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Ideas & Insights / Economic Review
The U.S. economy unexpectedly added a greater-than-expected 110,000 jobs in September, and payroll numbers for August were revised upward from an initially reported 4,000 decline (which would have been the first monthly shortfall in four years) to a gain of 89,000. On the negative side, the Labor Department reported that the unemployment rate climbed to 4.7% from 4.5% at the end of the third quarter. While that’s still a fairly low jobless rate from a historical perspective, it’s now at the highest level in over a year.
Despite concerns about an economic slowdown as well as the recent turmoil in U.S. and overseas credit markets, indicators at the end of the quarter showed better-than-expected spending levels on the part of the consumer. The personal consumption expenditures index rose by a higher-than-forecasted 0.6% in August (most recent statistic for this index), the strongest reading in four months. More current data from the Commerce Department noted that retail sales rose by 0.6% in September, comparing favorably to a 0.3% increase during August, and a 0.8% decline in the final month of the second quarter.
U.S. construction spending unexpectedly rose in August (most recent statistic), after two straight monthly declines, driven by the highest level of private non-residential building activity since last February. Unfortunately, growth in the overall index is still down 1.7% from August 2006 due to the continued slide in residential real estate expenditures.
The equity markets posted strong gains for the quarter, with the Dow and S&P 500 climbing a respective 4.19% and 2.03%, as Fed rate cuts and a substantial increase in temporary reserves to the banking system helped ease the lack of liquidity in the financial markets and also allayed concerns that the U.S. economy might slip into a recession. Note: The above-mentioned indices both hit record highs during the second week of October due to the continued restoration of investor confidence.
Weakness in the housing market, and its overall impact to the economy continued to be a primary concern during the third quarter. In August (most recent statistic), sales of new homes fell to the lowest annual level in seven years, and prices dropped 7.5% from the same time last year, the biggest twelve-month decline since 1970. Moreover, purchases of existing homes declined to a five year low for the month, and the supply of properties on the market rose to a record high.
Home foreclosures continued to increase substantially during the quarter, due to rising levels on existing adjustable rate mortgages, declining home prices, and previous loose lending standards. According to RealtyTrac, 223,538 foreclosure filings were recorded in September, double the number from a year earlier. Nevada, Florida, and California experienced the highest default rates per number of households.
The financial markets experienced considerable turmoil during the middle-part of the quarter, as a lack of willingness on the part of banks and investors to lend funds (due to solvency concerns amid the growing number of mortgage lender/hedge fund shutdowns, and uncertainty regarding future losses in sub-prime securitization holdings) drove up borrowing costs, or made the ability to obtain financing non-existent. Speculation increased during the quarter that even Countrywide Financial Corp., the largest U.S. mortgage lender, could face bankruptcy due to its inability to tap the commercial paper markets for funds. Note: The situation has improved somewhat at Countrywide, as the company obtained additional bank financing, including a preferred stock investment purchase from Bank of America. By the end of the quarter, the liquidity concerns in the financial markets began to ease after the Fed lowered rates, increased temporary reserves, and encouraged even well-capitalized banks to obtain resources at the Fed window, a source of funds that had previously been viewed as a last resort for troubled financial institutions.
Oil prices rose almost 16% during the quarter and hit a record high of $83.32 on September 20th, due to reports of falling supplies, the threat of refinery closures during the busy hurricane season, and a decline in the value of the dollar. 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.
In September, consumer confidence declined to the lowest reading in almost two years as weakness in the real estate sector and concerns that the labor market might be softening weighed on sentiment levels. Some economists believe there is a strong correlation between confidence levels and the amount of consumer spending.
The Fed’s preferred price gauge, the personal consumption expenditures core index, rose at a 1.8% annual pace in August (most recent statistic), down from a 1.9% reading the previous month, and the lowest level since February 2004. The price index has now remained within the Central Bank’s comfort zone of between 1% and 2% for three straight months.
Producer prices rose by a greater-than-expected 1.1% in September, led by a rise in energy prices. That followed a 1.4% decline in August, which was the lowest reading in ten-months. The core rate, which excludes more volatile food and energy costs, increased by a more moderate 0.1% in the final month of the quarter.
