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Ideas & Insights / Economic Review
U.S. exports to overseas consumers/manufactures climbed by 0.4% in November (most recent statistic) to an all-time high of $142.3 billion. It was the ninth consecutive month of new record levels, as the decline in the dollar resulted in cheaper prices of U.S. products for foreign purchasers. The higher demand for American goods has likely prevented a more precipitous drop in the U.S. manufacturing sector, an area that has come under distress as of late.
U.S. construction spending unexpectedly rose in November, driven by record expenditures on government and business projects. Unfortunately, the overall index is still down 0.1% over the last year due to the continued slide in homebuilding. Note: Residential construction activity fell by the most in almost five years during November, marking the 21st straight month of declines in this segment.
Consumer confidence unexpectedly rose in December, the first increase in five months. According to the Conference Board’s survey, the end-of-the-year gain primarily reflected increased optimism about the future prospects for the U.S. economy. Some economists believe there is a strong correlation between confidence levels and the amount of consumer spending.
Consumer spending rose by a robust 1.1% in November (consensus forecast was for a 0.7% gain), the strongest monthly increase in over two years. Many analysts believe the strength in this area may be short-lived given the distinct slowdown in economic activity at the end of the 2007.
Job growth increased by 18,000 in December, far less than the 70,000 consensus forecast, and the weakest level since August 2003. For all of 2007, payroll growth registered 1.33 million, the smallest annual rise in four years. The unemployment rate, compiled as part of a separate survey, jumped to 5% in December from 4.7% in November. That’s the biggest monthly gain since April 1995, and the jobless rate now stands at the highest level in over two years.
The troubled residential real estate sector continued to weigh heavily on the economy during the quarter, as the combination of tighter lending standards and a surge in foreclosures led to a glut of properties on the market, and a subsequent decline in prices. Building permits, a gauge of future activity, fell in November (most recent statistic) to a fourteen-year low and purchases of new homes for the month dropped by 9% to the weakest level since April 1995. According to the National Association of Realtors, “The median price of existing homes will probably fall 1.9% in 2007, the first annual decline since the Great Depression.”
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, 201,950 foreclosure filings were recorded in November, 68% higher than the same month a year earlier. Nevada, Florida, and Ohio experienced the highest default rates per number of households.
Oil prices rose by 17.5% during the fourth quarter and hit a record high of $98.18/barrel on November 23rd, due to increased domestic demand with the start of the colder winter temperatures, high foreign consumption from India and China, supply shortages, tensions in the Middle-East, and the decline in the dollar. Gasoline costs followed suit, increasing by 9.1% during the period to close on December 31st at $3.043/gallon for the average price of regular unleaded. 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.
The Institute of Supply Management’s gauge of U.S. manufacturing fell in December to 47.7 from 50.8 the prior month. It was first time that activity contracted (below-50 level) since January 2007, and the weakest monthly reading in almost five years. The decline reflected a drop-off in new orders, which came in at the weakest pace since October 2001, a time when the U.S. economy was suffering from a recession.
Concerns over weaker economic conditions, declining corporate profitability, and steep losses on mortgage-related securities led to a 3.33% decline in the S&P 500 during the quarter and a 3.91% loss in the Dow. Both indices fell by an additional 4.52% and 4.88%, respectively during the first two weeks of 2008 as the risk of a soon-to-occur recession became more prominent.
The Fed’s preferred price gauge, the Personal Consumption Expenditures core index, rose at a 2.2% annual pace in November (most recent statistic), up from a 2% reading in October, and the highest level in eight months. The price index now exceeds the Central Bank’s comfort zone of between 1% and 2% in terms of inflation.
Prices of goods imported into the U.S. were unchanged in December, after climbing by 3.3% in November (due to surging oil costs), the biggest monthly jump in seventeen years. For all of 2007, prices rose by 10.9%, the largest annual increase since 1987.
The Commodity Research Bureau’s (CRB) index, a gauge of raw materials prices, rose 7.5% for the quarter and 16.74% for all of 2007. On January 3, 2008, the index hit an-all time high of 368.61.
