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Tapering in September--Not So Fast

A poor August employment report may remove tapering from the agenda for now, but investors should be careful what they wish for.

Robert Johnson, CFA, 08/24/2013

Markets bounced up and down most of the week with little change by week's end. Europe's economic data looked better, while news out of China and the U.S. was mixed.

The news at the beginning of the week was good enough to convince market participants that the tapering of the Federal Reserve's bond-buying program was at hand. Even the Fed minutes released on Wednesday seemed to suggest that the economy was on the path that the Fed anticipated when it announced that its tapering program might end soon after its June meeting (though that was before a patch of soft economic numbers was released). The 10-year U.S. Treasury bond soared above 2.9% before backing down on Friday. Tapering threats also continued to hit emerging markets hard. Investors have begun to pull funds out of emerging-markets countries, which has depressed many currencies (notably India and Brazil), in turn causing a spike in inflation and slower growth in those regions.

However, the real news this week was a round of continuing bad bulletins from the corporate sector. More weakness was reported in both the tech and retail sectors, along with major layoffs beginning at mortgage processors. Even the previously strong housing sector seemed to be taking a pause.

I've always said it is best to watch consumer spending to determine the direction of the economy, and the news there is not getting any better. This week teen retailers--including Abercrombie and Fitch ANF--and Sears Holdings SHLD joined the growing list of poor-performing retailers that now extends to Wal-Mart WMT, Macy's M, Target TGT, and Kohl's KSS. While many attribute the poor results to improved auto and housing markets that are sucking cash out of consumers' wallets, I am not buying it. Housing, which was actually much stronger at the beginning of the year, didn't seem to be much of a drag back then. Consumption data next week, which includes all the data from individual stores and also services, will shed more light on the consumers' situation through July.

I believe the softening is real and that even my conservative 2% GDP growth rate for 2013 forecast may be at risk. However, I will wait to see the July consumption numbers, the August auto sales report, and August employment data before I make a move. My caution flag has been up since this spring, and this week's announcements seem to indicate the U.S. economy has taken a turn for the worse. While a lot of people are excited about Europe and stronger manufacturing data, it is the consumer and maybe housing that are driving the ship, and those numbers have not been pretty. While the market might be temporarily excited by the push-off in the tapering program that may ensue if the economy slows as I surmise, investors will eventually realize the economic weakness isn't so fun after all.

Fed Minutes Fail to Shed Much Light
The basic gist of the Federal Reserve minutes was that the economy had improved over the previous month and was in line with what the Fed was thinking when it broached the tapering issue a month earlier. In other words, all systems were go for tapering to begin soon. However, there was little if any news on the tapering timetable or the mechanism. This caused the rates on the 10-year Treasury bond to rise above 2.9% for the first time since 2011. The U.S. has come a long way from the 1.6% rate of earlier this year, with a potential to move to 3.5%-4.0% if inflation stays in its current range. Even the normally optimistic National Association of Realtors believes that 30-year mortgages, now at 4.6% or so, could move to over 5% by year-end. There are some initial signs (new home sales) that suggest that those higher interest rates are beginning to bite.

Tapering in September--Not So Fast
First, a caveat: No matter exactly when the tapering will occur, rates will trend up to reflect the current inflation rate. Any delay in the tapering rate will just be a short-lived relief before the final deed is done. Frankly, if the buying goes on for much longer, there won't be a lot of bonds left for the Fed to buy given the shrinking budget deficit and smaller mortgage balances.

That said, the Fed's meeting of July 29-30 happened before the announcement of July's weak employment data and relatively soft housing and manufacturing data. In truth, the Fed didn't see all the large GDP revisions until its meeting was almost over. In addition, employment growth slowed noticeably in July, with most of the growth in lower-wage segments, including retail and restaurants. If the August employment report isn't any better than July's, my guess is that tapering will be off the table until the end of the year. The news flow hasn't looked great recently, with many retailers reporting soft results, the tech sector showing an unusual stumble, and mortgage bankers ramping up layoffs. One poor employment report may be enough to remove tapering from the agenda for now.

Robert Johnson, CFA, is director of economic analysis with Morningstar.

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