August 2016
British Bravado
UK cuts interest rates, as BOE  fails to find sellers of long bonds
US jobs recover, but GDP growth is tepid
US Housing is a bright spot
Market returns in August were mostly muted. The largest moves were in emerging markets (+.09%) and gold (-3.3%). Stocks provided modest positive returns, while bonds were down slightly:
Not much has changed from a longer term perspective: U.S. stocks have trounced all other major groups:
The month of August began with major policy announcements from the Bank of England (BOE), as it fired the opening salvo in the battle to mitigate the shock of the Brexit vote. Unveiling the biggest downgrade to domestic growth for more than 20 years, the BOE said the outlook for the UK had "weakened markedly". They cut their key benchmark interest rate by a quarter point to 0.25%, the lowest level ever. They also signaled that the rate could go even lower in the months ahead.
In addition, the bank also launched a huge new 100 billion funding program that offers banks cheap 4-year loans in order to lend to households and businesses. Lastly, the BOE will commence a new bond buying program of 70 billion, which will include the purchase of corporate (private) bonds. Overall the measures were much larger than markets anticipated, driving the British pound down and the 10-year UK government bond yield down to a record low. There will most likely be more (accommodative) policy changes in the coming months. The British bravado is only beginning!
Source: The Financial Times       
The UK rate cuts continue the story of the "race to zero" that began in 2008, as central banks globally cut rates to jump-start growth. (So far nothing has worked, but hey, what's a few more billion between friends?) Contrary to the popular script, interest rates continue to do down. Negative rates are forcing investors to buy yield wherever they can find it, and hang onto that which they've bought.
As an example, in a little noticed story on August 10, the Bank of England offered to buy 1.17 billion in bonds with a maturity greater than 15 years as part of their normal "QE" operations. However, in an unexpected failure, they could not buy all the bonds they set out to, encountering an "offerless" market, something that has rarely if ever happened in central bank history. This is startling since the central bank is willing and able to pay any price to "satisfy its quota", yet many investors simply refused to sell - at any price!
Bloomberg and others noted that the BOE's failure to reach its target is an early warning of the challenges it may face in expanding its QE plan. The BOE has already scooped up about a third of the U.K. government bond market since 2009, so there is a shortage of long UK bonds, which are in particular demand from pension funds that hold the securities to match their liabilities. This is a classic supply/demand imbalance that receives almost no mention for contributing to the persistence of ultra-low interest rates.
Now, there appears to be a pervasive lack of willing sellers, who are desperate to keep the yield they have (which typically can be found in longer maturity bonds). But the BoE has a big problem, as they just announced plans to increase its holdings of government securities by 60 billion pounds over the next six months. The bond fail in August doesn't suggest a deep and liquid market in UK gilts. Instead it begs the question, how low must yields / how high must prices go to entice sellers? And, if the BOE is the only buyer, what happens when they need to unload the estimated 465 billion in bonds on their balance sheet? (The same could be said of the US Federal Reserve.)
In U.S. economic news, the labor department reported on August 5th that the U.S. economy added 255,000 jobs in July, well above the expected 180,000. The unemployment rate remained unchanged at 4.9 percent. "The jobs report was incredibly impressive," said J.J. Kinahan, chief strategist at TD Ameritrade. "What I think it did, is it took the May report and made it into an anomaly." (May's jobs report was a shockingly low 38,000.)
The highlight of the report was the 2.6% year-over-year increase in average hourly earnings, near the highest level seen over the last seven years: 
Overall, the July employment report produced good economic data, with strong and relatively broad-based job growth, higher wage growth, and an increase in the average workweek. This report, when combined with the strong report for June, strengthens the argument that the Fed has a data-driven rationale to raise the fed funds rate at least one time before the end of the year.
Later in the month, the GDP release showed that the U.S. economy grew at a rather weak +1.1% annualized rate in the second quarter, on the heels of weaker business investment and government spending (the original estimate had been for a +1.2% gain):   
Personal consumption expenditures increased at an annual rate of +4.4% for the quarter with strong growth in durable goods purchases of 9.9% and solid growth in services, up 3.1%. In the details of the report, corporate profits decreased -$24.1 billion in the second quarter, following an increase of +$66 billion in the first. Adjusted pretax corporate earnings dropped -1.2% to mark the fifth earnings decline in the last six quarters. Market pundits point out that, unless profits turn up again, the economy is unlikely to grow much faster.
Lastly, the U.S. housing market is showing signs of renewed vigor. The Commerce Department reported in August that new home sales rose +12.4%, to a seasonally adjusted annual rate of 654,000 units. The rate was +31.3% higher than this time last year and easily beat economists' forecasts of 581,000. The median sales price of a new home last month stood at $294,600. At the current sales pace, there is a 4.3 month supply of homes on the market. (As a caveat, the government's new-home sales data can be quite volatile and comes with a large margin of error.) However, Trulia Chief Economist Ralph McLaughlin released a note stating that last month's figures "are a rare case where the year-over-year change is statistically significant, indicating the surge in sales can be taken with more than just a grain of salt." Higher wages and low interest rates seem to be working:
  Source: BofA Merrill Lynch
Pending home sales in July reached their second highest reading in a decade, as a strong jobs market and record low mortgage rates support the demand. The National Association of Realtors reported that its pending home sales index rose +1.3% in July, up +1.4% versus year ago levels, and the second strongest reading since April. For the West, the index rose to the highest level in over three years. (Pending home sales refer to when a contract has been signed, but the transaction has not yet closed.)
The National Association of Realtors also forecast that existing home sales will reach almost 5.4 million units this year, an increase of +2.8% and the highest level since 2006. These are all welcome developments that suggest the consumer is re-engaging.     
As we head into the fall, we are reminded that September and October can be tricky months. Many large institutional investors use the last calendar quarter to prepare for year end and make longer term strategic changes. We will be watching to see how these flows unfold, and how they impact the momentum of various markets and asset classes.    
Have a great month, and thanks for reading our Journal!
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