U.S. stock prices recaptured ground lost in last Friday’s Egyptian sell-off, with the Dow and the S&P 500 closing above 12000 and 1300, respectively, for the first time since June 2008. Combined with a growing expectation that the turmoil in Egypt could end with a benign outcome, today’s robust ISM manufacturing report that its purchasing managers’ index hit its highest level since 2004 sent stock prices back above its pre-Egyptian levels and in the case of the Dow and S&P 500 to levels not seen in more than two and a half years. The risk-on trade is back, the market’s implied volatility measure has backed down to pre-uprising levels, and Treasury notes sold off Tuesday (by roughly half a point for the 10-year T-note); yields at the long end of the Treasury yield curve are at or near their 2011 highs. The twos, tens yield curve steeped to 283 basis points, highest since mid-December.
Today’s ISM purchasing managers’ report was stunningly better than market expectations, generally good news except for the 2½-year high in prices paid component index. First the good news: the overall PMI hit 60.8 in January, its highest level since May 2004; the new orders component of the survey jumped to a reading of 67.8, also a seven-year high; the employment component of the survey, which admittedly isn’t as significant as will be Thursday’s jobs reading for the bigger non-manufacturing survey, climbed to the highest level (61.7) since 1973. One difference between now and then, among other things, is that in 1973 the ISM manufacturing employment index was descending from its high, while today it is climbing, a decidedly better portent – although no guarantee that we aren’t about to descend. The leading indicators generally don’t suggest as much for the next several months at least. The effect of weather on national output, in the short run anyway, may be negative, but recent market action suggests to us that this should not be more than a temporary obstacle to the economy and stock prices.
The bad news in purchasing managers’ survey was the rise in the prices paid index to 81.5, which indicates that a sizeable majority of manufacturing industries are seeing their input costs rise. Maybe we need to rethink our belief that inflation is likely to stay relatively tame in 2011; certainly commodities prices have been stronger than expected, which in places like Egypt and China count for more of the consumer basket than in the United States, where food is 14% of the CPI and total commodities weight is 40%. More important here are labor costs, and price indications on that front are still tame, particularly when considered on a unit labor cost basis, which incorporates gains in productivity. To become ingrained in the economic system, inflation has to become a wage phenomenon as well as a price phenomenon, and to date there is little evidence of that. Still, climbing interest rates at the long end of the yield curve and the renewed uptrend in commodities prices seen of late are worthy of some worry at this point.
INVESTMENT OUTLOOK…The respectable year-end rally in stocks, fashioned out of improvement in leading economic indicators, continued early in 2011, extending the S&P 500’s total return to 100% since the market bottomed in March 2009. In reaction to the outbreak of protest and violence in Egypt, following on the same trends in Tunisia, stock market volatility, as measured by VIX, climbed back above 20% last Friday, the first time VIX has been that high in two months. To be sure, stock market volatility has since come down and in any case is still well off the awful levels of 2008-09. But, depending on the turn of events in Cairo, where Hosni Mubarak said Tuesday he will not run for re-election in the fall but protestors appear to want an earlier regime change, investors seem to be assuming for the moment that Egypt will not be the next “black swan.” We would not be surprised if the market’s flightiness of the past week is the first of the occasional bouts of volatility in 2011. For the moment, though, corporate earnings prospects remain positive, and if worse doesn’t come to worst in Egypt, the general trend of stock prices figures to be up.
Copyright © 2011 by Wright Investors’ Service, Inc.