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Ideas & Insights / Economic Review
The economy created a greater number of jobs than expected in the final two months of the year, and December marked the 40th consecutive month of rising payrolls at U.S. companies. The unemployment rate finished the year at 4.5%, close to the five-year low of 4.4% reached in October.
Equity markets rallied during the period, as energy prices declined and it appeared the Fed may have orchestrated a difficult-to-achieve soft landing, i.e., applying enough restraint to reduce inflation without sending the economy into a recession. The S&P 500 advanced 6.7% during the final three months of the year and returned 15.23% for all of 2006. It was the biggest quarterly gain in two years. The Dow Industrial Average hit a record high at the end of December, after rising by 7.39% for the quarter and 18.3% for the year.
Oil prices declined about 3% during the quarter to finish at $61.05 a barrel, and tumbled to $52.99 by the end of the second week in January, as unseasonably warm temperatures reduced demand. Note: crude prices are down from an all-time high of $77.03 per barrel reached in July 2006. Lower energy costs increase the amount of funds businesses and consumers have to spend on goods and services that more directly drive economic growth.
Consumer Confidence unexpectedly rose to an eight-month high in December, as a strong labor market, rising stock valuations, and lower fuel costs (from earlier in the year record levels) boosted sentiment readings. Some economists believe there is a strong correlation between higher consumer confidence and increased consumer spending.
Retail sales had the biggest increase in six months at the end of the quarter, and purchases excluding autos jumped by the most since last January, as very warm weather brought shoppers out to the malls and falling oil prices increased disposable incomes. Overall retail sales in November and December registered the strongest back-to-back gains in almost a year.
The Institute for Supply Management’s (ISM) manufacturing index contracted for the first time in over three years in November, and a gauge of manufacturing in the Philadelphia area fell in December to the weakest level since April 2003. While the ISM reported stronger-than-expected gains in the final month of the quarter, many analysts are predicting further weakness going forward. According to the ISM’s Chairman, Norbert Ore, “The manufacturing sector had a good month during December. The Index probably won’t advance much more because the economy is cooling and companies are still paring inventories.”
Construction spending fell in November (most recent statistic available), reflecting a drop in home building. It was the third straight monthly decline. While business and public works construction spending continued to show decent gains, private residential building slipped for an eighth consecutive month, and has fallen 11% from November last year.
Despite unexpected increases in new and existing home sales in November (most recent statistics available), other indicators suggest the housing market has yet to hit a bottom and will likely detract from economic growth over the near term. Building permits, a good predictor of future activity, dropped by 3% in November to a nine-year low and declined 31% from the same month last year. In addition, pending sales of existing homes, (another leading indicator) fell for a third straight month in November. Note: pending re-sales is considered a more current gauge than the widely-noted existing home purchase figures because it tracks contract signings, rather than closings, which are often based on activity from the previous couple of months.
Although U.S. sales of cars and light trucks rose in December (typically one of the better months of the year for purchases), they were down 2.6% for all of 2006, registering a total of 16.56 million units. That was the lowest number of sales since 1998. The industry may not fare any better going forward, as analysts for Ford and DaimlerChrysler are predicting even weaker sales projections for 2007.
The personal savings rate registered a minus 1.0% in November, the twentieth straight month of negative readings. Consumer expenditures are still exceeding incomes, indicating that individuals are dipping into their savings to maintain their spending levels.
The Fed’s preferred price gauge, the personal consumption expenditures core index, fell to an annual pace of 2.2% in November (most recent statistic) from 2.4% the previous month. While that was still above the Central Bank’s comfort level of between 1% - 2%, it was the lowest year-over-year gain in six months.
Core consumer prices, which exclude volatile fuel and energy costs, remained unchanged in November following seventeen straight months of increases. On a twelve-month basis, the index declined to 2.6%, the smallest year-over-year gain in six months. Note: The overall price index did rise more than expected in December; however, the bigger gain reflected higher energy costs, which fell considerably towards the end of the year and the first couple of weeks of January.
The Commodity Research Bureau’s (CRB) index, a gauge of raw materials prices, declined to the lowest level in almost two years during the second week of the new year (gauge equaled 286.06 on 1/11/07) in response to falling energy prices and concerns that a slowdown in U.S. economic growth would reduce resource demand. Note: the CRB index had reached an all-time high of 365.35 in May 2006.
On the negative side regarding inflation, employee earnings jumped by the most in eight months during December. The annual increase in earnings was 4.2%, a twelve-month gain that hasn’t been exceeded since the year ending November 2000.
Growth in the U.S. economy is expected to remain below average during the next several quarters, due to the likelihood of continued weakness in the housing market, and a drop off in consumer spending from recent strong levels, which may have been distorted by unusually warm temperatures. Most economists are expecting GDP to rise near a lackluster 2.5% annualized pace for the next few quarters with a similar increase for all of 2007.
Consumer prices are forecast to increase at a moderate 2% during 2007, down from a 2.5% gain in 2006, as weak economic growth and lower energy costs keep a lid on prices.
