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Ideas & Insights / Economic Review
The Index of Leading Economic Indicators, a gauge that points to the future direction of the economy, rose by 0.1% in March, following five straight months of negative readings. The index has declined at a 3.3% annual pace over the last six months, still above the 4.5% reduction that typically signifies a current or impending recession.
U.S. exports to overseas consumers/manufacturers climbed by 2% in February (most recent statistic) to an all-time high of $151.4 billion. It was the 12th 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 pressure as of late.
The Federal Reserve’s Index of Industrial Production, a gauge that measures activity at U.S. factories, mines, and utilities, unexpectedly rose by 0.3% in March following a large 0.7% drop the prior month. Analysts attribute some of the gains to an increase in overseas orders due to the weaker dollar. Unfortunately, the index has still fallen at an annual rate of 0.1% during the first quarter, after a 0.4% increase in the final three months of 2007.
In February, the President and Congress finalized and signed into law a $168 billion dollar economic stimulus package in an effort to prevent or minimize a looming recession. The bill includes tax rebate checks for many individuals, business incentives (such as bonus depreciation allowances for new equipment purchases), and increased loan limit allowances on mortgages to be eligible for purchase by Fannie Mae and Freddie Mac. According to the Bush Administration, the stimulus package could boost growth by 1% to 1.5% in the second half of 2008.
The U.S. economy lost a greater-than-expected 80,000 jobs in March, the third straight month of shortfalls. For the first three months of 2008, payrolls declined by a steep 232,000. Moreover, the unemployment rate rose by three-tenths of a percent to 5.1% in the final month of the quarter. That’s the highest level since September 2005, and well above of the cycle low of 4.4% that occurred a year ago.
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 measure of future activity, fell to a sixteen-year low in March and new home construction starts came in at the weakest pace since 1991. According to the National Association of Realtors, “The median home price fell 2% in 2007, its first nationwide decline since the Great Depression.” The group predicts further price reductions on new and existing homes this year before a rebound in 2009.
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, 234,000 foreclosure filings were recorded in March, 57% higher than the same month a year earlier. Nevada, California, and Florida experienced the highest default rates per number of households.
Oil prices rose by 5.83% during the first quarter and hit a record high of $110.33/barrel on March 13th, as investors purchased commodities in order to hedge against the slide in the dollar, the risk of inflation, and as an alternative investment to the U.S. equity markets. Costs for gasoline also climbed during the period, and closed at an all-time high of $3.29 a gallon (average price of regular unleaded) at the end of March. 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 fell to a five-year low in March and the outlook for the economy over the next six months dropped to the weakest reading since 1973. The decline in sentiment levels reflects rising job losses, falling equity market valuations, the poor conditions in the housing market, and the rising cost of fuel. Some economists believe there is a strong correlation between confidence levels and the amount of consumer spending.
Concerns about weak corporate earnings, instability in the financial markets, mortgage-related write-offs/losses, and the potential of an economic recession pushed stocks lower on average during the first three months of the year. The S&P 500 has posted five straight months of negative returns and lost 9.45% during the first quarter, its worst performance since the third quarter of 2002.
The Fed’s preferred price gauge, the Personal Consumption Expenditures core index, rose at a 2% annual pace in February (most recent statistic), unchanged from the prior month, and down from a 2.2% reading at the end of 2007. The price index is within the Central Bank’s comfort zone of between 1% and 2% in terms of inflation.
Prices of goods imported into the U.S. jumped 2.8% in March, the biggest gain in four months, as the dollar fell and energy costs accelerated. During the last year, prices have soared by 14.8%, the largest annual increase since record-keeping began in 1982.
The Commodity Research Bureau’s (CRB) index, an indication of raw materials prices, rose 7.9% for the quarter due to the fall in the dollar and an increase in speculative investor demand. On March 13, 2008, the index hit an-all time high of 420.64.
Producer prices jumped by a higher-than-expected 1.1% in March, the biggest increase in over four months. In addition, the year-over-year gain in core prices (excludes volatile food and energy components) registered 2.7%, the largest annual rise since the period ending July 2005. Fortunately, inflation on the consumer side has been more benign as producers haven’t had much success passing on the higher costs.
Growth in the U.S. economy is expected to remain flat or decline slightly (most analysts are now leaning towards the latter assessment) during the first six months of 2008, as rising job losses, higher fuel costs, and a reduction in sentiment levels reduce consumer spending. For all of 2008, GDP is forecast to rise by a lackluster 1.3%. That would be the weakest annual growth rate since 2001, a time when the U.S. economy was in a recession.
