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ALM First Financial Advisors
First Quarter 2007 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
January 12, 2007
TOPICS
COVERED
Year End Review
The year 2006 was a story of two halves: surprisingly strong growth, particularly in the first quarter, and then a fairly sharp deceleration in the second half, notably in the U.S. and Japan. The turning point was the beginning of a serious slump in U.S. housing, which started in the second quarter.
Domestic demand slowed moderately, as a significant housing correction took shape while other sources of demand were resilient. Core inflation picked up, while headline inflation decelerated sharply late in the year. The Fed continued to raise its funds rate target through mid-year, then entered a holding pattern which it maintained for the remainder of the year.
For stocks, 2006 was a year that will be remembered for the market's great comeback, as a year-end rally pushed the Dow Jones industrials past the 12,000 level for the first time. The markets approached record levels in the spring, pulled back sharply in the summer, but found a clear direction in the fall to send the major indexes to multi-year highs.
Needless to say, the major indexes posted healthy gains for the year, with the Dow Jones industrials rising 16.29 percent, the S&P 500 adding 13.62 percent, and the Nasdaq up 9.52 percent. That's the best showing since 2003.
Blue chips were the standouts of 2006. The Dow hit record levels dozens of times since achieving its first close above 12,000 on October 19; it traded as high as 12,530 before dipping to its close of 12,463 for the year.
The bond market for the most part ignored repeated Fed warnings of a bias toward tightening, and mounting inflation risks in the labor market. After two years where the Treasury curve flattened strongly by about 100 basis points (bps) each year, the curve stalled in slightly inverted territory and barely budged last year. The Fed continued to push short-term rates higher but long-term rates moved less than in just about any previous tightening cycle, defying expectations of how the markets are supposed to behave.
The yield on the 10-year note, the benchmark for mortgages, loans and corporate bonds, ended the year at 4.71 percent, compared with 4.39 percent at the end of 2005. Long-term bond yields have been hovering below yields on short-term Treasury securities since mid-July when the Fed decided to pause; as a result 10-year Treasury yields fell more than 70 bps.
Our forecast early last year called for an upward sloping curve by the end of 2006 with a 10-year Treasury yield of 5.29 percent. Instead we saw 10-year yields rise to a monthly average of 5.10 percent in June but then fall as the pause in rate hikes seemed to trigger even more foreign buying which lowered long-term yields and maintained an inverted curve.
Monetary Policy
Contrary to market expectations, the Fed was more sensitive to higher inflation than slightly softer growth, and tightened by more than the market expected in the first half of the year.
The Fed stopped tightening at midyear based on two factors: first, the Fed considered the downturn in housing a significant enough threat to warrant a pause, even though its baseline forecast views housing as unlikely to produce sustained weakness in economic activity; and second, it was hopeful that core inflation would gradually subside in an environment of a rising unemployment rate (expected to move back towards 5 percent) and stabilization in energy prices.
In the December FOMC statement the committee called the cooling of the housing industry "substantial," in another change in language from the October statement. The Fed also predicted a moderate expansion "on balance over coming quarters," in a change indicating that not every quarter may see an expansion.
On growth, the Fed stated that "Economic growth has slowed over the course of the year, partly reflecting a substantial cooling of the housing market. Although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over coming quarters." New in this statement was the word "substantial" in the description of the housing market cooling. Also, the second sentence in the paragraph was expanded from the last statement when the Fed only noted "Going forward, the economy seems likely to expand at a moderate pace."
There were no other changes to the policy statement. On inflation, the Fed again noted, "Readings on core inflation have been elevated, and the high level of resource utilization has the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand."
The policy paragraph was also repeated verbatim as the Fed stated, "Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."
Economic Indicators
After the U.S. expansion found its legs in mid-2003, the economy delivered nearly three full years of sustained and broad-based growth at a 3.5 percent pace. However, growth dynamics have changed dramatically over the past three quarters as the economy had to absorb a housing market downturn prompted by a squeeze in affordability and a surge in energy prices through the early summer. These shocks have slowed growth to close to 2.0 percent and have produced wide divergences in performance across different sectors of the economy.
Over the first three quarters of 2006, nominal GDP growth averaged 6.3 percent. Real GDP growth has averaged 3.4 percent thus far in 2006. The drag from residential investment hit strongly after the first quarter. Real GDP growth was 5.6 percent in the first quarter but has slowed to an estimated average pace of about 2.4 percent since then, as a decline in residential investment subtracted what appears to be slightly more than one percentage point from real GDP growth.
In the preliminary third quarter GDP report, annualized growth was upwardly revised to 2.2 percent (from an advance estimate of 1.6 percent). Growth for the fourth quarter is estimated to continue at the same 2 percent pace.