Growth in the U.S. economy is expected to rise at a lackluster 1.5% annual rate in the first two quarters of 2008 due to expectations of continued weakness in the housing market and a projected decline in consumer spending. For all of 2008, GDP is projected to rise by 2.1%, the weakest pace in six years. Most economists believe the economy will avert a recession (a viewpoint that’s currently coming under more debate), as strong export growth and steady business expenditures cushion the down-fall.
The Personal Consumption Expenditures Price Index, the Fed’s preferred inflation gauge, is forecast to hold near current levels, as high oil and other raw material costs offset what normally would be diminished pricing power due to a lower rate of economic growth.
The unemployment rate is anticipated to rise slightly from 5% at the end of the fourth quarter to around 5.2% at this time next year. That would be the highest level since March 2005.
The U.S. economy appears to be worsening at a more pronounced level at the end of 2007 than even we expected, given the less-than-optimistic viewpoint we held over the last couple of quarters. The housing market remains in a freefall; manufacturing activity is coming under significant pressure, despite record exports; and employment, which had remained at fairly full levels for most of the year, took a considerable downturn in December. According to David Rosenberg, Chief Economist at Merrill Lynch, “At no time in the past sixty years has the unemployment rate risen 60 basis points (50 basis points is the actual cutoff) from the cycle low without the economy slipping into a recession, and here we now have the jobless rate hitting 5% in December versus the March/07 trough of 4.4%. In addition, aggregate hours worked in the economy contracted at a 0.4% annual rate in 4Q, and this comes on the heels of a 0.6% decline in 3Q. Back-to-back declines in total hours worked have always been associated with a recession.” Other indicators that don’t bode well for growth include the decline in U.S. equity market valuations and very high fuel costs, both of which can have an adverse affect on consumer spending habits going forward.
As a result of the many negative factors facing the economy, and an acknowledgment of the statistics laid out above by Merrill’s, Rosenberg, we believe there is a very high probability of a recession over the next few quarters. The degree and timing of future Fed rate reductions, along with the amount other probable government initiatives (to be discussed in greater detail in the next section) should have a great deal of bearing on the severity of the contraction.
Yields on all benchmark Treasury securities fell significantly during the fourth quarter due to speculation that the Fed would have to lower rates by a larger magnitude in order to prevent a more severe decline in the economy. Treasuries also benefited from strong “flight to quality” demand as losses mounted on some financial/insurance companies holdings of mortgage-related securities. For the quarter, the yield on the ten-year Treasury Note dropped by 56 basis points (68 bps YTD) to 4.02%. The yield on the two-year note, the most sensitive of the issues to the future direction of monetary policy dropped by a substantial 94 basis points (169 bps YTD) to 3.05%.
As a result of the aforementioned yield movements, the slope of the Treasury yield curve between two- and ten-year notes increased by 36 basis points to 97 basis points at the end of the quarter. The spread reached over a three-year high of 123 basis points on 1/11/08, as some very weak economic data led many investors to believe the Fed was behind the curve (pardon the pun) with regard to rate cuts if they were going to prevent a recession.
Heightened concerns about a recession led to even lower yield levels during the first two weeks of 2008. By 1/11/08, yields on two- and ten-year notes had dropped by 50 and 24 basis points to 2.55% and 3.78%, respectively. That’s the lowest level on the 10-year note since March 2004 and the lowest on two’s in over three years.
The Merrill Lynch U.S. Treasury Master Index rose by 3.98% over the last three months, the biggest quarterly gain in over five years. For all of 2007, the index returned 9.06%, the best annual performance since 2002.
The Fed met twice during the quarter and cut the Fed Funds rate (target overnight rate for member banks that have excess bank reserves to lend to one another) at both meetings. The rate now stands at 4.25%, the lowest level since January 2006. The Fed also reduced the discount rate (level charged on loans by the Central Bank to its member banks) by 50 basis points during the period. Note: the Fed has attempted to increase the usage of the discount window as a source of funds for banks, as there had been an unwillingness of many institutions to lend to one another due to credit worthiness-based concerns related to known and unknown sub-prime mortgage losses.
The Fed’s growing pessimism regarding their outlook for the economy/financial markets was evident during the quarter. The statement following the October 31st meeting noted that “Economic growth was solid during the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.” In contrast, The Fed policy statement on December 11th stated that “Incoming information suggests that economic growth is slowing, reflecting intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks.”