The Personal Consumption Expenditures Price Index, the Fed’s preferred inflation yardstick, 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 from a current reading of 5.1% to 5.5% at the end of 2008. That would be the highest level since October 2004.
The U.S. economy appears to be facing some very strong headwinds as we move forward into the remainder of 2008. Job losses are mounting, consumer sentiment/spending levels are waning, energy costs are at record highs, and the financial markets are plagued with uncertainty. Moreover, the housing market remains in a freefall and the ability to get credit is difficult at best due to a much tighter standard of lending.
In all likelihood, the economy will fall into a recession (if it’s not currently in one) during the early part of the year. This is not only our viewpoint, but also the outlook of many market strategists, in addition to staff economists at the Federal Reserve. Note: due to delays in tabulating/releasing/revising much of the data (e.g., first quarter GDP won’t be released until April 30th and is subject to a final revision on June 26th), it may take some time to officially declare a contraction if one occurs. In fact, the National Bureau of Economic Research, an arbiter of peaks and troughs of the business cycle, typically waits anywhere from six to eighteen months before they affirm the start and end date of recessions/expansions.
Given that most economists have substantially raised the odds of a recession this year, the next question that’s often debated is the timing and severity of the downfall. It is our opinion (and hope) that the contraction will be mild and won’t last through the year due to the large amount of Fed rate cuts and other liquidity measures that have been implemented (to be discussed in greater detail in the next section). The $168 billion stimulus package enacted in February should also help in this regard. While the large amount of monetary and fiscal stimulus appears to have been necessary to prevent a more pronounced decline in growth, the unfortunate result could be a heightened risk of inflation as we proceed into the next several quarters.
Yields on all benchmark Treasury securities fell significantly during the first quarter, as concerns about an economic recession led to speculation that the Fed would have to lower rates further. Treasuries also benefited from strong flight-to-quality demand due to a continuation of mortgage-related losses/write-downs at Wall Street firms. For the quarter, the yield on the ten-year Treasury fell by 61 basis points to 3.41%. It bottomed out at 3.31% on March 17th, the lowest level in almost five years. The yield on the two-year note, the most sensitive of the issues to the future direction of monetary policy, dropped by a substantial 146 basis points to finish at 1.58%. It touched 1.34% on March 17th, also near a five-year low.
As a result of the aforementioned yield movements, the slope of the Treasury yield curve between two- and ten-year notes increased by 85 basis points to 183 basis points at the end of the quarter. The spread reached 208 basis points (close to a four-year high) on March 6, as some very weak economic data and financial market uncertainty 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 or minimize a recession.
Yields rebounded during the first three weeks of April due to concerns that the large magnitude of Fed rates cuts, combined other stimulus measures could ignite inflation risks. Investors also began to speculate that we may be nearing the end of the Fed rate cut cycle, as financial market uncertainty appeared to be moderating and speeches by several central bankers seemed to indicate a growing reluctance to ease much further. By April 18th, yields on ten- and two-year Treasuries had climbed by 30 and 55 basis points to 3.71% and 2.13%, respectively.
The Merrill Lynch U.S. Treasury Master Index rose by 4.39% during the first quarter of 2008. That’s the best quarterly performance since a 4.42% return for the three months ending in June 2002.
The Central Bank cut the federal funds rate (target overnight rate for member banks that have excess bank reserves to lend to one another) by 75 basis points to 3.5% in an emergency inter-meeting session on January 22nd. It was the first inter-meeting reduction since the days following the tragedy of September 11th, and the biggest cut since 1984. Note: the Fed also dropped the discount rate (level charged on loans by the Central Bank to its member banks) by three-quarters of a point on the same day. While the Central Bank cited deteriorating economic conditions and tighter credit availability for businesses/consumers as the reasons for the monetary adjustment, some investors believe it was partly a result of the sharp sell-off in the equity markets that was occurring in the days preceding the action, especially since the next scheduled meeting was only about a week later on January 30th. Unbeknownst to the Fed and the markets at the time, was the news that a rogue trader at Societe Generale had accumulated positions that generated a $7.2 billion loss. Also unknown at the time, was that on January 21st (one day prior to the Fed’s meeting) the French Bank began to unwind some of these holdings leading to a sharp fall in European equity markets.
