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Ideas & Insights / Economic Review
While the U.S economy created a fewer-than-expected 51,000 jobs in September (expectations were for a 120,000 increase), payroll gains were revised upward in August by 60,000 to a six-month high of 188,000. Moreover, the unemployment rate fell during the final month of the quarter to 4.6%, matching readings in May and June for the lowest level in over five years.
After hitting a record high of $77.03 per gallon on July 14th, oil prices declined as tensions moderated in the Middle East and data on fuel supplies came in higherthan-expected. Crude prices finished the quarter at $62.91, down about 15% during the three months. According to the Automobile Association of America,
the average price of regular unleaded gasoline also fell substantially, dropping by 19% over the period to finish on September 30th at $2.33 a gallon. Lower energy costs increase the amount of funds businesses and consumers have to spend on goods and services that more directly drive economic growth.
U.S. retail sales figures excluding autos, gasoline, and building materials, the component that’s used to calculate GDP data, rose by a sharp 0.8% in the final month of the quarter. It was the strongest reading in eight months, and helped to allay some concerns that consumer spending was faltering.
Corporate profits are expected to rise by a robust 11.5% in the third quarter, according to projections by Thomson Financial. That would be the thirteenth straight quarter of double-digit earnings growth.
Equities posted a significant rally in the third quarter, as energy prices fell and it appeared the Federal Reserve had finished its two-year cycle of rate increases. The Dow Jones Industrial Average closed near a record high at the end of September and the S&P 500 climbed to around its highest level in over five years.
The housing market continued to show substantial weakness during much of the third quarter. Sales of previously owned homes declined in August (most recent statistic available) to the lowest level since the beginning of 2004, and the number of existing homes on the market rose to over a thirteen-year high. During that same month, housing starts fell to a three-year low (down almost 24% from a year earlier) and building permits, a gauge of future home construction, declined for a seventh straight month. Although new home sales posted an unexpected gain in August (up from July’s three-year low), some economists are attributing the increase to additional price reductions and incentives offered by dealers in order to reduce bloated inventories.
In contrast to the positive sentiment regarding consumer spending in the abovenoted retail sales data, other reports are showing prevailing weakness in this important segment of the economy. The Institute for Supply Management’s (ISM) service-related industry index fell to over a three-year low at the end of the quarter, and the Commerce Department’s gauge of consumer spending posted its weakest gain in nine months in August (most recent statistic available).
Activity in the manufacturing sector of the economy began to wane towards the end of the quarter, as consumer spending slowed and the production of goods related to the housing market declined. The Philadelphia-Area manufacturing index unexpectedly dropped to minus 0.4 in September from 18.5 in August. It was the biggest monthly decline since January 2001, and the first negative reading in three years. In addition, the ISM’s gauge of national factory output fell in September to the weakest level in over a year. The group’s Chairman, Norbert Ore, stated that "manufacturing is nearing the end of a cycle."
The Conference Board reported that CEO confidence regarding the state of the economy turned negative for the first time since the last recession. According to Lynn Franco, the Conference Board’s director, "The lack of confidence expressed by CEOs is a result of the recent slowdown in economic growth combined with expectations that this lackluster pace of growth will carry over into the beginning months of 2007." A decline in business leader sentiment could result in lower corporate expenditures going forward. Note: many economists are expecting a higher rate of corporate spending to help offset a projected decline in consumer purchases.
The Index of Leading Economic Indicators, a gauge that’s designed to predict future economic activity, declined in August for the second straight month. Over the last six months, the index has fallen at an annualized 1.2% pace.
The Fed’s preferred price gauge, the personal consumption expenditure’s core index, increased to an annual pace of 2.5% in August (most recent statistic). That’s the biggest year-over-year gain since April 1995, and also above the Central Bank’s comfort level of between 1% and 2%.
Employee wages were up 4% in September from a year ago, matching the previous month’s reading for the highest year-over-year pace in five years.
