Looking for different investment ideas for our customers, APS Financial and its affiliates has been involved with the trading and research of high yield, giving special emphasis to out-of-favor situations, distressed, and companies in bankruptcy since 1981.
Ideas & Insights / Economic Review
The economy created a greater-than-expected 180,000 new jobs in the final month of the quarter, and the unemployment rate fell to 4.4%, matching last October’s reading for the lowest level in almost six years. March marked the 43rd consecutive month of rising job growth at U.S. companies.
The Commerce Department reported that personal income growth exceeded expectations in the first two months of the quarter (most recent statistics), as a strong labor market gave rise to more job opportunities and higher earnings potential. Over the past year, average hourly wages have increased by a robust 4% pace, close to the six-year high of 4.3% reached in December 2006.
Confidence among U.S. corporate chief executive officers turned positive during the quarter for the first time in a year. The Conference Board’s survey of business sentiment rose to 53 from 50, the second straight gain in the index. Increased confidence levels may lead to a welcome increase in corporate expenditures, an area of the economy that has shown some recent weakness.
Construction spending unexpectedly rose in February (most recent statistic) by the biggest monthly increase in almost a year, driven by gains in commercial and government expenditures. Unfortunately, growth in this sector is still down 2.4% since February 2006 due to the continued slide in residential projects.
Weakness in the U.S. housing market and its overall impact to the economic expansion continued to be a primary concern during the first quarter. In January, home prices declined from the same period twelve months ago for the first time in six years, and February sales of new homes fell to the lowest level since June 2000. Moreover, building permits for single family homes, a good predictor of future activity, dropped in February to a nine-year low.
Rising loan payments on outstanding adjustable rate mortgages, coupled with falling real estate prices and a glut of unsold properties on the market, led to a continued sharp increase in home foreclosures (especially in the sub-prime, or higher credit risk sector) during the period. According to the Mortgage Bankers’s Association, “U.S. sub-prime borrowers fell behind on their mortgages at the highest rate in four years during the fourth quarter and foreclosures begun on all types of home loans rose to an all-time high.” The trend of increasing mortgage delinquencies continued in the first quarter, with the number of foreclosures rising by 12% in February from the same month a year ago. In addition, a large number of sub-prime lenders shut down operations or filed for bankruptcy over the last several months due to the prohibitive cost of writing new business, a lack of available credit, and the inability to adhere to a provision that requires buy-backs on poorly performing new loans.
Oil prices rose almost 8% during the quarter and gasoline costs increased to over a six-month high as a number of factors, including the return of colder temperatures, refinery shut-downs, the approach of the busy driving season, and mounting tensions with Iran (intensified after the capture of British navy personnel) led to supply concerns. Note: higher energy costs reduce the amount of funds businesses and consumers have to spend on goods and services that more directly drive economic growth.
Consumer sentiment dropped to a six-month low at the end of the quarter in response to higher energy prices, rising volatility in the equity markets, and a surplus of negative news regarding home mortgage defaults.
Activity at service related industries declined in March to the lowest level in almost four years, according to the Institute of Supply Management. The group’s gauge of U.S. manufacturing activity also came in below expectations during the final month of the quarter due to weakness in both the housing market and automobile production.
The Fed’s preferred price gauge, the personal consumption expenditures core index, rose to a 2.4% annual pace in February (most recent statistic) from 2.2% the previous month. That’s above the Central Bank’s comfort zone of between 1% and 2%, and is also a level that hasn’t been exceeded since April 1995.
Producer prices rose by higher-than-expected 1% in March, reflecting a large boost in energy prices. That pushed the year-over-year gain to 3.2%, the largest annual increase since last August. Core prices, which exclude volatile food and energy costs, fortunately remained unchanged in March (expectations were for a 0.2% gain), following four straight monthly increases.
Import prices rose by a much-larger-than-anticipated 1.7% in March, up significantly from a 0.1% pace the previous month, and the highest level in almost a year. Analysts attribute much of the gain in the price of imports (which account for about 17% of goods and services purchased in the U.S.) to the recent surge in energy costs.