The unemployment rate is projected to rise moderately from its near five-year low level of 4.5% to around 4.9% by this time next year.
The negative sentiment regarding the U.S. economy, which became more pervasive in the middle of the quarter, began to fade somewhat by year-end, as oil prices declined, equity markets rallied, and job creation continued to exceed expectations. Even the much maligned housing and manufacturing sectors began to show a resurgence of activity. While there wasn’t a shortage of positive news late in the year, most economists are still calling for a below potential rate of growth over the next several quarters, as the recent rebound may have been temporarily influenced by unseasonably high winter temperatures that reduced fuel costs and bolstered consumer spending.
We also believe the economy will remain on the weak side during 2007, and continue to expect growth to come in below the consensus forecast. Despite a recent increase in home sales, we think the residential real estate market will contract further in 2007 and have a more severe effect on GDP. In a December interview, Scott Simon, Managing Director at Pacific Investment Management Co., stated, “Overall, we think the drag from housing on GDP is a minimum of 1% for the next 3 to 4 quarters. When you consider the multiplier effect that a housing slowdown could have on consumption, the impact on the economy could be even larger. Because of that multiplier effect, we think we are much more likely to have underestimated the impact on the economy than to have overestimated the effect.” Other factors that don’t bode well for the economy as we head into 2007 are the expected weakness in U.S. manufacturing (especially in the auto sector), and the substantial increase in interest rates by the Federal Reserve over the last couple of years. Because it could take as long as eighteen months for the full effects of rate hikes to work their way into the system, the end result could prove to be more restrictive than intended.
Yields on all benchmark Treasury securities rose moderately during the fourth quarter, as late-in-December economic reports indicated stronger-than-expected growth, and investors began to reduce their expectation for a near-term interest rate cut by the Federal Reserve. After falling to a ten-month low yield of 4.51% on December 5th, the two-year Treasury note finished the quarter at 4.81%, up thirteen basis points for the period. The ten-year note increased by seven basis points to 4.70% during the final three months of the year. Note: the ten-year yield declined to 4.42% on December 4th, the lowest level since January 2006, before heading north again.
A continuation of strong news on the economy sent yields even higher during the first two weeks of January 2007. The yield on the two-year climbed to 4.88% and the ten-year note rose to 4.77%.
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 eleven basis points higher than ten-year notes. Note: the last four recessions in the U.S. have been preceded by an inverted yield curve.
Despite the small sell-off during the quarter, the Merrill Lynch Treasury Master Index rose by 0.72% for the period, as income gains offset the price decline. For all of 2006 the index returned 3.14%.
The Fed once again held rates steady at 5.25% during the fourth quarter. That’s now the fourth straight FOMC meeting without a change to monetary policy, and follows seventeen consecutive 25 basis point increases beginning in June 2004.
While the Fed reiterated their ongoing concerns about inflation at the October 25th FOMC meeting, their outlook regarding the economy appeared to grow more pessimistic. They cited, “Economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market. Going forward, the economy seems likely to expand at a more moderate pace.” The above statement was modified slightly (even less optimistic) at the December 12th meeting to read, “Economic growth has slowed over the course of the year, partly reflecting a substantial cooling of the housing market. Although recent indicators have been mixed, the economy seems likely to expand at a more moderate pace on balance over coming quarters.”
The combination of weaker economic data in the middle of the quarter and the above-noted softer language by the Fed, led many investors to increase their predictions of an early 2007 rate cut. At one point, the futures market was even indicating a 100% probability for a quarter point reduction during the first three months of the New Year.
The likelihood of a near-term Fed rate cut became remote in late December and into the first couple weeks of the New Year due to a series of better-than-expected economic releases.
Despite the late-in-the-year rebound in economic activity, bond market participants are still predicting the Fed to lower rates by a quarter point during the second quarter of 2007 and to 4.75% by the end of the year. The housing market is expected to have a continued dampening effect on GDP, and the recent resurgence in consumer spending, which was likely stimulated by very high temperatures, may be difficult to sustain.
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 2007.
We remain optimist on the longer-term (six months to a year) performance of the U.S. bond market. We believe the economy will slow more substantially during the course of the year due the likely fall-out from the housing market, and the absence of growth from the manufacturing sector. We agree with the above-noted bond market consensus forecast that the latest rebound in consumer spending will likely diminish, especially if the weather turns cooler and/or energy prices climb higher. However, we believe the Fed will have to lower rates by a larger magnitude (down into the 4.25 to 4.5% area) in order to offset a more pronounced slowdown. As signs of weaker economic growth become more apparent, and inflation concerns diminish (price pressures already began to moderate during the fourth quarter), yield levels should also decline. Consequently, we view the current back-up in levels as a good buying opportunity, and are advising investors to lengthen the duration of their 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 2% annual rate in the third quarter (most recent statistic), down from a 2.6% pace in the previous three-month period. It was the weakest GDP reading since a 1.8% rate in the final quarter of 2005, and analysts attribute the slowdown to a significant drop in home building. Note: residential construction fell by an annualized 18.7%, the biggest decline since 1991. A measure of inflation tied to the GDP report, the personal consumption expenditures core price index, rose at a 2.2% annual pace, comparing favorably to a 2.7% gain in the second quarter.