Large declines were seen in consumer and producer inflation data in September due to plummeting energy costs. Producer prices had the biggest drop in over three years and consumer prices fell by the most since November 2005. Note: excluding food and energy, prices were still higher than desirable, but many economists believe lower fuel costs should help in this regard over time.
Falling energy prices and a weaker level of economic growth resulted in a 12% drop in the Commodity Research Bureau’s (CRB) index, a gauge of raw materials prices, during the quarter. On October 3rd, the index declined to the lowest level since May 2005.
Weakness in the housing market is expected to spill over into other areas of the economy, resulting in a below-potential rate of growth. Most economists are forecasting GDP to rise at a lackluster 2.5% annual pace during the second half of this year and increase only slightly to 2.6% in 2007. Next year’s prediction, if true, would be the lowest growth rate since 2003, and below the two-decade average of 3.07%.
Consumer prices are expected to rise by 3% this year and then decline to the mid-2% area in 2007, as falling energy prices and a weaker level of economic growth hold price gains in check.
The unemployment rate is projected to rise moderately from its current five-year low of 4.6% to around 5% by this time next year.
We continue to believe that economic growth will weaken more substantially than the consensus forecast over the next several quarters. The housing market, which had been a major component of the most recent expansion, appears to be undergoing a severe correction, manufacturing activity is starting to wane, and confidence among business leaders is faltering. While the recent decline in energy costs has been favorable (increasing consumer/business purchasing power), prices still remain well above historical levels, and could very well go higher with the approach of colder winter temperatures and the unstable nature of the Middle East. We are also concerned that the substantial increase in interest rates by the Federal Reserve likely hasn’t fully worked its way into the system and the impact could prove much more onerous than anticipated. According to San Francisco Fed President Janet Yellen, "It will take anywhere from months to a couple of years before the economy feels the full effects of the seventeen past rate increases." As a result, we believe a "soft landing" will be difficult to achieve.
Yields on all benchmark Treasury securities declined substantially during the third quarter, as the economy began to show signs of weakness and it appeared the Fed was done raising rates during this cycle. The yield on the ten-year Treasury dropped by 51 basis points and hit a seven-month low of 4.54% on 9/25/06. The two-year note’s yield declined by 47 basis points during the quarter, and finished the period at 4.68%. The yield declines on shorter maturity issues, which are more influenced by monetary policy, reflected increased investor speculation that the Fed might have to soon start lowering rates in order to combat a weakening economy.
The yield curve inversion (short-term rates higher than long-term) widened further during the quarter, with the yield on the two-year Treasury ending six basis points higher than ten-year notes. Note: the last four recessions in the U.S. have been preceded by an inverted yield curve.
Yields began to climb higher during the final days of quarter and the first two weeks of October, as some stronger economic data and a series of statements by Fed officials warning about the increased risk of inflation reduced the likelihood the central bank would cut rates over the next six months.
The Merrill Lynch Treasury Master Index rose by a sharp 3.64% during the threemonth period due to increased signs of an economic slowdown. It was the best quarterly performance for the index in four years.
After seventeen consecutive quarter point rate hikes (a total of 425 basis points), the Federal Reserve held rates steady at 5.25% during the quarter. At both meetings, the Fed indicated that economic growth was moderating due to a cooling housing market. At the September 20th meeting the Fed suggested that the decline in energy prices would help reduce the risk of inflation.
With the economy showing signs of a slowdown, especially in the housing market, and the Fed on hold during the quarter, bond market participants reversed their forecasts for future monetary policy. The consensus outlook went from the strong possibility of another 25 basis point hike (viewpoint at the end of the second quarter) to the increased probability of a 25 basis point cut over the next six months. Some analysts even suggested the Fed would have to lower rates before the end of the year.
