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Ideas & Insights / Economic Review
The economy created a greater-than-expected 132,000 new jobs in the final month of the quarter, and the unemployment rate held at 4.5% (near a six-year low) for a third straight month. June marked the 46th consecutive month of rising job growth at U.S. companies.
The U.S. manufacturing sector regained some momentum after some uneven performance in the prior two quarters. The Institute of Supply Management’s (ISM) factory index rose to a fourteen-month high in June, led by gains in production and new orders. Factory output in the Philadelphia area surged to the highest level since April 2005 in the final month of the quarter, and the Chicago Area index came in near a two-year high.
The equity markets rallied during the second quarter due to signs of stronger economic growth, easing inflation pressures, and a continued wave of acquisition activity by private equity firms. The S&P 500 and Dow Industrials rose by a respective 6.28% and 9.11% during the period and both indices hit all-time highs on June 4th.
Construction spending rose in May (most recent statistic) by the biggest monthly increase in over a year, driven by gains in factory and utility building projects. Unfortunately, growth in this sector is still down 2.8% from May 2006 due to the continued slide in residential activity.
Weakness in the U.S. housing market and its overall impact to the economic expansion continued to be a primary concern during the second quarter. In May, (most recent statistic) combined sales of new and existing homes fell to the lowest level in four years. Moreover, the number of existing homes on the market climbed to almost a fifteen-year high. According to the National Association of Realtors, the median home price could fall by 1.3% in 2007. That would be the first annual decline since the Great Depression in the 1930’s.
A surge in home mortgage defaults continued during the second quarter due to falling home prices, rising mortgage rates, and previous loose lending practices. According to RealtyTrac, U.S. mortgage foreclosures rose to a record 926,000 notices in the first half of 2007. In June, the number of defaults (164,644) increased 87% from the same time last year. Nevada, California, Colorado, and Florida were the hardest hit states in terms of foreclosures for the month.
Oil prices rose over 7% during the quarter to finish at a ten-month high of $70.68 per barrel and gasoline costs were up over 11% during the period, reaching an all-time high of $3.227 a gallon on May 23rd. A number of factors led to the surge in energy prices over the last three months, including increased gasoline demand in the midst of the busy summer driving season, supply concerns due to lower refinery output, and continued unrest in the oil producing country of Nigeria. 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 confidence dropped to a ten-month low in June due to concerns that rising fuel costs and a weak housing market could negatively impact job growth going forward. Some economists believe there is a strong correlation between confidence levels and the amount of consumer spending.
Sales at U.S. retailers unexpectedly fell by 0.9% in June, the biggest drop in almost two-years. Sales, excluding automobiles, declined by 0.4%, the most since last September. Analysts attributed some of the weakness to the continued fallout in residential real estate, as purchase declines were notable in housing-related items such as building materials, appliances, garden supplies, and furniture.
The Fed’s preferred price gauge, the personal consumption expenditures core index, rose at a 1.9% annual pace in May (most recent statistic), down from a 2% reading the previous month, and the lowest level since March 2004. That’s now within the Central Bank’s comfort zone of between 1% and 2% for the first time in over three years.
Consumer prices, excluding volatile food and energy costs, registered a 2.2% year-over-year gain in May (most recent statistic), down from a 2.3% rise the prior month. That’s the lowest annual increase since March 2006, and provides further evidence of a moderation in inflationary pressures.
Import prices rose by a greater-than-expected 1% in the final month of the quarter, after a 1.1% jump in May. It was the fifth straight monthly increase in this inflation measure, and according to economists, reflects rising energy costs, robust growth outside the U.S., and a weaker dollar, which makes imported goods more expensive.
Growth in the U.S. economy is expected to rebound from first quarter’s four-year low to a mid-2% to 3% range for the remainder of the year. Strong overseas economic growth and an increase in domestic business expenditures is expected to offset both a weaker level of consumer spending and the potential spillover effects from the ongoing housing market slump.
Consumer prices are forecast to rise in the mid-2% to 3% range for the next couple of quarters. This is a small increase from last quarter’s outlook in response to higher energy costs and a more robust pace of economic growth.
The unemployment rate is projected to rise slightly from its near six-year low level of 4.5% to around 4.7% by year-end.
Sentiment regarding the U.S. economy turned more optimistic during the quarter due to better-than-expected job gains, new highs in the equity markets, and strong overseas growth, which combined with a weaker dollar, resulted in record exports and revived a faltering U.S. manufacturing sector. These factors helped to overshadow the continued weakness in the U.S. housing market and, by the end of June, bond market yields had moved up considerably, as there were little expectations of a Fed rate cut in the foreseeable future.
