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Fed chief seeks to calm; Detroit seeks protection

July 19, 2013

Vanguard's Economic Week in Review

Given the volatility in financial markets triggered when the Federal Reserve indicated it might start to scale back economic stimulus measures later this year, Federal Reserve Chairman Ben Bernanke this week sought to calm concerns during testimony before Congress. He reiterated that the central bank won't begin to change course until the economy recovers further.

This week's other big economic story was Detroit's Chapter 9 bankruptcy filing. Even though the Motor City's economy has been struggling for several decades, this step is an unusual one that's already facing opposition from city employees and pension funds.

For the week ended July 19, 2013, the S&P 500 Index rose 0.7% to 1,692 (for a year-to-date total return—including price change plus dividends—of 20%). The yield on the 10-year U.S. Treasury note fell 11 basis points for the week to 2.50% (for a year-to-date increase of 72 basis points).

Fed will let the economy be its guide

Plans to pull back on bond buying designed to stimulate the economy "are by no means on a preset course," the Fed chairman told the House Financial Services Committee during his biannual testimony. Mr. Bernanke stressed that the Fed will slow its bond buying—known as quantitative easing or QE—only if economic conditions warrant. The purchases are aimed at holding down long-term interest rates, making it cheaper for consumers and businesses to borrow. Mr. Bernanke said that the Fed could reduce its QE buying more quickly "if economic conditions were to improve faster than expected, and inflation appeared to be rising decisively back toward our objective."

Still, based on current conditions, it appears the Fed is in no rush to change course. "With unemployment still high and declining only gradually, and with inflation running below the Committee's longer-run objective, a highly accommodative monetary policy will remain appropriate for the foreseeable future," Mr. Bernanke said. He repeated that the Fed also intends to continue its policy of near-zero interest rates for an extended period.

While there have been signs of improvement, especially in labor and housing, economic growth has slackened in 2013 compared to 2012. Mr. Bernanke credited some of the slowdown to federal spending cuts, known as the sequester, which he classified as a "strong headwind." He told Congress the Fed also stands ready to take additional action if the economy weakens. "If needed, the Committee would be prepared to employ all of its tools, including an increase [in] the pace of purchases for a time, to promote a return to maximum employment in a context of price stability," he said.

"Chairman Bernanke and Fed governors have been attempting to calm market fears by reiterating their stance," said Vanguard economist Andrew J. Patterson. "They've continually said that the unwinding of purchases and eventual rise in the target federal funds rate would be a long process and that actions taken during it have always been contingent on economic and financial market conditions. There's no preset course or timetable. It seems market participants may finally be listening."

Vanguard believes our clients face minimal risk from Detroit's bankruptcy.

Exposure to the city's municipal debt across all Vanguard national tax-exempt funds amounted to less than $157 million, or 0.16% of the total in that asset class, as of July 18, 2013.

All Detroit debt in Vanguard funds is insured, and the insurers have sufficient claims-paying resources should that become necessary.

Learn more »

Detroit declares bankruptcy

With more than $18 billion in debt, a population that's been shrinking for decades, and the resulting loss of tax revenue, Detroit this week became the largest U.S. city ever to file for bankruptcy protection. The Chapter 9 filing must be approved by a bankruptcy judge. Although the filing attempts to shield the city against lawsuits, city employees and Detroit's two pension funds have sued. Governing magazine reported that, overall, it's extremely rare for municipalities to declare bankruptcy, with only 13 cities or towns (about 0.06%) doing so since 2008. ("How Rare Are Municipal Bankruptcies?" by Mike Maciag, January 24, 2013.)

"The news of the Detroit bankruptcy doesn't actually come as a surprise to many municipal market investors because Detroit's structural challenges (high unemployment, shrinking population, severe financial mismanagement) are well documented," said Sarah Hammer, a senior investment analyst with Vanguard Investment Strategy Group.

"That being said, the municipal bond market remains a high-quality market with a limited history of defaults," she said. "We believe that state and local governments have the ability and willingness to make their debt service payments. Tax collections have begun to improve, and the broad U.S. economy is showing signs of sustained, albeit slow, recovery."

Beige Book reports slow but steady progress

The economy continued on its "modest to moderate" growth pace in June. Manufacturing increased in all districts but Kansas City, where storms interfered with activity. Consumers continued to help drive economic growth, with consumer sales up in most districts, thanks in part to auto sales showing some muscle. Weather was again a factor, with the New York, Philadelphia, Cleveland, Richmond, and Atlanta districts blaming weather conditions for slower sales.

Weather's reach extended beyond consumer sales to agriculture. Rain delays interfered with crop planting in the Midwest and South. Droughts affecting these districts, as well as the West, further hampered agricultural growth.