The likelihood of a near-term cut in rates by the Fed became more remote in early October after several members of the Fed warned about the heightened risk of inflation. On October 5th, Philadelphia Fed President, Charles Plosser, said, "We need to remain vigilant and recognize that maintaining the current stance of policy, or even firming further, may be in the best interests of the economy’s long-run performance." On October 11th, Richmond Fed president, Jeffrey Lacker, stated, "Should inflation persist around the current elevated level, firmer monetary policy would be required to restore price stability."
The Fed’s concerns about inflation were reinforced with the release of the September FOMC minutes on October 11th. The minutes noted that "Recent rates of core inflation, if they persisted, were seen as higher than consistent with price stability, and participants underscored the importance of ensuring a moderation in inflation. Members continued to see a substantial risk that inflation would not decline as anticipated by the committee."
Bond market participants are now predicting the Fed will lower rates to 5% in the second quarter of 2007, due to a slowdown in economic growth and a subsequent decline in inflation risks. They see the Fed dropping rates by another quarter point in the July though September period and holding it at that level for the remainder of the year.
Yields on two-year Treasuries are forecast to stay close to the anticipated Fed Funds rate of 4.75% for the next several quarters.
Investors anticipate a very flat yield curve, with ten-year yields in the 4.75% to 5% range through the end of next year.
We remain very optimist on the longer-term (six months to a year) performance of the U.S. bond market. The substantial weakness in the residential real estate sector and the large amount of past Fed rate hikes should have a continued dampening affect on the economy and reduce the level of inflation to a more moderate pace. We agree with the above consensus forecast that the Fed will begin to lower rates in the second quarter of 2007, but believe a larger magnitude of cuts (around 75 bps to 100 bps) will ultimately be necessary next year in order to avert a more severe slowdown. As signs of weaker economic growth become more apparent, yields should begin to decline again as we head towards the end of 2006 (falling further next year). Consequently, we view the current back-up in levels as a good buying opportunity. Note: a more precipitous drop in yields could occur, particularly on treasury/agency issues, if geopolitical risks heighten (Middle East and North Korea) and "flight to quality" demand increases.
Given our forecast for a slower rate of economic growth and more pronounced than anticipated Fed rate reductions, we are advising investors to lengthen the duration of the portfolios. We continue to favor low call risk government debentures & municipals and well-structured mortgage-backed issues in lieu of corporate securities, which could face some pressure in a weaker economy.
Gross Domestic Product
The U.S. economy grew at a weaker-than-expected 2.6% annual pace in the second quarter (most recent statistic available), down from a 5.6% rate during the first three months of the year. The slowdown in GDP reflected a decline in consumer expenditures due to high energy prices, and a substantial drop-off in homebuilding activity. Note: Residential home construction fell at an 11.1% annual pace during the three-month period, the biggest drop since 1995. Business spending was also fairly weak during the quarter, with purchases of equipment and software declining by an annualized 1.4%.
Unemployment
While the U.S. economy added a lower-than-expected 51,000 jobs in September (estimates were for a 120,000 gain), payroll data in August was revised upward by 60,000 to a six-month high of 188,000. Moreover, the labor department, in a preliminary estimate, said that job gains in the year ending in March 2006 may be adjusted higher by a substantial 810,000. The unemployment rate fell to 4.6% in September, down from 4.7% in the previous month. That matched earlier in the year levels (May and June) for the lowest reading since 2001.
Producer Price Index
Prices paid to U.S. factories, farmers, and other producers fell by a larger-than-expected 1.3% in September. It was the biggest drop in the index in over three years, and reflects the substantial decline in energy prices during the period. The core rate, which excludes volatile food and energy prices, rose by a significant 0.6% (highest since January 2005); however, the large gain was primarily due to a jump in new vehicle costs, which some analysts view as temporary. Over the last twelve months, overall prices have risen by 0.9%, down from a 3.7% increase in the year ending in August. Note: the sharp decline in year-over-year prices partly reflects the drop-off of September 2005 data, the month where energy costs spiked in the aftermath of Hurricane Katrina. The core index rose by a modest 1.2% over the last year, versus an annual 0.9% increase in August.