While we are also more confident about the economy than we were a few months ago (less chance for a recession), we continue to expect that growth will be weaker than the consensus forecast. The above-noted increase in yields acts much in the same way a Fed rate hike would; by driving up borrowing costs for businesses and consumers. One area that certainly doesn’t need any additional restraint is the already besieged housing market, but that’s exactly what’s happened during the quarter, as the average 30-year mortgage rate rose by over 50 basis points. As a result, home purchases are now less affordable, and it’s more expensive for existing adjustable rate borrowers (who are likely facing significant increases in monthly payments) to refinance into fixed rate loans. We are also concerned that near record high energy costs, if sustained, could have a dampening effect on the economy, as businesses/consumers would have less disposable income and could cut back on expenditure levels.
Yields on most benchmark Treasury securities rose during the second quarter, as economic conditions improved and the odds of a Fed rate cut diminished. The yield on the two-year note rose by 28 basis points to end the quarter at 4.86%. The ten-year note’s yield increased 38 basis points to 5.02%. It had reached a greater than five-year high of 5.29% on June 12th after former Fed Chairman Alan Greenspan predicted further increases in long-term rates.
As a result of the aforementioned yield movements, the slope of the Treasury yield curve between two- and ten-year notes increased approximately 10 basis points to 16 basis points at the end of the quarter. The spread reached 22 basis points on June 22nd, the highest level since October 2005, as investors priced in less chance of a Fed rate cut, and the risk premium on longer-term issues rose in response to signals of faster economic growth and the increased potential for inflationary pressures.
Treasuries also came under pressure during the period on concerns that overseas central banks might diversify into higher yielding securities, possibly outside the U.S. According to HSBC securities, foreign investors own 80% of Treasury securities maturing in three to ten years. Many economists believe that the lower-than-historical Treasury yield levels witnessed over the last several years have been partly due to the significant overseas demand.
The Merrill Lynch U.S. Treasury Master Index fell by 0.401% over the last three months, the biggest quarterly drop in a year. For the first six months of the year, the index is still up 1.031%.
The Fed once again held rates steady at 5.25% during the second quarter. That’s now the eighth straight FOMC meeting without a change to monetary policy, and follows seventeen consecutive 25 basis point increases beginning in June 2004.
At both meetings the Fed predicted a continued “expansion of economic growth at a moderate pace over the coming quarter’s, despite the ongoing adjustment in the housing sector.” They also reiterated that “the committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.”
Given the stronger-than-expected economic data over the quarter, the likelihood of a Fed rate cut(s) quickly diminished. According to the futures market, the probability of a quarter point cut before the end of the year went from about 100% at the beginning of May to less than 25% odds at the end of the quarter. Note: back in March, the futures market was predicting two quarter point cuts by year-end.
After a rough initial start as Fed Chairman, Ben Bernanke (succeeded Alan Greenspan in February 2006) received praise from some market analysts for quite possibly orchestrating a difficult-to-achieve soft landing, i.e., applying enough restraint to reduce inflation without sending the economy into a recession.
The majority of economists expect the Fed to hold rates steady through 2008, as the economic expansion is expected to continue without a significant rise in inflation.
Yields on two-year Treasuries are forecast to stay close to 5% for the next several quarters.
Investors anticipate a very flat yield curve, with ten-year yields in the 5% to 5.25% range through mid-2008.
It was a rough quarter for the U.S. bond market, as economic indicators pointed to faster growth and the likelihood of a Fed rate cut in the near-term faded. Like many economists, we have also abandoned our forecast for a soon-to-occur rate cut; however, we continue to remain less optimistic than the current majority. As noted in our economic viewpoint, we believe the expansion faces some substantial headwinds, such as the significant weakness in the housing market and very high energy costs, both of which can negatively impact growth going forward. We are also concerned about potential losses on the large amount of sub-prime mortgages that have been bought by hedge funds/other entities (sometimes with significant leverage) as either stand-alone investments or packaged into collateralized debt obligations (CDO’s). Note: A CDO is a pool of assets that’s securitized into different tranches, with ratings as high as Aaa down to a high credit risk first loss issue. In June, a highly leveraged Bear Stearns hedge fund with significant CDO holdings was rescued by the parent company from collapse. According to a recent report by Credit Suisse, “Investor losses from CDOs could range from $26 billion to $52 billion.” On July 2nd, Deutsche Bank analysts said that “Losses from bonds backed by sub-prime mortgages made in 2006 may swell to $90 billion.” The end result of this fallout over time could be higher risk premiums on non-government securities; stricter lending standards, which could limit the number of leveraged buyouts that’s helped fuel the equity markets; and a possible “flight to quality” into Treasury securities, with a subsequent decline in yields.
Given the above-noted risks that face the economy and the credit markets, we are advising investors to continue to maintain a slightly longer duration target, as we believe yields will moderate from current levels. We also advocate a more defensive stance with regard to credit selection due to the potential for spreads to widen further as investors re-evaluate risk.