Housing was a bright spot for most districts, continuing a steady rebound. Boston, New York, Minneapolis, Kansas City, Dallas, and San Francisco in particular reported strong residential real estate markets. San Francisco was the only one of those cities that didn't also report tighter supply and upward price pressure. Philadelphia, Richmond, Cleveland, Atlanta, and Chicago noted that new home loans were on the rise, while refinancing waned. Commercial real estate also held strong for most districts. Dallas, in particular, saw strong growth in office-space leasing.

Hiring generally held steady in most districts. Demand for technology workers in the Northeast, South, and West caused wages in those areas to rise somewhat. However, wage pressures remained contained.

Autos drive sluggish growth in retail sales

Retail sales were up 0.4% in June but missed expectations of 0.8%. Consumers who've put off big replacement purchases, such as autos and auto parts (up 1.8%) and furniture (up 2.4%) for the past few years may no longer be able to wait. The sales growth was welcome in a month where sectors such as restaurants (down 1.2%) and department stores (down 1%) saw declines.

Retail sales

Business inventories barely up

Business inventories were up just 0.1% in May, slightly higher than predictions of no change. Auto/parts and furniture retailers both increased their inventories to meet demand, by 1.2% and 1.4% respectively.

Sales for the month rose 1.1% from April. Retailers have been able to meet consumer demand by increasing inventories, while wholesalers are being more cautious about getting saddled with goods. Economists expect wholesalers will need to increase inventories, which could help boost economic growth in the third quarter.

Gas prices rev up CPI

The consumer price index (CPI) increased 0.5% in June, exceeding economists' consensus estimates of 0.3%. A big driver was gasoline prices (up 6.3%), which accounted for two-thirds of the seasonally adjusted all items change. The rise in gasoline prices was tempered by a decrease in the cost of fuel oil, which was down 0.5% now that summer's warmer temperatures started kicking in. Food costs also bumped up in June, by 0.2%.

Excluding volatile food and energy prices, core CPI increased a modest 0.2%. With core CPI over 12 months at a relatively low 1.6%, there's concern among some economists about the risk of deflation. The Federal Reserve uses core CPI, along with its preferred method of personal consumption expenditures (PCE), to determine its policies.

Leading indicators flat, but long-term trend still positive

While The Conference Board Leading Economic Index® for June was unchanged from May, at 95.3, its six-month growth rate remains positive. According to The Conference Board economist Ataman Ozyildirim, the trend "suggest[s] the economy will continue expanding through the end of the year."

Another economist from The Conference Board, Ken Goldstein, noted, "The biggest uncertainties remain the pace of business spending, the improvements in consumer spending power, and the impact of slower global growth on U.S. exports."

Industrial production regains momentum

After a 0.3% drop in April and a flat month in May, industrial production saw an increase of 0.3% in June, in line with economists' expectations. Some contributors to the production rise included textiles (+ 2.3%); home electronics (+ 2.2%); and automotive products (+ 1.4%).

Multifamily home slowdown pulls housing starts down to 10-month low

An unexpected 9.9% drop in housing starts in June brought them to the lowest level (836,000) since August 2012. The 26.7% fall in starts of homes with five or more units was a big contributor to the overall decrease. Construction of multifamily homes is often more volatile than that for single family homes. There's still positive momentum year-over-year, however, with housing starts up 10.4% from June of 2012.

The economic week ahead

Reports on existing home sales (Monday), new home sales (Wednesday) and new orders for durable goods (Thursday) will be released next week.

Summary of major economic reports
Date Report Actual
value
Consensus
expected value
10-year note yield S&P 500 Index
July 15 Retail Sales (June)
Source: Commerce Department
+0.4% +0.8% –4 bp +0.1%
  Business Inventories (May)
Source: Commerce Department
+0.1% +0.0%    
July 16 Consumer Price Index (June)
Source: Labor Department
+0.5% +0.3% –2 bp –0.4%
  CPI, except food and energy (June)
Source: Labor Department
+0.2% +0.2%    
  Industrial Production (June)
Source: Federal Reserve Board
+0.3% +0.3%    
July 17 New Residential Construction (June, annualized)
Source: Commerce Department
836,000 960,000 –3 bp +0.3%
Beige Book
Source: Federal Reserve Board
   
July 18 Initial Jobless Claims (week ended July 13)
Source: Labor Department
334,000 343,000 +4 bp +0.5%
  Leading Economic Indicators (June)
Source: The Conference Board
0.0% +0.3%  
July 19       –3 bp +0.2%
    Weekly change –11 bp +0.7%

bp=basis points. 100 basis points equal 1%. For example, if a bond's yield rises from 5.0% to 5.5%, the increase is 50 basis points.

Notes

  • The economic statistics presented in this report are subject to revision by the agencies that issue them. For more information on the reports mentioned in this article, read our Guide to major U.S. economic reports.
  • All investing is subject to risk, including possible loss of the money you invest.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal alternative minimum tax. We recommend that you consult a tax or financial advisor about your individual situation.
  • Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
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