Consumer Price Index
U. S. consumer prices dropped by a larger-than-expected 0.5% in September, the biggest decline in almost a year, as energy prices plummeted. The core rate, which excludes volatile food and energy prices, increased by 0.2%, in line with analysts’ expectations. Over the last twelve months, overall prices have risen by 2.1%, versus a 3.8% annual pace in August (large gains in September 2005 due to Hurricane Katrina dropped out of the index). The core rate jumped by 2.9 over the last year, the biggest rise since 1996, up from a 2.8% increase in August.
Productivity
U.S. worker productivity rose at a slow 1.6% annual pace in the second quarter (most recent statistic), down from a 4.3% gain in the first three months of the year. The lower rate of efficiency was partly due to the weaker level of economic growth during the period. Note: GDP fell to an annualized 2.6% in April through June, versus a robust 5.6% rate in the first quarter. Unit labor costs, or the amount paid for each unit of production, rose by a sharp 5% in the year ending June 30, 2006, the biggest twelve-month increase since 1990.
Industrial Production/Capacity Utilization
Production at U.S. factories, mines, and utilities fell by a larger-than-expected 0.6% in September, as factories scaled back output and utility usage fell in response to cooler-thannormal temperatures. It was the first negative reading in the index since last January, and the biggest drop in a year. Capacity utilization, which measures the percentage of factory capacity in use, fell to 81.9% in September, the lowest level since May. The decline in the plant-use rate, which hit a sixyear high of 82.6 in July, helped reduce some concerns that bottle-necks might be emerging in the production process, a factor that could potentially lead manufacturers to raise prices.
Commodities
The Reuters/Jefferies CRB Index, an equal-weighted geometric average of nineteen raw materials, fell by almost 12% during the third quarter to finish on September 30th at 305.58. The drop in the index was led by a sharp decline in energy prices due to diminished tensions in the middle-east, a lack of significant hurricane activity, and reports that indicated greater than-expected fuel supplies. In other markets, gold fell by about 3% during the period to $598.6 an ounce (down from a 26-year high of $732 in May) as signs of a slower rate of economic growth and subsequent lower inflation concerns led to reduced demand for the precious metal that’s often used as a hedge against rising prices.
Housing
The much-anticipated slowdown in the housing market continued during the third quarter, as speculative activity declined and inventories rose. Sales of existing homes dropped for a fifth straight month in August (most recent statistic available), and prices declined for the first time in eleven years. Moreover, the supply of existing homes on the market rose to the highest level since 1993. Sales of new homes unexpectedly rose in August from a three-year low in the prior month; however, many economists are attributing the increase to additional price reductions and incentives offered by dealers in order to reduce bloated inventories.
Consumer Confidence
The Conference Board’s index of consumer confidence rose to a higher-than-expected 104.5 in September, up from a nine-month low of 100.2 in the prior month. Analysts attributed the rise in sentiment levels to a sharp decline in energy prices, continued strength in the labor market, and rising equity valuations during the period. Also noteworthy was a survey taken as part of the report, which showed a welcome drop in inflation expectations over the next year (4.9% forecast in September vs. 5.5% in August). The consumer confidence index is based on a survey of 5,000 households regarding their appraisal of present and future economic conditions.
Dollar
The dollar rose by 0.92% against the euro and 3.28% versus the yen during the third quarter. It was the largest gain against Japan’s currency since the final three months of last year. The greenback got a boost late in the quarter, as reports on economic growth and inflation were strong enough to limit the probability of a Fed rate cut this year. Note: the fed funds rate is currently 5.25% versus 3% in the euro-region and a low 0.25% in Japan. The higher yield differential in the U.S against its above-noted trading partners benefited the dollar due to increased demand for fixed income securities from overseas investors.
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