U.S. stocks recovered from early losses just an hour into trading and held close to the cut line for most of the day, but for the second-straight session share prices got smacked in the final hour of trading to close meaningfully lower. 

This time the selling appeared to follow news that Israeli military jets were fired upon from Lebanon, which means Hezbollah is now fully involved, yet again – early Monday morning the markets were lower as conflict between Israel and Hamas increases, yet again; the flotilla raid related to the Israel/Egypt blockade of the Gaza strip is all about stopping the delivery of weapons to Hamas. 

In the end, no one can really know what moves the market in any 60-minute interval, but as we keep saying: Risks currently lurk around many corners, just waiting to jump out and scare the holders of higher-risk assets. 

Strong manufacturing and construction spending data reversed the early-session slide.  Pre-market futures trading was showing some real weakness on the heels of a weaker-than-expected factory report out of China and increasing tensions around the Gaza Strip. When the U.S. factory data was released, the markets here turned positive and European bourses, which were down 1.5%-2.0% across the board at the session’s nadir, pared losses in the final hour of their trading session.  Ultimately though, the geopolitical news appeared to erase any memory of the positive economic data earlier in the day. 

Energy, basic material and utility shares led the declines, but all 10 major industry groups closed down for the session.   Consumer staple stocks, after getting whacked over the past two weeks (quite unusual in a down market as this is the traditional safe-haven equity play), were the clear winners yesterday – off just 0.19%. 

Market Activity for June 1, 2010

Central Banking in Commodity Country

The Reserve Bank of Australia held off on raising their benchmark interest rate (known as the cash rate, the equivalent of our fed funds) yesterday morning – they had raised the rate six times in seven months.  The Aussies have gone too far in their tightening campaign and now know it.  The commodity-laden Australian economy has been almost solely fueled by massive Chinese stimulus along with the jump in commodity prices via the inflation trade.  But now that Chinese stimulus has been reined in (for fear it fosters an ever-expanding property bubble) and the inflation trade has evaporated, the Aussie central bank should be quite concerned.  Many believed the Reserve Bank would get the cash rate back to 5% (currently stands at 4.5%), but they’ll be forced to lower rates in the coming months as global economic growth is not as embedded as Aussie policy makers  thought was the case.

In other central bank action, Canada (the other major commodity economy) became the first G7 member to begin tightening by increasing their overnight rate (our fed funds equivalent) 25 basis points to 0.50%.  Unlike the Aussie’s, this does seem to be an appropriate move, and getting their benchmark rate above 1.00% is probably the right direction – unlike our Fed that remains unwilling to remove even the “emergency” level of accommodation. 

I don’t believe the global economy is ready to expand in a durable manner (particularly for these countries so dependent on high commodity prices).  It will take additional time for various economic issues to work out, but sometimes you just have to get to beginning the process of rate normalization -- even if it is accomplished in baby steps.  Holding rates at emergency levels for 18 months and counting has its consequences. 

ISM Manufacturing

The Institute for Supply Management’s manufacturing gauge decelerated, but just slightly as the figure came in at a hot 59.7 for May (a reading of 59.0 was expected).  ISM hit 60.4 in April, a level not seen since 2004 when it spent six of seven months at the robust level of 60-plus. 

The breadth of the report was pretty awesome.  New orders held at the very strong level of 65.7, the 11^th month of expansion; backlog of orders and supplier deliveries both remained right near 60, so this nationwide look is not showing the weakness some of the regional reports printed for these two measure; employment hit 59.8, a big number and the best since May 2004 when the unemployment rate stood at 5.6%; export orders rose another point to 62.0, the highest level since July 1988; inventories contracted for a second-straight month, but this appears to be due more to orders increasing than real fear of rebuilding stockpiles; the customers’ inventories fell to 32.0 from 33.0, a reading below 50 illustrates that most suppliers view their customers’ inventory level as too low – backing up the prior point on the inventory contraction. 

Factory activity is hot, but my view is it will wane as we get the August/September reports (which will be released in September and October).  At that point, factory work will test contraction mode as underlying demand is not there to meet these production increases – specifically within the export and auto markets, two areas that have fueled the manufacturing expansion. 

Construction Spending

The Commerce Department reported that construction spending was strong in April.  Total spending rose 2.7% from March (expected to come in flat), with outlays on residential building up 4.5% and commercial up 2.0%. 

It wasn’t all government-related spending either as private-sector construction jumped 2.9% -- residential up 4.4% and commercial up 1.7%.   This was the first increase in private-sector commercial in a year.  While the bounce on the commercial side was bound to occur as activity is down 20% since late 2008, I don’t think builders are going to appreciate the increase on the residential side over the next several months.

This is kind of the reverse of what we saw in those personal spending data figures on Friday, in terms of the market reaction.  On Friday, the Commerce Department reported that consumer activity fell.  While the market doesn’t want to hear this kind of thing, it is what’s necessary based on the jobs scene and household debt levels.  Conversely, while the market may like seeing some bounce in construction activity, the market fundamentals cannot support additional supply coming on line.  This will result in continued downside activity over the next year.  Particularly on the residential side of things, builders will have to compete with large increases of distressed properties hitting the market, and they’ll lose that competition – more weakness within the construction industry will ensue.

On public-sector side, residential spending rose for a third-straight month -- up 31.4% at an annual rate over these past three reporting months.  Nonresidential spending rose 2.3%.  As we enter the back-half of 2010, the government’s stimulus spending will wane. 

Have a great day!