Import prices rose by 1% in the final month of the quarter, after a 0.3% decline in August. The index of overseas prices that excludes oil fell by 0.2%, the biggest decline in eleven months.
The dollar fell to a record low versus the Euro and against a basket of six other major world currencies (The Dollar Index). A weak dollar increases the risk of inflation because it can drive up the cost of goods purchased from overseas companies.
Growth in the U.S. economy is expected to fall to a lackluster 1.8% annual rate in the fourth quarter and then rise slightly into the low 2% area for the first two quarters of 2008. The lower-than-potential GDP estimates reflect weakness in the housing market (and a drop in related purchases), as well as an expected slow rise in the jobless rate, which could negatively impair consumer spending levels.
The Personal Consumption Expenditures Price Index, the Fed’s preferred inflation gauge, is forecast to hold near current benign levels, as a lower projected pace of economic growth limits price gains.
The unemployment rate is anticipated to rise slightly from 4.7% at the end of the third quarter to near 5% at this time next year. That would be the highest level since November 2005.
While we believe the U.S. economy will likely avert a recession (although it will be close), we continue to expect growth to be slower than the above-noted consensus forecast. The housing market remains extremely weak, and an end to the fall-out doesn’t appear in sight especially given the recent tightening of lending standards, high monthly foreclosure rates, declining real estate prices, and the substantial amount of adjustable rate mortgages that will soon increase to higher levels. According to UBS, “About 100,000 sub-prime mortgages a month will reset to higher rates for the first time during the next two years.” Many of these lower credit borrowers could see a considerable increase in their mortgage payments due to the low introductory (teaser) rate that often lasts for the first twenty-four months of the loan. Further mortgage defaults and a subsequent increase of properties on the market may be the end result of this rise in borrowing costs unless additional government legislation is enacted to alleviate these homeowners from rising loan payments.
Other areas of the economy that remain a concern for the near future include the gradual expected rise in unemployment rates, which could reduce consumer confidence and spending; the recent decline in manufacturing activity, despite a record increase in exports; and the surge in oil prices to all-time highs. Fortunately, the rise in crude hasn’t yet translated into higher gasoline prices, as an end to the busy summer driving season reduced demand. However, with colder winter temperatures upon us, consumers may find themselves burdened with higher home heating costs, leaving fewer funds available to purchase other goods and services that more directly drive the economy.
Yields on all benchmark Treasury securities fell significantly during the third quarter due to speculation that weaker economic activity and financial market turmoil would lead the Fed to lower interest rates. The Central Bank did cut the fed fund rates by 50 basis points in late September. Treasuries also benefited from strong “flight to quality” demand for government bonds given the rising threat of a severe liquidity squeeze (reluctance of banks to lend funds), which could result in additional company bankruptcies/shutdowns and forced sales of leveraged investments. For the quarter, the yield on the ten-year Treasury note dropped by 44 basis points to 4.59%. The yield on the two-year, the most sensitive of the issues to the future direction of monetary policy, declined by 87 basis points to 3.98%.
As a result of the aforementioned yield movements, the slope of the Treasury yield curve between two- and ten-year notes increased by about 43 basis points to 60 basis points at the end of the quarter. The spread reached 64 basis points on 9/26/07, the highest level since April 2005, as the comparative risk premium on longer-term issues rose due to concerns that the Fed rate cut (‘s) could result in increased inflationary pressures.
Yields began to climb during the first two week’s of October due to stronger-than-forecast employment data and comments by several members of the Fed indicating they might not be in a hurry to drop rates further. On October 12th, yields on two- and ten-year notes had climbed by respective 24 and 9 basis points.
The Merrill Lynch U.S. Treasury Master Index rose by 3.82% over the last three months, the biggest quarterly gain in five years. For the first nine months of 2007, the index returned 4.89%.
In order to stave off a liquidity crisis, the Fed injected $62 billion in temporary reserves into the banking system on August 9 and 10, the most since the week after September 11th, in an attempt to bring down soaring inter-bank lending rates. On August 9th the European Central Bank added a record 94.8 billion euros to their reserves after the overnight London interbank offering rate (libor) surged to over a six-year high. These moves followed news that BNP Paribas, France’s largest bank, had halted redemptions on three asset-backed funds, because they were unable to “fairly” value their holdings due to a lack of liquidity in the sub-prime mortgage market.