On January 30th at a scheduled meeting, the Central Bank cut both the fed funds and discount rate by 50 basis points to 3.0% and 3.5%, respectively. The Fed cited that “Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.”
On March 11th, the Fed announced a new program called the Term Securities Lending Facility (TSLF), which will allow Primary Wall Street dealers to temporarily exchange agency debentures, agency mortgages, and Aaa-rated private label residential and commercial mortgages for Treasuries. This new measure was partly aimed at reducing yield spreads on mortgage securities (and subsequently lower home loan rates) that had spiked to over two-decade highs on Agency MBS issues. It would also provide dealers with Treasuries securities, which they could lend out on a temporary basis for cash in order to shore up their balance sheets.
On March 16th, a Sunday, the Fed announced it was cutting the discount rate by 25 basis points to 3.25%. It was the first weekend adjustment in borrowing costs since 1979. The Fed also announced a new tool, called the Primary Dealer Credit Facility (PDCF), which will allow all primary dealers, not just banks, to borrow funds at the same level as the discount rate. Moreover, the Fed stated it had orchestrated a deal for J.P. Morgan to buy Bear Stearns (the fifth largest securities firm), a company that was incurring a severe liquidity squeeze and a heightened risk of imminent bankruptcy. The buy-out requires the Fed to loan as much as $29 billion to cover potential losses on Bear Stearns assets. According to Fed Chairman Bernanke, “The Fed agreed to the emergency Bear Stearns loan to prevent a disorderly failure of the company and the unpredictable but likely severe consequences of such a failure for market functioning and the broader economy.” These moves, the Bear Stearns loan and the Primary Dealer Credit Facility, represent the Federal Reserve’s first loans to non-banks since the Great Depression.
On March 18th, the Central Bank cut the fed funds and discount rate by an additional 75 basis points to 2.25% and 2.5%, respectively. The Fed cited a further deterioration in economic activity, including a drop-off in consumer spending, tight credit availability, weaker labor markets, and the dismal conditions in the housing market.
The majority of economists expect the Central Bank to cut the fed funds rate by an additional 50 basis points to 1.75% in the second quarter, and leave them at that level for the remainder of the year. The Fed is then anticipated to slowly begin to raise rates beginning in early 2009, as economic growth rebounds and the risk of inflation increases.
Yields on two-year Treasuries are forecast to remain near current levels (low 2% area) for the next several quarters, and then rise in a similar and slow fashion with the above-noted anticipated rate hikes next year.
Investors also expect an upward move in ten-year Treasury yields (25-30 basis points) during 2008, with further similar gains in early 2009, as a likely reemergence of economic growth leads to an increased risk of inflation.
While we’ve often had an opposing viewpoint with many economists and market participants over the last couple years, our outlook this time around is very similar to the above-noted Bond Market consensus forecast (although we expect a greater increase in yields). The Fed has cut rates by a substantial 300 basis points since last September, and due to the lag time of between six to twelve months before monetary policy adjustments effect the economy, many of these reductions likely haven’t worked there way into the system yet. In addition, the Fed has introduced a number of new programs to boost liquidity and individual tax rebate checks should be forthcoming beginning in May. Given the substantial amount of economic stimulus that currently exists, we are concerned that inflation risks may intensify, especially if energy prices remain high, leading to a necessary reversal in Fed policy, and an upward move in Treasury yields.
Despite our “bearish” view on Treasuries, we believe investors can still find value in certain securities and sectors where the yield differential has widened out significantly. We currently are advocating shorter-term (two-five year maturity) highly rated corporate issues where the yield spreads are well in excess of historical ranges. We also would look for opportunities in agency mortgage pass-throughs and CMO’s that are available at very attractive spreads.
Gross Domestic Product
The U.S. economy grew at a 0.6% annual rate in the final three months of 2007 (most recent statistic), down from a 4.9% reading in the third quarter. For all of last year, GDP rose by 2.2%, the weakest pace since 2002. According to the commerce department, the reduction in growth at the end of 2007 was led by a sharp decline in residential construction and drop-off in business inventories. In fact, had it not been for an increase in exports (due to a weaker dollar), GDP would have a fallen by 0.4% during the quarter. That would have been the first contraction since the recession of 2001.
Unemployment
The U.S. economy lost a greater-than-expected 80,000 jobs in March (estimates were for a 50,000 decline), the biggest drop in five years, and the third consecutive month of payroll shortfalls. Moreover, revisions by the Labor Department subtracted 67,000 jobs from initial estimates reported back in January and February. The unemployment rate, which is derived from a separate survey, rose to a higher-than-forecast 5.1% from 4.8% in February. That’s the highest jobless rate since September 2005, and it’s up from a cycle low of 4.4% a year ago.