Growth in the U.S. economy is expected to remain below potential over the next several quarters due to the fall-out in the housing market and weak levels of business and consumer spending. Economists predict GDP will rise by an annual 2.4% in the second quarter, up from an estimated 2% in the first three months of this year. For all of 2007, growth is expected to rise at a 2.4% rate, the weakest pace in five years.
Consumer prices are forecast to rise in the low to mid 2% range between now and the end of the year. This is a moderate increase from last quarter’s outlook in response to rising fuel prices.
The unemployment rate is projected to rise from its near six-year low level of 4.4% to around 4.8% by year-end.
We continue to see a weaker pace of economic growth during this year than the above-noted consensus forecast. With the exception of a very low unemployment rate (a statistic that’s regarded as a lagging indicator) and strong job growth, there really weren’t a great deal of positive economic signals. The housing market continues to falter, and we don’t expect a rebound in this sector anytime soon. A February 23, 2007 report by Merrill Lynch noted that “going back seven cycles to 1950, the average peak-to-trough decline in residential construction from the GDP accounts is 28% and lasts an average of 10 quarters (minimum length is four quarters, max is sixteen quarters, and the median was eleven quarters). This construction downturn this time around has only been five quarters and has only seen a 12.8% decline in activity.” Given the speculative nature of our most recent housing market expansion, with the surge in foreclosures and the likely tightening of lending standards, it would seem probable that the timing of this correction would be at the longer end of the historical range. Other factors that don’t bode well for the economy include a reduction in disposable income due to higher energy prices, a manufacturing sector that appears to be just treading water, and the recent pull-back in business expenditures, an area that many analysts had expected to help compensate for a forecasted decline in spending on the consumer front. Note: corporate spending on software and equipment fell in the fourth quarter by the most since 2002. More recent statistics indicate this trend isn’t subsiding, as factory orders for capital goods excluding aircraft and military equipment (regarded as a gauge of future business investment) fell by 2.4% in February, following a very large 6.2% decline the previous month.
Yields on most benchmark Treasury securities declined during the first quarter, as weaker economic growth and a rise in mortgage foreclosures increased the potential for the Fed to cut rates later this year. The yield on the two-year Treasury, which is the most sensitive of the benchmark issues to the future direction of monetary policy, dropped the most, falling by 23 basis points to 4.57%. The ten-year note’s yield declined by six basis points to finish the period at 4.64%.
As a result of the aforementioned yield movements, the Treasury curve between two- and ten-year notes regained a positive shape (short-term rates lower than long-term) during the last couple of weeks of March, after being inverted for seven months.
Yields began to climb during the first two weeks of April, as strong employment gains, worsening inflation statistics, and harsher comments by the central bank reduced the likelihood of a near-term Fed rate cut. On April 13th, yields on two- and ten-year notes had both climbed to 4.76%.
The Merrill Lynch U.S. Treasury Master Index increased by 1.44% during the first quarter. For all of 2006, the index posted a 3.14% return.
The Fed once again held rates steady at 5.25% during the first quarter. That’s now the sixth straight FOMC meeting without a change to monetary policy, and follows seventeen consecutive 25 basis point increases beginning in June 2004.
The statement following the March 21st FOMC meeting indicated that central bank members were more pessimistic about the strength of the economy, largely due to the deteriorating conditions in the housing market. Although the Fed stressed that the risk of inflation (rather than weaker growth) was still the primary concern, they left out a reference used in the five previous releases, which noted that additional rate hikes may still be necessary. Some investors believed the Fed’s shift in language was setting the stage for possible rate cuts later in the year.
Given the strong March employment gains and worsening inflation data, it didn’t take long for the Fed to reverse its more conciliatory stance on monetary policy. In the first couple weeks in April, speeches by several Fed officials took on a much harsher tone, reiterating that inflation was still too high, and that additional rate hikes were not off the table.
