Some Red Flags

Over the last few months we have had a rising stock market mainly driven by a reduction in risks of financial contagion in Europe and improving economic data in the US.

The main cause of improvement in Europe was due to the action taken by the ECB where they offered banks 3 year loans and also reduced the quality of the collateral they would take to secure the loans. The program called Long Term Refinancing Operation (LTRO) has allowed the banks to borrow around 1 trillion Euros. This has averted a liquidity crisis in Europe because banks had to roll over a lot of debt this year and they were having trouble raising money in the private credit markets. Now the banks have met their refinancing needs through the LTRO.

On the economic front the US economy is showing signs of improving. The jobs data has been coming in stronger than expected and the unemployment claims data has been hitting new lows not seen since 2008. Due to operation twist from the Fed we have also had no increase in yields which generally puts a damper on economic growth and the stock market.

Due to the reasons outlined above, risk assets like equities have done very well. This week though we have had two data points which are raising some red flags. One was that the Durable goods orders month over month came in quite worse than expected. They were down 4% for January and even ex-transportation (which is very volatile) they were down 3.2%. Expectations were for a flat reading. The main reason for the drop was that December was pretty good due to an expiry of tax credit, but still the drop was worse than expected. The other data point which was not good was the manufacturing ISM index which was released today morning and came in at 52.4, worse than the expectations of 54.6. Considering the good numbers coming from the employment front, one would have expected an acceleration in the economy but these numbers are sort of throwing water on those expectations. These numbers don’t point to a recession but they do lower expectations for a stronger recovery.

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