Producer Price Index
Prices paid to factories, farmers, and other producers rose by a much greater-than-anticipated 1.1% in March, (consensus forecast was for a 0.6% increase), led by higher costs for food and energy. The core rate, which excludes volatile food and fuel costs, rose by 0.2%, in line with expectations. In the twelve months ending in March, overall producer prices were up 6.9%, versus a 6.4% year-over-year gain in February. Core prices increased 2.7% during the last twelve months, up from a 2.4% year-over-year pace in February, and the biggest annual gain since July 2005.
Consumer Price Index
Consumer prices rose by 0.3% in March (in line with expectations), as the biggest drop in clothing costs since 1998 wasn’t enough to offset higher food and fuel costs. The core rate, which excludes volatile food and energy prices, rose by an expected 0.2% in the final month of the quarter, a pace that’s about equal to the average monthly gain over the last ten years. During the last year, overall consumer prices have risen by 4%, the same annual gain that occurred in February. Core prices have increased 2.4% in the last twelve months, up from a 2.3% year-over-year climb in February.
Productivity
U.S. productivity rose at a faster-than-expected 1.9% annual pace in the final quarter of 2007 (most recent statistic), up slightly from the consensus forecast of a 1.8% reading. Analysts attribute the higher efficiency level to a reduction in hours worked, as businesses looked to cut expenses in a weak economic environment. In fact, hours worked declined at a 1.6% annual rate during the quarter, the biggest drop in almost five years. For all of last year productivity increased by 1.8% versus a 1% gain in 2006.
Industrial Production/Capacity Utilization
Production at U.S. factories, mines, and utilities rose by a greater-than-expected 0.3% in March after a 0.7% decline the previous month, which was the lowest level in over two years. Analysts attribute some of the rebound to an increase in utility output (due to colder temperatures) and a gain in orders from overseas in response to a weaker dollar. For the quarter, industrial production still fell at a 0.1% annual rate, versus a 0.4% gain in the final three months of 2007. Capacity utilization, which measures the percentage of factory capacity in use, rose to 80.5%, up from a two-year low of 80.3% in February.
Commodities
The Reuters/Jefferies CRB Index, an equal-weighted geometric average of nineteen raw materials, rose 7.9% for the quarter to finish at 386.89. The index hit a record high of 420.64 on March 13th due to speculative buying of raw materials (as an alternative to the equity markets) and in response to the steep slide in the dollar. Note: the components in the CRB are denominated in dollars, so a declining currency typically requires an upward adjustment in price. Natural gas was one of the leading performers for the period, rising by 35%, due to declining supplies, colder temperatures, and record high oil prices. Copper also did very well during the quarter, as diminished stockpiles of the widely-used industrial metal ahead of the peak summer building season sent prices up by 27%.
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 in February (most recent statistic). However, on a year-over-year basis sales are still down almost 24% and median prices have fallen by 8.2% from February 2007. That’s the biggest drop in home values since record keeping began in 1968. Sales of new homes, which are based on more current data than those of previously owned properties, dropped by 1.8% in February to the lowest monthly level in thirteen years.
Consumer Confidence
The Conference Board’s index of consumer confidence fell to a five-year low of 64.5 in the final month of the quarter, down from a 76.4 in February. Moreover, the group’s measure of expectations for the next six months dropped to the lowest reading since 1973. Analysts attribute the steep drop in sentiment levels to concerns about rising job losses, falling equity prices, record high energy prices, and the continued weakness in the housing 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 U.S. currency declined by 7.6% against the Euro during the first three months of the year to finish at $1.5788, close to the record low of $1.5903 reached on March 17th. It was the worst quarterly performance versus the 15-nation European currency in over three years, and reflects the declining yield differentials on U.S. government bonds compared to its Euro-counterparts. Note: the Fed cut rates during the period to 2.25%, while the ECB held its overnight level at a 6-year high of 4%. The yen appreciated 10.6% against the dollar during the quarter to finish at 99.69. It reached a 12-year high of 97.33 on March 17th due to the declining yield advantage of U.S. Treasuries. The yen also benefited from a reduction in the carry trade, a practice where investors borrow the yen in order to purchase higher yielding investments in other currencies.
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