wages growth needed to support an expanding middle class?

 

Fed staff economists accepted in 2010 that labor's share of annual U.S. output, which over a decade had dropped to around 56 percent from its long-term average of around 62 percent, was unlikely to recover. Before that, the relative stability of labor's share of output had provided a benchmark for Fed forecasters, helping them to anticipate a rise in prices if labor's share of output crept above the norm, or a rise in wages if labor's share was below average.

 

But the financial crisis of 2008-2009 and the painful recovery since then has cast doubts over how wages, prices and employment will play out in the future, clouding the outlook for monetary policy and the potential date for any rate rise.

 

Over the last year Fed staff changed their main model for forecasting wage and price inflation to reflect evidence that companies were adjusting prices more slowly than in prior years. That implies the Fed has more time to allow wages to rise and employment to expand before having to be concerned about inflation accelerating.

 

Yellen's own academic work describes the potential benefits of patience as the Fed approaches its first cycle of interest rate increases in six years.

 

In a 1990 paper, "Waiting for Work," co-authored with her economist husband George Akerlof and another researcher, Yellen discussed how in the wake of a downturn skilled workers might wait until wages recover before returning to the labor force, rather than accept inferior pay.

 

One issue the Fed is closely watching is whether sidelined workers will start looking for jobs again as conditions improve. The labor force participation rate has dropped steadily, from 66.4 percent at the end of 2006 to 62.8 percent last month - a level not seen since the late 1970s when participation rates were rising as more women joined the workforce.

 

Yellen also delved into an issue that has puzzled labor economists - why wages aren't typically cut in a downturn. Her research outlined a number of possibilities, including that companies realize upsetting workers may only cost companies more in the long run as some will quit or become less productive, while rehiring in a recovery will prove more costly. 

 

Yet, as economies recover, firms make up for the lack of wage cuts by keeping worker pay constant for as long as possible.

 

The San Francisco Fed tracks the percentage of workers whose wages did not rise in the prior year. The bank's "Wage Rigidity Meter" remains near an all-time high - evidence it will take more time before the type of wage-growth Yellen hopes to see.

 

San Francisco Federal Reserve Bank President John Williams was explicit in a recent paper, saying the Fed "should trade a transitory period of excessive inflation" for stronger job markets.

 

Business owners and analysts in labor-intensive industries paint a muddled picture on the ground of firms that will remain reluctant to hire unless they are jolted to a new level of certainty that the economy will expand and that the incomes of their customers will grow.

 

Restaurants are one of the industries that can pull less skilled and discouraged workers back into the labor force. Industry officials say there is little evidence restaurant wages, staffing levels or revenues are poised for liftoff.

 

In the building industry, one of the sectors that continues to worry the Fed, entrepreneurs and analysts describe an economy poised for better performance - but lodged in a circular, you-go-first stare-down among consumers, businesses and banks, with the unemployed stuck on the sidelines.