In a further attempt to quell disruptions in the financial markets, the Fed unexpectedly cut the discount rate (level charged on loans by the Central Bank to its member banks) on August 17th by 50 basis points to 5.75%. The Fed stated that “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably.” While the Fed window had previously been utilized as a last resort for troubled financial institutions, the Fed encouraged its use, indicating it would be viewed as “sign of strength”, not weakness.
On September 18th, the Central Bank cut the fed funds rate (target overnight rate for member banks that have excess bank reserves to lend to one another) by a larger-than-expected 50 basis points to 4.75%, and also cut the discount rate by an additional 50 basis points to 5.25%. It was the first reduction in the fed funds rate since June 2003. The Fed stated that “Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to forestall some of the adverse effects on the broader economy that might otherwise arise from the disruption in financial markets and to promote growth over time.”
The Fed was criticized by some market participants who thought the larger-than-expected cut (consensus was for a 25 basis point reduction) might increase the risk of inflation. Other analysts suggested that the cut might not have the intended consequence, as it was historically low interest rates and loose lending standards that popped the housing bubble, not tight monetary policy.
The majority of economists expect the Central Bank to cut the fed funds rate by an additional 25 basis points to 4.5% before the end of the year, and to hold it steady at that level through 2008.
Yields on two-year Treasuries are forecast to remain near current levels (4% to 4.2%) for the next several quarters before climbing slowly in the later part of next year in response to predictions of stronger economic growth.
Investors also anticipate little change in ten-year Treasury yields until the second half of 2008, with a moderate rise beginning at that point, as faster growth leads to an increased inflation risk.
Although we believe economic growth will be weaker than the consensus forecast, we are taking a cautious stance with regard to the U.S. bond market. First, as noted above, the short-end of the curve has come down considerably, with two-year Treasuries at the time of this writing (mid-October) yielding about 4.23%. Over the last twenty years, two-year Treasuries have averaged 45 basis points more than the fed funds rate, which currently stands at 4.75%. That means it would require approximately another 100 basis point reduction (or perceptions of that extent) by the Fed just to bring the short-end back to fair value. While that degree of Fed easing, and lower, is certainly attainable if the economy weakens considerably and/or financial markets conditions deteriorate further, we would look for better opportunities, such as a temporary sell-off, to allocate funds in this part of the curve. Second, despite the significant performance in Treasuries during the quarter, many other asset classes only partly (or not at all) participated in the rally due to credit concerns and subsequent spread widening. We think this situation will likely only worsen, at least in the corporate, sub-prime/alt-a and ABS CDO markets, given our expectations for weaker economic growth and more fallout in the housing market.
Despite our less-than-rosy assessment of the U.S. fixed income market, we do believe there are some areas that still offer investors good value. Although Agency CMO’s have high credit quality, spreads on these structures widened out during the quarter and currently can be bought at very attractive levels. We believe that spreads in this sector will come down over time, as investors seek high yields with low credit risk. Another area that we are advocating is longer-term Treasury and Agency Debentures, as we think that inflation concerns are overblown, and believe that pricing pressures will continue to moderate in a weaker economic environment. Note: Longer-term government securities are more sensitive than shorter-term bonds to inflation expectations. These issues may also benefit from an increase in “flight to quality” purchases if the credit-related financial market upheaval continues.
Gross Domestic Product
The U.S. economy grew at a strong 3.8% annualized rate in the second quarter (most recent statistic), down from a four-year low of 0.6% pace in the first three months of the year. Growth during the period was led by a surge in commercial construction and an increase in exports due to a weaker dollar. The personal consumption expenditures index, a measure of inflation tied to the report, rose at a 1.4% annual rate. That was the lowest reading in four years, and compares favorably to a 2.4% gain in the first quarter.
