Stocks finish the week at record highs after the weak NFP report. The S&P 500 rose 0.4% to 2,439 and the Dow Jones rose 0.3% to 21,206. Over the course of the week those indices were higher 1% and 0.6% respectively. Today the KBW Bank index lost 0.7% while utilities rose fractionally. Economic data today showed that nonfarm payrolls rose just 138k in May compared to estimates which called for a 185k gain. The prior two months were also revised downwards by a net 66k. On the bright side the unemployment rate did decline from 4.4% to 4.3% however this could be partially attributed to a decline in the labor force participation rate. Average hourly earnings disappointed slightly as well. Average hourly earnings rose 2.5% which missed expectations by 0.1%. Investors had been expecting a strong number this morning following an ADP report yesterday that called for 253k gain in private payrolls which was significantly higher than consensus. In spite of the weak data many investors still expect a June hike from the Fed. Data yesterday also showed that the ISM manufacturing index came in at 54.9 which was slightly higher than consensus. New orders, production, employment, and import orders were signs of strength which is bullish. On that backdrop rates rallied. The two year Treasury yield finished at 1.30% and was little changed, however the 10 year Treasury yield was down 4bp to 2.16%. Accordingly 2yr vs 10yr bull flattened to 0.86%. Over the course of the week the 2yr and 10yr were unchanged and down 9bp respectively. The dollar was mostly weaker in line with the soft data. USD rose 0.2% against EUR to $1.1282. USD fell 0.3% against JPY to Y110.41. USD was little changed against GBP to $1.2891. Oil prices were lower on the day. WTI fell 1.3% to $47.74 and Brent fell 1.3% to $49.95 as investors lose confidence in Opec. The VIX closed again below 10 at 9.75. Next investors will be paying close attention Thursday to the UK election, a statement by Mario Draghi, as well as Comey’s testimony. Any one of those could bring volatility to markets.
Some investors are shifting towards longer dated Venezuelan debt relative to shorter term maturities in spite of an almost certain risk of default. Short term Venezuelan debt has performed very well over the last year as the government has managed to stay current on its payments. In February of last year a bond issued by PdVSA was trading at 36 cents on the dollar, and when it was repaid fully this year investors doubled their money in just a year. However as more and more payments come due investors are certain that the country will run out of money soon. From the investor perspective whether or not they get paid for buying a very risky bond today is a binary outcome, and many investors aren’t willing to stomach that risk. That explains why they are willing to buy longer term debt, as they are betting that the government will be forced to restructure its bonds which will be favorable for investors. The worst case scenario for holders of long dated Venezuelan bonds is that a new government refuses to pay its bonds such as Argentina or Cuba. However analysts don’t believe that will happen since Venezuela is much more dependent on access to the global market than those other countries were. Any type of bond restructuring, including lower coupons or extension of maturities is believed to be bullish for prices of Venezuelan bonds. The country also has good collateral as Venezuela has the highest amount of proven oil reserves of any country in the world. Therefore they are looking to buy the most cheaply priced bonds they can find since those will experience the biggest rally in the event of a restructuring. It goes without saying that it is obviously a risky position as the country’s economy contracted 20% in 2016 and inflation is around 800% currently. Certain long dated bonds are currently trading around 40 cents on the dollar and offer yields in excess of 16%. Some investors are facing criticism for buying the bonds, however they argue that instead blame should be cast towards the government itself and that they don’t have much of a choice since the debt is included in the index. It is a slippery slope for index providers to exclude countries based on moral or ethical judgements.
Currencies of many emerging market countries have been strengthened recently, however central banks in those central banks haven’t been intervening which is somewhat out of the ordinary. The currencies of South Korea, Taiwan, India, Russia, and Mexico are all up more than 5% on an inflation adjusted basis against the US dollar this year. Investors have been bullish on emerging markets given low volatility there which has resulted in capital inflows and currency appreciation. Year to date according to the IIF more than $20bn has flowed into emerging markets. Normally central banks in emerging market economies, as well as developed markets, don’t like having strong currencies because it makes their exports more expensive on the global market. However central banks have still refrained from buying dollars and selling local currencies to weaken the local currency because growth is still strong in many of those countries. That strategy in the past has been evidenced by rising foreign reserves in the emerging market central banks. To reflect that central banks are intervening less, increases in foreign exchange reserves have decreased from more than 12% in the case of India and Korea to around 2% per year currently. Taiwan also shows a similar pattern however not as pronounced. Additionally countries are skeptical to intervene in currency markets for fear of being labeled a currency manipulator by the US Treasury. Currently Korea and Taiwan are on the watchlist for being considered currency manipulators. There are other benefits to having strong currencies for emerging markets. It helps control inflation, and it makes it easier to pay down dollar debt. Writing more generally about emerging markets, Gabriel Sterne of Oxford Economics proposes that in countries where the majority of the external debt is denominated in local currency, it is a good bet to own debt denominated in dollars. That is because when those countries run into financial difficulties and might have problems repaying debt, they are easily able to inflate and depreciate their way out of the local currency debt. On the other hand it isn’t worth the trouble and reputational risk to defaulting on a much smaller portion of dollar denominated debt so countries tend to pay. Sterne argues that that was the case between 2011 and 2016 when emerging markets suffered a period of capital outflows and difficult economic conditions per plummeting commodity prices. More countries have been increasing their share of local currency compared to hard currency debt. Looking at a sample of 14 large emerging markets between 2014 and 2012, local currency as a percentage of total bond issuance increased from 15% to 60%. That makes it a much more favorable environment for investors who own the dollar debt Sterne suggests.
The May nonfarm payroll numbers complicate matters for the Federal Reserve. As long as economic data continues to come in as expected the Fed is on track to maintain its tightening bias, however as data comes in worse it introduces more uncertainty into their decisions. The data is sending conflicting signals to the Fed, however it is likely that the FOMC will continue with its plans to hike this month. Although the job gains this month were lackluster, the unemployment rate continues to trend lower. The last time the unemployment rate was this low was in May of 2001. Jerome Powell of the Fed yesterday suggested he expects unemployment to remain low which will over time put upward pressure on wages, inflation, and investment. The FOMC is also unlikely to be deterred by one month of bad data as they look for longer term trends and expectations. They anticipated that weak inflation numbers earlier this year had been transitory and that doesn’t seem to be stopping them from raising rates this month. The slowdown in hiring could possibly be attributed to factors that over the long term may be positive to wages, such as a shortage of skilled labor. Evidence that job openings are near all time highs could suggest this. Patrick Harker today of the Philadelphia Fed today said that the economy only needs 100k jobs added a month to maintain a healthy track so this month’s data seems like it will be unlikely to deter his view on the June vote. Since the start of the year the economy has averaged 121,000 per month job growth.