While borrowing at the discount window did rise during the last couple months of the year, the Fed acknowledged that there was still a reluctance on the part of banks to utilize this funding source, which had previously been viewed as a last resort for troubled financial institutions. In an attempt to provide (and reduce) funding rates for banks, and to overcome the stigma of the discount window, the Fed announced a new program on December 12th, called the Term Auction Facility. This program essentially called for four auctions of discounted loans (at lower rates than the discount window) for lending institutions, totaling $20 billion each. There were two auctions in December, which were met with a great deal of success, and there will be two more in January. The January auctions have since been increased to $30 billion each, and there is talk of making this facility a permanent part of the Fed’s arsenal. Note: It appears the Fed is making headway in reducing lending rates and increasing liquidity in the banking system. By the end of the year, the three month London inter-bank lending rate (libor), a gauge of bank’s willingness to lend funds to each other, fell to 4.70%, from over a six-year high of 5.73% on 9/7/07.
During the early part of 2008, statements from some Fed officials indicated what appeared to be a growing sense of concern regarding weakness in the U.S. economy. On January 9th, St. Louis Fed President, William Poole, said that “Odds of the U.S. falling into a recession have increased and are high enough to worry about.” On January 10th, Fed Chairman Bernanke stated that “The Fed isn’t forecasting a recession. We are forecasting slow growth, but there are downside risks.” On January 11th, Boston Fed President, Eric Rosengren noted that “The continued decline in residential investment has heightened the risk of a more significant downturn in the overall economy.” These comments, along with some very weak recent economic data, led many Wall Street traders to predict a larger-than-initially-anticipated 50 basis cut (consensus was for a 25bp drop) at the Fed’s January 30th meeting. Some have even suggested there might be a substantial 75 basis point drop. Note: The last time the Fed reduced more than 50 basis points was in October 1984.
The majority of economists expect the Central Bank to cut the fed funds rate by 50 basis points during the first quarter of 2008, and by an additional 25 basis points before the middle-part of the year. That would bring the Fed Funds rate down to 3.5%, the lowest level since September 2005.
Yields on two-year Treasuries are forecast to climb by about 50 basis points during 2008, as Fed rate cuts are expected to boost economic growth, leading to a possible reversal in monetary policy (higher Fed Funds) in the early part of 2009.
Investors also anticipate an upward move in ten-year Treasury yields (25-50 basis points) during 2008, as a projected better level of future economic performance leads to an increased risk of inflation.
Our viewpoint differs from the above-noted consensus forecast in that we see the economy getting considerably worse (i.e., recession), for a longer time period, before signals of a higher rate of growth become apparent. While Treasury yield levels may ultimately rise in the latter part of the year, if the Fed gets the situation under control, we believe there is a higher probability they will fall during the next couple of quarters, especially on the short-end, as the Fed will likely have to enact more rate cuts in order to avert a substantial slowdown. In addition to our prediction of more pronounced monetary easing, Treasuries may also benefit from a persistence of strong “flight to quality” demand if mortgage-related losses continue to plague corporate balance sheets.
While we believe that short-term Treasuries will perform well over the near term, and certainly like the safety of such issues given the high level of uncertainty in the economy/financial markets, we do concede that it’s not very attractive to commit funds at below 4% yield levels on longer dated Treasury investments. We therefore would recommend investors seek well-financed, high quality corporate securities that will hold up in a struggling economy, in addition to well-structured agency mortgage-backed issues that are currently available at above-average yield spreads. We also advocate select municipal bonds with high underlying credit ratings (not including the insurance enhancement) for taxable investors. Concerns over the viability of some insurance companies backing these deals have led to the availability of good quality non-taxable issues at yield levels even exceeding those of like-maturity taxable Treasury securities.
Gross Domestic Product
The U.S. economy grew at a 4.9% annualized rate in the third quarter (most recent statistic), up from a 3.8% rise in the second quarter, and the highest level in four years. The strong increase in GDP was led by a jump in inventory building and a surge in exports, as the decline in the dollar boosted oversees demand for U.S. goods. The severe downturn in the housing market continued to detract from growth during the period. Residential construction fell at an annualized 20.5% pace, the biggest decline since 1991.
