|
ALM First Financial
Advisors
First Quarter 2002 Economic Outlook
Prepared
by: J. Steven Orr, CFA
January 4, 2002
TOPICS
COVERED
Fourth
Quarter Review
The
U.S. economy slid deeper into recession in the last quarter
of 2001. During the quarter the National Bureau of Economists
decided the recession officially began last March. The average
postwar recession has lasted 10 months, with the longest taking
16 months. So the conventional wisdom of Wall Street is that
the recession will be over by the middle of the year, with
positive growth in Gross Domestic Product for rest of 2002.
The outplacement
firm of Challenger, Gray and Christmas tracks company layoff
announcements. Their January 3rd press release states that
2001 was the largest downsizing year on record, with nearly
2 million announced job cuts. The previous record was set
in 1998, with announced cuts of 677,795 versus 2001's 1,956,876.
It bears noting that these are announced cuts, and often companies
stop short of laying off all the announced figure as things
turn around. Still, that this figure would be three times
as large as the previous slowdown suggests that there is more
to come in this recession.
A bit
of forest work should make the trees easier to see. The recession
of 2001 and beyond was caused not by tech blow-ups or failed
Internet experiments. These were symptoms. We are coming off
a credit bubble so big it may be the largest ever. The last
four years credit and venture capital has been priced very
cheaply. Some argue the easy money and credit date to Greenspan's
policies in the early nineties when he was trying to restore
the banking industries' balance sheets. There is not room
to address that here. But there is sufficient evidence to
argue that from about 1995 on, one could get financing or
securitize loans fairly easily. A credit bubble leads to the
worry that there will be a quality bubble on the horizon.
In other words, if too many loans were made to questionable
borrowers, what happens when those borrowers loose their jobs?
Already consumer finance companies such as Providian have
cited credit deterioration as a reason for earnings problems.
Stocks,
as the anticipation mechanism for future earnings, rallied
strongly back from their September lows. For the quarter the
S&P 500 returned 10.6%.
This was
not enough to reverse the bear market that dates back to the
September 1st, 2000 high, however. Indeed, as the chart above
shows, the stocks were just able to rally back to the pre-September
11 falling trend.
The disturbing
news on the stock front is that the price-to-earnings ratio
of the S&P 500 is above 23 times. In most recessions it
bottoms in the 14x range, so stocks may be too high at these
levels.
Fiscal
Policy
We began the fourth quarter betting on how big the fiscal
stimulus package would be. Congress surprised us all by arguing
the entire package to a stalemate. Clearly this has to be
the first time Congress has passed on the opportunity to spend
(pork barrel) more tax dollars. In truth there was some politicking
and deals, but Bush standing up to Robert Byrd, "King
Pork" himself, certainly set the tone. When the Democrats
and Byrd were not going to get their way, they took their
toys and went home. Congress has appropriated over $60 billion
in emergency funding for homeland defense and the war effort.
Look for
President Bush to use his approval ratings and the bully pulpit
to push for more tax relief and different spending priorities.
Monetary
Policy
The quarter
saw the Federal Open Market Committee (FOMC) continue its
easing program with a bias toward continuing the cuts. Indeed,
the Fed report released from the summer Jackson Hole meeting
stated that the Fed "would continue to ease until the
first signs of increasing activity." The Fed cut the
Funds rate three times during the quarter: for a total of
125 basis points. For all of 2001 the Fed cut eleven times
and dropped the rate 475 basis points.
Since
the tragic events of September 11th the Fed has pumped huge
amounts of liquidity into the financial system using repurchase
agreements and lending from its SOMA account. The first weekend
after the attack the Fed lent over $80 billion versus a normal
weekend of about $4 billion.
In a further
attempt to lower rates, the Treasury department announced
on Halloween that it was canceling the thirty-year bond. The
thought was that by making it "scarce," the rate
would fall because of the high demand. There was an immediate
reaction as the long bond rose five points in one day. This
indeed pushed the rate down from 5.21% the day before to a
new low of 4.79%. Neither the Street, nor the investor community
were happy with the move, and in poetic justice, the thirty
year closed the quarter at a yield of 5.46%, exactly where
it began in 2001.
Along
with the rest of the curve, the two-year Treasury rallied
strongly into early November. The curve reached levels not
seen in forty years, with the two year bottoming at 2.30%
on November 7th. The chart below can be read either of two
ways but only has one conclusion. First, the two-year is a
good anticipator of Fed action. Second, Greenspan listens
to what the market wants. There is antidotal evidence of the
latter. The conclusion is the two-year area of the curve is
the last place to be when the Fed quits easing.