The corporate sector is healthy and still expanding. Corporate profit margins from domestic operations are at their highest point since the 1960s. Corporate financial net worth is hitting new highs, and business has continued to hire and spend.
Corporate profits, as measured by the Commerce Department, have risen more than 12 percent a year since 2002, hitting a high of 19 percent in 2004. In the third quarter of 2006, profit growth was running at an annualized rate of 16 percent and has increased by a stunning 30.9 percent in the past year.
Nonfarm payrolls showed continued strength throughout 2006. The December report was significantly stronger than expected, rising by 167,000. In addition, the pattern of upward revisions to prior months' payrolls continued in December as the previous two monthly payroll readings were revised higher by a net of 29,000. This was the seventh consecutive month of net upward revisions to the two previous monthly payroll readings (the cumulative upward revision over this period totals 304,000). Over the last three months, nonfarm payrolls have averaged a monthly increase of 136,000 and, factoring in the benchmark revision, it appears that payrolls grew by over two million in 2006.
After large declines in September and October, the producer price index rebounded strongly in November, jumping 2.0 percent. Most of the increase resulted from higher energy prices and an increase in vehicle prices, which reversed a sizable 9.7 percent decline in light truck prices in October. Core PPI prices rose 1.3 percent after a 0.9 percent decline in October.
While it was a strong release, the PPI report for November was much better behaved that the headline numbers suggest. Excluding the 13.7 percent jump in vehicle prices, core PPI rose only 0.2 percent. Over the past six months, core finished goods inflation has averaged 1.1 percent on an annualized basis, indicating rather modest price pressures.
The inflation outlook from a consumer perspective has improved in recent months. Headline inflation over the first 10 months of the year was 2.4 percent, a full percentage point lower than in for the whole of 2005.
The latest report showed the consumer price index (CPI) was flat in November, below the 0.2 percent median of analysts. forecasts. Year-over-year headline CPI inflation rose to 2.0 percent in November but remained below core inflation for a third consecutive month. Energy prices fell a slight 0.2 percent in November, after large drops in September and October, as gasoline prices fell 1.6 percent and electricity 0.2 percent but fuel oil prices rose 0.3 percent.
Core inflation . which excludes volatile food and energy prices . has increased 2.8 percent so far this year, 60 bps higher than in 2005. Core inflation experienced a significant increase in the first nine months of the year, rising from 2.0 percent to 2.9 percent year-over-year, but now we are seeing a pull back with lower energy prices and vehicle prices. Core CPI prices (excluding food and energy) increased at a 1.6 percent annual rate in the past three months, down from a 3.0 percent rise in the prior three months and 3.8 percent in the three months before that.
The October ISM manufacturing index was weaker than expected, falling to 51.2 from 52.9 in September. Both manufacturing orders and production showed slow rates of decline in November, pushing the overall ISM manufacturing index below 50 for the first time in 3½ years. However the index rebounded in December, coming in at a stronger than expected 51.4 in December, up from 49.5 in November.
The December ISM manufacturing report points to a modest pickup in activity as new orders rose to 52.1 in December from 48.7 in November and the production index improved by 3.3 points to 51.8. The employment index rose to 49.7 from 49.2. Importantly, the index did not continue to deteriorate as it did at the end of 2000, which was a prelude to rate cuts in January 2001. In 2000, once the ISM fell below 50 in August, the index never recovered above this level until February 2002.
The ISM non-manufacturing index, which represents a much larger portion of the economy than the manufacturing index, remains on solid ground. The December reading of 57.1 was in line with expectations and down just slightly from November.s reading of 58.9. This index has not dipped below the neutral level of 50 since early 2003.
The Conference Board's measure of consumer confidence was stronger than expected in December and the preliminary November report was revised upward. The December reading jumped up to 109.0 from an upwardly revised 105.3 in November (original report was 102.9). The December reading brought the index level to its highest point since April and the second highest level since 2002. However, there was a major divergence among the three major consumer confidence surveys. While the Conference Board measure hit a recent high, the University of Michigan poll saw a slight decline and the ABC News/Washington Post survey remained steady.
In the first 10 months of 2006, real consumer spending growth averaged 3.1 percent at an annual rate, which has largely matched the 3.0 percent growth rate in real disposable income. There is no evidence that the weakness in housing and autos has spilled over into the rest of the economy.
Consumer spending rose 0.5 percent in November in both nominal and real terms. Real consumer spending is growing at a pace close to 4.5 percent in the fourth quarter.
November retail sales were much stronger than expected (up 1.0 percent), led by a surge in electronics and appliances. With the exception of clothing, sales were strong across the board. Sales in October were relatively flat (down 0.1 percent).