As of April 13th, the likelihood of a 25 basis point cut in September stood at about 22%, according to the futures market. That’s down from expectations several weeks ago, which showed close to 100% odds for a third quarter reduction.
The majority of economists still expect the Fed to cut rates by 25 basis points late this year in response to projected weak economic growth and a subsequent diminished risk of inflation.
Yields on two-year Treasuries are forecast to stay close to their current levels of 4.76% 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.
Given our less-than-optimistic forecast for the economy this year, with predictions of a more severe housing correction and diminished levels of consumer/business spending, we believe the Fed will have to cut rates more than the consensus forecast (at least 50 basis points this year and further in 2008) in order to avert a pronounced slowdown. Although the unemployment rate stands at over a five-year low, and recent inflation statistics have worsened, these are regarded as lagging indicators and may not give a clear signal with respect to future growth. Looking back at the end of the past business cycle, a recent Bloomberg article noted that, “on November 15th, 2000, the FOMC was worried that economic growth would deteriorate because of slower investment spending, tightening lending standards, and falling stock prices. At the same time, inflation was elevated (twelve month CPI core rate was 2.6%, above the current reading of 2.5%), and unemployment was close to a 30-year low (3.9% versus current level of 4.4%). The FOMC unanimously voted to retain its bias towards inflation risks and leave rates unchanged. By January 3, 2001, the FOMC was convening an emergency session by telephone to cut the benchmark rate a half a percentage point.” Several months later the U.S. economy went into a recession. Note: each business cycle is unique in nature, and we are not yet calling for a recession (although the risk does exist). Our primary reason for the look-back in time is to illustrate how quickly things can change once conditions take a downturn.
Given our outlook for weaker economic growth and more pronounced rate cuts, we are advocating that investors increase the duration of the portfolios and look for low call-risk securities in order to take advantage of a likely decline in yields. While we are advocating a more aggressive interest rate stance, we would be more defensive in credit selection, looking for opportunities in issues that will perform well in a slowing economy.
Gross Domestic Product
The U.S. economy grew at a lackluster 2.5% annual pace in the final three months of 2006 (most recent statistic), up from an even weaker 2% rate in the previous quarter. The moderate level of GDP at the end of the year was partly due to the continued fallout in the housing market, as residential construction declined by 19.8%, the biggest drop since 1991. Growth was also limited by a sharp decline in business expenditures during the period. Note: Corporate spending on software and equipment dropped by an annual 3.2%, the largest decline in four years.
Unemployment
The U.S economy added a greater-than-expected 180,000 jobs in March (estimates were for a 130,000), and payroll gains for the prior two months were revised upward by 32,000. It was the 43rd consecutive month of rising job growth at U.S. companies. Another surprise in the Labor Department’s report at the end of the quarter was an unexpected decline in the unemployment rate by one-tenth of a percent to 4.4%. That matches last October’s reading for the lowest level in over five years, and exceeds the consensus forecast of an increase to 4.6%.
Producer Price Index
Prices paid to U.S. factories, farmers, and other producers rose by a higher-than-expected 1% in March, following a 1.3% increase the previous month. Analysts attribute most of the larger reading (consensus forecast was 0.7%) to rising fuel costs during the period. Note: Oil prices rose to a six-month high at quarter end, and gasoline prices jumped by a sharp 8.7% in March. Fortunately, the core rate, which excludes volatile food and energy prices, remained unchanged after four consecutive monthly gains. Over the last year, overall wholesale inflation has risen by 3.2%, compared to a 2.5% year-over-year rise in February. Core prices are up 1.7% during the last year, down from a 1.8% twelve-month increase in February.