Unemployment
The U.S. economy added a greater-than-expected 110,000 jobs in September (estimates were for 100,000) and payroll gains for the prior month were revised upward by 93,000. Note: The labor department had initially reported a 4,000 decline in jobs for August, which would have been the first drop in four years. The unemployment rate (derived from a separate survey) rose by one-tenth of a percent to 4.7%, the highest level in over a year.
Producer Price Index
Prices paid to U.S. factories, farmers, and other producers rose by a greater-than-expected 1.1% gain in September after a 1.4% decline the previous month. The increase in wholesale prices, the most in seven months, reflects a jump in energy costs during the period. The core rate, which excludes the volatile food and energy components, increased by a more moderate 0.1% in the final month of the quarter. For the last twelve months, overall wholesale inflation has risen by 4.4%, up from a 2.2% annual gain in August, and the biggest year-over-year rise since June 2006. Core prices are up 2% during the last year, compared to a 2.2% twelve-month increase in August.
Consumer Price Index
Higher energy and food costs drove U.S. consumer prices up by a greater-than-expected 0.3% in September, the biggest gain in four months. The core rate, which excludes the above-noted volatile components, rose by an expected and more moderate 0.2% pace. During the last year, overall consumer prices rose 2.8%, compared to a 2% annual rise in August, which was the lowest level in ten months. The core rate rose by 2.1% in the last year, unchanged from the year-over-year reading in August.
Productivity
U.S. productivity rose at a stronger-than-expected 2.6% annual rate in the second quarter (most recent statistic), after a 1.8% increase in the first three months of 2007. The larger gain reflects an increase in output due to a faster pace of economic growth during the period. Unit labor costs, or the amount paid for each unit of production, rose at a lower-than-forecast 1.4% annualized rate, comparing favorably to a 5.2% jump in the first quarter.
Industrial Production/Capacity Utilization
Production at U.S factories, mines, and utilities rose by an uninspiring 0.1% pace in September, as weaker motor vehicle sales and a two-day strike at General Motors reduced output at automakers. For all of the third quarter, production increased by an annualized 4% rate, led by a surge in exports, which helped boost factory activity earlier in the period. That compares favorable with a 3.5% pace in the second quarter. Capacity utilization, which measures the percentage of factory capacity in use, remained unchanged in the final month of the quarter at 82.1%. That’s down from an eleven-month high of 82.2% in July.
Commodities
The Reuters/Jefferies CRB Index, an equal-weighted geometric average of nineteen raw materials, finished on September 30th at 333.67, up 5.68% for the quarter. Oil was one of the leading performers for the period, rising by 15.53%, and hitting an all-time high of 83.32 on September 20th. Crude benefited from lower supplies, weather-related concerns due to the hurricane season, and the falling value of the dollar. Note: Oil is denominated in dollars, so a declining currency typically requires an upward adjustment in price. In other markets, gold (also denominated in dollars) did very well, as investors bought the precious metal as a hedge against inflation. Prices rallied 14.12% and reached $742.8/oz on the last day of the quarter, the highest level since January 1980.
Housing
The beleaguered housing sector continued to suffer during the third quarter, as stricter lending standards in response to surging foreclosures and higher mortgage rates compared to earlier-in-the-year levels, reduced demand. In August, sales of existing homes fell (most recent statistic) to a five-year low and are down a substantial 13% from a year earlier. Moreover, the number of properties on the market rose to a record high of 4.58 million. During that same month, purchases of new homes registered the lowest level in seven years and average prices dropped by the most since 1970 on a year-over-year basis.
Consumer Confidence
The Conference Board’s index of consumer confidence fell to a much lower-than-expected 99.8 reading at the end of the third quarter, down from 105.6 in August. It was the weakest level in almost two-years, and reflects heightened concerns about the fall-out in the housing sector as well as deteriorating conditions in the labor market. 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 considerably during the third quarter due to speculation that the disruption in the credit markets and weaker economic growth would lead to additional Fed rate cuts and further reduce yields on U.S. government bonds as compared to overseas counterparts. Over the last three months, the U.S. currency dropped 5.09% against the Euro and ended the quarter at record low of $1.4267. Against the yen, the dollar fell 2.58% to 114.8 on September 30th.
For more information about this report contact:
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