Unemployment
The U.S. economy added a greater-than-expected 167,000 jobs in December (estimates were for 100,000), and payroll numbers for November were revised upward by 22,000 for a 154,000 gain. The unemployment rate held at 4.5% for the second straight month. Inflation statistics tied to the report were somewhat concerning, as average hourly earnings increased by an eight-month high in the final month of the quarter. For all of 2006, earnings rose by 4.2%, an annual level that hasn’t been exceeded since the twelve months ending in November 2000.
Producer Price Index
Prices paid to U.S. factories, farmers, and other producers rose by a higher-than-expected 0.9% in December, following a 2% increase the previous month. Analysts attribute the gain to rising energy prices, which have declined considerably since the report was tabulated (around the second week of December), and higher food costs. The core rate, which excludes volatile food and energy prices, rose 0.2% last month, after a 1.3% surge in November. For all of 2006, producer prices were up 1.1%, the slowest pace in five years, versus a 5.4% rate in 2005. The core rate increased by 2% over the last twelve months, compared to a 1.4% gain last year.
Consumer Price Index
U.S. consumer prices rose by a higher-than-anticipated 0.5% in December, following an unchanged reading the previous month. It was first gain in four months, and reflects higher energy prices that have since subsided. The core rate, which excludes volatile foods and energy costs, rose by 0.2%, in line with analysts’ expectations. For all of 2006, the consumer price index increased by 2.5%, comparing favorably to a 3.4% pace the previous year. The core rate rose by 2.6% over the last twelve months, versus a 2.17% gain in 2005.
Productivity
U.S. productivity rose at a lower-than-expected 0.2% annual rate in the third quarter (most recent statistic), as weaker economic growth reduced worker output. It was the slowest pace since the final three months of last year, and compares to a 1.2% gain in the second quarter. Unit labor costs, or the amount paid for each unit of production, rose by a slower-than-anticipated 2.3% during the period, and a 2.9% level for the twelve months ending in September. Note: The Labor Department initially estimated a much higher 5.3% increase in labor costs during the year, which would have been the most since 1982.
Industrial Production/Capacity Utilization
Production at U.S. factories, mines, and utilities rose by a stronger-than-anticipated 0.4% in December, following three consecutive monthly declines. Increased demand was seen for motor vehicles, home electronics, and business equipment. Factory output, which accounts for 80% of the index, rose by 0.7%, the most in seven months. Utility usage fell by 2.6%, due to unusually warm weather, and dragged down the overall gain in industrial production. Capacity utilization, which measures the percentage of factory capacity, rose to 81.8%, up from 81.6% in November.
Commodities
The Reuters/Jefferies CRB Index, an equal-weighted geometric average of nineteen raw materials, was relatively unchanged during the fourth quarter to finish at 307.26. For the year the index fell 6.7%, hitting a record high of 365.35 in May and a sixteen-month low of 295.13 in October. Copper prices dropped 18% during the final three months of the year due to concerns of slower U.S. economic growth and diminished demand by homebuilders for the widely-used industrial metal. Home heating oil prices declined over 5% during the period, as unusually warm winter temperatures reduced fuel usage. On the positive side, corn prices increased 49%, driven in part by strong demand from ethanol producers.
Housing
The beleaguered housing market rebounded during the quarter, as falling mortgage rates fueled purchases. Sales of existing homes unexpectedly rose in November (most recent statistic) for the second straight month. It was the first back-to-back gain since March 2005, and followed eight months of declining activity. New home sales, bolstered by a continuation of builder incentives, also exceeded forecasts with a 3.4% increase in November. On the negative side, building permits, an indicator of future real estate activity, fell to a nine-year low, suggesting the potential for further weakness in the jittery housing sector.
Consumer Confidence
The Conference Board’s index of consumer confidence rose to a much-higher-than expected 109 in December, up from a 105.9 reading at the end of the third quarter. It was the highest level in eight months and reflects the continued strength in the labor market, as well as lower fuel costs than earlier-in-the-year periods. A component of the sentiment index showed that consumers’ expectations for the economy over the next six months rose to the highest since June 2005. 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 finished the year at $1.3199 per euro, a decline of 4% during the fourth quarter and a drop of 10.3% for the year. The euro continued to benefit from expectations that the European Central Bank will continue to raise interest rates, while the U.S. Fed is forecast to maintain current policy or even cut rates sometime in 2007. That would likely further reduce the yield advantage of U.S. fixed income assets and the subsequent demand for dollars from overseas investors. Against Japan’s currency, the dollar finished relatively unchanged at 119.07 yen, gaining 0.8% and 1.1% for the quarter and the year, respectively.
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