Unemployment
The U.S. economy added a much less-than-expected 18,000 jobs in December (estimates were for 70,000), the weakest reading since August 2003. Payroll declines were notable in home building, retail, and manufacturing sectors. Note: It was the 18th consecutive month of shortfalls in factory employment. The unemployment rate, which is derived from a separate survey, jumped by a considerable three-tenths of a percent to 5%. That’s the highest level in over two years and the biggest monthly increase in the jobless rate since April 1995.
Producer Price Index
Prices paid to U.S. factories, farmers, and other producers unexpectedly fell in December by 0.1%, led by a decline in energy costs in the early part of the month, which has since reversed course. Note: Data is tabulated around the second week of the month. That compares to a 3.2% jump in November, the biggest monthly increase in 34 years. The core rate, which excludes volatile food and energy prices, increased by an expected 0.2% in December. For all of 2007, producer prices rose by 6.3%, the most since 1981, versus a 1.1% increase last year. The core index was up by 2%, the same gain as 2006.
Consumer Price Index
Consumer prices rose by a faster-than-expected 0.3% pace in December, after a 0.8% surge in November, which was the largest monthly gain in over two years. Cores prices (excludes volatile food and energy costs) rose by 0.2%, in line with expectations. For all of 2007, consumer prices increased by 4.1%, the most since 1990. That compares to a 2.5% gain last year. Core prices rose by 2.4% in 2007, down from a 2.6% pace the previous year.
Productivity
U.S. productivity rose at a greater-than-expected 6.3% annual rate in the third quarter (most recent statistic), the highest reading in four years. The very strong gain reflects both an increase in output due to the faster pace of economic growth during the period, and a sharp drop in hours worked. Unit labor costs, or the amount paid for each unit of production, fell at a 2% annualized rate, the biggest decline since the third quarter of 2003.
Industrial Production/Capacity Utilization
Production at U.S. factories, mines, and utilities remained unchanged in December (forecast was for a 0.2% drop), after a 0.3% gain the prior month, and a sharp 0.5% drop in October. For the last three months of the year, output fell at an annual rate of 1%. According to the Federal Reserve, that’s the first quarterly decline in a year. Capacity utilization, which measures the percentage of factory capacity in use, fell to 81.4% from an 81.6% reading in November.
Commodities
The Reuters/Jefferies CRB Index, an equal-weighted geometric average of nineteen raw materials, finished on December 31st at 358.71, up 7.5% for the quarter, and 16.74% for all of 2007. Oil was one of the leading performers for the quarter, rising by 17.5%, and hitting an all-time high of $98.18/barrel on November 23rd. Oil benefited from rising demand from India and China, declining supplies, concerns over tensions in the Middle-East, and the ongoing decline in 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) rose by a robust 12.8% in the final three months of year, as investors bought the precious metal as a hedge against inflation, and as an alternative to U.S. equity investments.
Housing
The housing market continued to come under considerable pressure during the quarter, as stricter lending standards curtailed purchases and a surge in foreclosures led to a glut of properties on the market. Sales of existing homes unexpectedly rose slightly in November (most recent statistic). However, on a year-over-year basis, sales are still down 20% and median prices have fallen 3.3% from November 2006. Sales of new homes, which are based on more current data than those of previously owned properties, dropped by a steep 9% in November to the lowest monthly level in twelve years. Over the last year, new home sales have declined by 34%, the worst twelve-month performance since January 1991.
Consumer Confidence
The Conference Board’s index of consumer confidence unexpectedly rose to 88.8 in the final month of 2007 (consensus forecast was for a drop to 86.5), up from an 87.8 reading in November, which was the lowest level in over two years. While December’s gain was welcome news due to concerns that waning optimism would lead to a drop off in consumer expenditures, the measure was still far lower than the 109.66 average over the last decade. 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 declined against the currencies of most major trading partners during the quarter due to concerns that weak U.S. 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 dollar dropped 2.2% against the Euro (down 9.5% for 2007) to finish the year at $1.459. That was the second straight annual decline versus the 13-nation European currency. Against the yen, the dollar fell 2.7% during the fourth quarter to 111.72, and was down 6.2% for the year.
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