Gross Domestic Product
The U.S. economy grew at a very low 0.7% annual pace during the first quarter (most recent statistic), the weakest level in four years, and down from a 2.5% gain in the final three months of 2006. Growth during the period was restrained by a wider trade deficit, a reduction in business inventories, and a continued sharp drop-off in residential real estate spending. Note: the large decline in home construction expenditures subtracted 0.9% percentage points from GDP. The personal consumption expenditures core index, a measure of inflation tied to the report, rose by an annual 2.4% pace, the fastest since the second quarter of 2006.
Unemployment
The U.S. economy added a greater-than-expected 132,000 jobs in June (estimates were for 125,000) and payroll gains for the prior two months were revised upward by 75,000. Increased hiring was notable in service-related industries, and government payrolls rose at the fastest pace since last September. It was the 46th consecutive month of rising job growth at U.S. companies. The unemployment rate remained at 4.5% (near a six-year low and in line with forecasts) for a third straight month.
Producer Price Index
Prices paid to U.S. factories, farmers, and other producers rose by a higher-than-expected 0.9% in May (most recent statistic), led by a six-month high surge in energy costs. Core prices, which exclude volatile food and energy, increased by a more moderate 0.2% pace. Over the last year, overall wholesale inflation has risen by 4.1%, up from a 3.2% annual gain in April, and the biggest year-over-year rise since June 2006. Core prices are up 1.6% during the last year, compared to a 1.5% twelve-month increase in April.
Consumer Price Index
Higher energy costs drove U.S. consumer prices up by a greater-than-expected 0.7% in May (most recent statistic), the biggest monthly gain since September 2005. Investors were relieved, however, by a lower-than forecast 0.1% increase in core prices (excludes volatile food and energy categories) due to reduced medical care and shelter costs. During the last twelve months overall consumer prices rose 2.7%, up from a 2.6% annual pace in April. The core rate has increased 2.2% in the last year (the lowest twelve-month gain since March 2006), versus a 2.3% rise in April.
Productivity
U.S. productivity rose at a slow 1% annual rate in the first quarter (most recent statistic), after a 2.1% gain in the final three months of 2006. The sluggish pace of worker efficiency reflects a decline in production due to weak economic conditions. In fact, worker output rose by 0.6% during the period, the smallest increase in over four years. Unit labor costs, or the amount paid for each unit of production, increased by a much higher-than-expected 1.8% annual rise the first quarter, following an 8.9% surge in the prior three months.
Industrial Production/Capacity Utilization
Production at U.S factories, mines, and utilities rose by 0.5% in June, in line with expectations, and the fastest pace in four months. Analysts attribute the strong gain to increased output of automobiles, computers, and electronics. During the second quarter, production rose 2.9%, versus a 1.1% gain for the first quarter. Capacity utilization, which measures the percentage of factory capacity in use, increased to 81.7% (an eight-month high) from 81.4% in May.
Commodities
The Reuters/Jefferies CRB Index, an equal-weighted geometric average of nineteen raw materials, finished on June 29th at 315.74, relatively unchanged for the quarter and up 2.76% for the year. Wheat was the leading performer for the quarter, rising by 24.7% to record highs, due to weather-related reduced output. On the negative side, orange juice prices tumbled 42% during the period, as favorable weather conditions in Florida led to predictions for greater supplies next season.
Housing
The beleaguered housing sector continued to suffer during the second quarter, as rising mortgage rates and tighter lending standards reduced demand, while a surge in foreclosures led to a glut of properties on the market. New home sales came in below expectations for May (most recent statistic) and were down a substantial 16% from the same period a year ago. During that same month, sales of existing homes, which account for about 85% of residential real estate, fell to almost a four-year low and the number of unsold units rose to the highest level since 1992.
Consumer Confidence
The Conference Board’s index of consumer confidence declined to a weaker-than-expected 103.9 in June, down from 108.5 in May, and the lowest reading in ten months. The drop-off in sentiment levels reflects near record gasoline prices, the continued downturn in residential real estate, and concerns that the labor market might weaken. A component of the report showed that the number of people who said that jobs were plentiful fell to 27%, the lowest since last November. The Consumer Confidence Index is based on a survey of 5,000 households regarding their appraisal of present and future economic conditions.
Dollar
The yen dropped 4.54% against the dollar during the quarter to finish on June 29th at 123.18 yen (near a four-year low). It was the fourth quarterly decline for the Japanese currency versus the dollar, and reflects the continuation of the “carry trade”, a practice where investors borrow the yen in order to purchase higher yielding currencies. Note: The Bank of Japan’s overnight rate is a low 0.5%, compared to 5.25% in the U.S, 6.25% in Australia, and 8% in New Zealand. Versus the euro, the dollar fell 1.4% during the period to $1.3542 and hit an all-time low of $1.3681 on April 27. The euro continues to benefit from the increased probability of further rate hikes by the ECB, which should drive up interest rates and boost demand from overseas investors.
For more information about this report contact:
kjaskol@aps-financial.com
800-248-0620
1301 Capital of Texas Hwy.
Austin, TX 78746
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