The
divergence late in the year suggests that market participants
are getting ready for the Fed to stop easing and start tightening
policy.
Economic
Indicators
A review
of the major indicators released during the quarter shows
continued weakness.
The Consumer
Price Index slowed to an almost 2% annual rate as gasoline
and food price pressures moderated.
There
are several consumer confidence surveys; the two largest are
produced by the University of Michigan and the Conference
Board. The spike in the December reading most likely is not
a trend change.
Turning to the home front, the MBA Refinancing Index showed
the effects of lower rates on the mortgage industry. Both
home sales and refinance activity skyrocketed in November
as rates hit their lows. With the snapback in December activity
quickly cooled. Refinancing activity has drifted back down
to pre-Fed ease levels. For many of our clients these indices
point to longer duration mortgages in the future as prepayments
slow. The impact of refinancing in the fourth quarter on mortgages
cannot be overstated. The duration of the mortgage index went
from 4 down to almost 2 and back to 4 in less than two months.
This led to exaggerated moves in the Treasury market as leverage
and bank players sought to hedge the duration changes.
Turning
to the cyclical sectors of our economy Industrial Production
continued to fall. The manufacturing sector has contracted
in thirteen of the last fourteen months.
The automakers
had to idle plants and layoff workers because of the transportation
halt. Their just-in-time inventory methods rely on hourly
deliveries of parts from plants in Canada and the U.S.
First
Quarter Outlook
Looking
ahead we expect more deterioration in the economy. Although
interest rates are low and inventories have been pared down,
there are more negatives than positives.
Congress
will attempt to pass emergency appropriations bills, but tax
and spending reforms are off the table. Indeed this year could
set the stage for Bush to be remembered as the "big government
Republican." The 2000 Bush tax cuts that Daschle and
his henchmen are complaining about are not a cause of the
recession. The cuts do not kick in until 2004.
We expect
the Fed to ease at least one more time in the quarter. From
there the most likely scenario sees the Fed go on hold to
watch for effects of twelve straight rate reductions. Post
September 11th the cuts came fast and furious. These new levels
need time to work their way through the economy.
In other
speeches various Fed Governors have admitted that the FOMC
will not tighten until they see unemployment turn and head
south. At this point we have lost at least 1 million jobs,
and according to most estimates, have another 1 million to
cut.
For the
first quarter we expect gross domestic product (GDP) to be
flat, at best. Wall Street consensus is for the recovery to
begin in the second half of the year with growth in the 3%
to 4% range. Our outlook is not as bright, with the economy
only returning to positive growth toward the end of 2002.
We are
cautious for several reasons. First, consumer spending is
the largest component of our gross domestic product. Although
consumer debt as a percentage of income has been growing for
many years, the key is whether consumers can service their
debt and still spend. As layoffs and job insecurity increase,
we see the consumer cutting back. The auto industry had a
good fourth quarter in 2001 because of incentives. Since automobiles
are not purchased every day, this represents activity moving
forward for a couple of quarters. As a result industrial production
should stay weak.
Second,
corporate earnings should stay weak. For the last several
quarters we have seen companies come close to analyst's earnings
estimates by resorting to one-time gains or other accounting
gimmicks. Real earnings are hard to come by when there is
no demand. At 25 times earnings, stocks are still expensive
at these levels.
Third,
housing has held up well the last two quarters, thanks to
falling rates. The MBA purchase index has hit new highs recently.
Mortgage rates, however, have started rising. Refinancing
activity, as noted earlier, has fallen. As winter sets in,
we look for housing to fall farther than usual as the recent
"boomlet" comes to a close.
Inflation
is one relatively bright spot. Although the core consumer
price index (CPI) has risen the last several months, overall
inflation has remained in check. We look for CPI to drift
down to the 1.5% area from 2% now.
Summary
We
look for both the domestic and global economy to deteriorate
a bit further over the next three months. The middle of 2002
should see stabilizing economic data as corporations restructure
and low interest rates help repair debt-laden balance sheets.
The latter part of 2002 should see positive growth in all
areas of the economy as recovery takes hold. At that point
reducing interest rate exposure and conserving cash will be
the preferred strategy. Our fear is that the forecast is a
bit modest, with recovery occurring sooner than consensus.
In that case we would pull duration in quickly as rates begin
their inevitable rise.
Click
here to view Summary Chart
|