Consumer Price Index
Higher energy costs drove U.S. consumer prices up by an expected 0.6% rate in March, the biggest monthly gain in almost a year. Investors were relieved, however, by a lower-than-forecast 0.1% increase in the core rate (excludes volatile food and energy categories), due to reduced costs for medical care, away from home lodging, and clothing. During the last twelve months, overall consumer prices have risen by 2.8%, up from a 2.4% annual gain in February. The core rate has increased 2.5% in the last year, a ten-month low, and down from February’s 2.7% annual rise.
Productivity
U.S. productivity rose at a slow 1.6% annualized rate in the fourth quarter (most recent statistic), after falling by 0.5% in the previous three-month period. For all of 2006, productivity increased by the same 1.6%, the weakest gain in nine years. The sluggish pace of worker efficiency over the last several quarters reflects a drop-off in output due to a cooling economy. Unit labor costs, or the amount paid for each unit of production, rose at a much-higher-than-expected 6.6% annual rate for the fourth quarter, and were up 3.2% for the year, the biggest increase since 2000.
Industrial Production/Capacity Utilization
Production at U.S factories, mines, and utilities unexpectedly fell in March by 0.2%, as a large drop in electricity usage due to very warm weather dragged down the overall index. Factory output did, however, post a surprising 0.7% gain, the strongest in a year. Note: according to analysts at Deutsche Bank, “The entire rise in manufacturing was in high-tech production, which is surprising because other measures of tech spending/demand are soft. Excluding high-tech production, manufacturing declined 0.3%.” Over the last year, industrial production rose at a 2.3% pace, the weakest annual gain since September 2005. Capacity utilization, which measures the percentage of factory capacity, fell to 81.4% from 81.6% in February.
Commodities
The Reuters/Jefferies CRB Index, an equal-weighted geometric average of nineteen raw materials, increased by 3.13% during the first three months of the year to finish on 3/30/07 at 316.88. Nickel was the leading performer for the quarter, rising by 37.4%, and hitting a record high in the middle of March, as an increase in stainless steel production led to supply concerns. Note: The manufacture of stainless steel accounts for about 75% of nickel usage. Gasoline prices also had a sharp gain for the period (up 31.8%) due to refinery shut downs and rising oil prices, which were driven higher in March following Iran’s capture of fifteen British navy personnel.
Housing
The beleaguered housing sector continued to come under pressure during the first quarter, as a surge in mortgage foreclosures due to rising rates on adjustable loans, loose credit standards over the past few years, and falling prices led to a glut of properties on the market. New home sales were hit hardest by the increase in supply, and in February (most recent statistic) purchases fell to the lowest level in almost seven years. During the same month, sales of existing homes did surprise analysts with a sharp 3.9% gain; however, this statistic is based on activity that took place a couple of months earlier and could have been bolstered by unseasonably warm temperatures. Note: Existing home sales are recorded at the time of the closing, reflecting purchase decisions that are often made during the prior two months. Conversely, sales of new homes are tabulated when the contract is signed, and are therefore considered a better gauge of industry performance.
Consumer Confidence
The Conference Board’s index of consumer confidence declined to a lower-than-expected 107.2 in March, down from a 110 reading at the end of last year, and lower than February’s five-year high of 111.2. The drop-off in sentiment levels reflects rising concerns about higher fuel costs and a surge of foreclosures in sub-prime mortgages. Continued strength in the labor market did help buffer the decline in the confidence index. In fact, a component of the report showed that the number of people who said jobs were plentiful rose by the most since August 2001. 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 fell versus the Japanese yen and the euro during the first quarter, as signs of slower U.S. economic growth and the increased potential for Fed rate cuts led to concerns of reduced investment demand (and a subsequent drop-off in the purchase of dollars) from overseas buyers. For the first three months of the year, the dollar declined 1.19% against the thirteen-nation European currency, the second straight quarterly loss, to finish on March 31st at $1.3354 per euro. The dollar also dropped 1.03% versus the Japanese currency to end the period at 117.83 yen.
For more information about this report contact:
kjaskol@aps-financial.com
800-248-0620
1301 Capital of Texas Hwy.
Austin, TX 78746
APS Financial home