We don't yet know the final results of the holiday shopping season, since it has extended into January with the growing use of gift cards. Gains through November indicate that real consumption topped a 4 percent annual rate. December sales were likely healthy as implied by the sharp rise in consumer confidence and solid industry reports.
Durable goods orders rose 1.9 percent in November, after falling 8.2 percent in October. While the number was higher than expected, this was mostly due to a rebound in the volatile defense category. The details of the report were considerably weaker than implied by the headline figure. Excluding transportation, durable goods orders fell 1.1 percent. In particular, capital goods orders and shipments are both on track for a sequential decline in the fourth quarter.
Crude oil reached all-time highs in the summer when it briefly surpassed $78 a barrel due to the resilience of consumer demand and expectations of a bad hurricane season. But energy prices soon plummeted back to 2005 levels by the fall when traders saw that refiners in the Gulf of Mexico were untouched by hurricanes, and realized global crude inventories remained ample. The price of a barrel of light sweet crude ended the year at $61.05 on the New York Mercantile Exchange - about 22 percent below its highs of the year.
Housing Market
After several years of double-digit percentage increase, housing prices stopped soaring in 2006. Economists estimate home prices rose 2.8 percent last year and will fall by 0.5 percent this year. This contrasts with an increase of 13.4 percent in 2005.
The housing sector subtracted 1.1 percentage points from third-quarter GDP. Nonetheless there are signs that the most drastic parts of the housing downturn, marked by a sharp pull-back in demand and new construction, have run their course, and that the housing correction will be contained within the housing sector instead of spilling over into slower growth in other areas of the economy.
Indicators of housing demand have stabilized in recent months and the flow of new construction is now less than sales. As a result inventories have begun to drop. Looking ahead, in the "bubble" regions the housing slump has a long way to go; but in the other two-thirds of the country the healing should begin early in 2007.
The bearish camp, however, would argue that housing downturns happen in fairly slow-motion, so it could be that we are just beginning to see the impact on the market and the economy. We may not have felt the brunt of all the adjustable-rate mortgage resets and the massive increase in defaults and foreclosures in some of the states where there is a housing bubble.
Existing home sales rose for the past two months, rising 0.6 percent in November and 0.5 percent in October. Total sales were mixed across the country, rising 6 percent in the Northeast and 0.8 percent in the West, while sales fell 1.6 percent in the South and were steady in the Midwest.
October's new home sales were weaker than expected, including downward revisions to the prior 3 months; yet the new home sales trend continues to show signs of leveling off, following earlier steep declines. This report, coupled with the stronger existing home sales suggests that housing demand has firmed, although at a lower level than in 2005.
After plunging 13.7 percent in October, housing starts increased 6.7 percent to 1.59 million units in November. On a regional basis, the results were mixed, making in unclear how much the weather impacted November.s gains. The South and Northeast posted good gains, (up 18.5 percent and 8.6 percent) but the West and Midwest saw significant drops (down 8.1 percent and 6.3 percent).
Housing starts fell at an annualized pace of 39.5 percent pace in the second quarter and 29.8 percent in the third quarter as home builders responded to developments by slashing activity this year. The latest figures show housing starts running nearly 30 percent below their peak quarterly average. The upshot is that real residential investment is on track to post a third consecutive double-digit annualized decline in the current quarter, which would make it the largest and most sustained drag on growth from housing since the early 1980s.
First Quarter Outlook
The U.S. economy is poised to shake off the housing slump and regain momentum by the end of this year. 2007 should be a year of modestly above-trend economic growth accompanied by continued elevated rates of core inflation. If housing starts and new home sales have begun to stabilize, then the drag on growth from residential construction should begin to dissipate in the first quarter of 2007. The solid state of the labor market should support consumer spending, while healthy corporate balance sheets will buoy business investment.
The service sector should keep humming along as the recent weakness in housing and manufacturing abates and the Federal Reserve either remains in a holding pattern or begins to reduce interest rates. That would allow the economy to expand at a rate fast enough to keep investors happy, but slow enough to keep inflation at bay.
On average, the economists predict that inflation-adjusted gross domestic product will grow at an annualized rate of 2.3 percent in the first half of 2007 and 2.8 percent in the second half. That's up from a sluggish 2.2 percent in the third quarter of 2006, but still far below the robust annual growth rates of 3.2 percent for 2005 and 4.1 percent for early 2006.
The job market should remain fairly healthy with unemployment remaining below 5 percent. Firms have been fairly conservative in hiring relative to historical standards. Meanwhile wage pressures continue to rise as the labor market reaches full employment.
Consumer balance sheets remain relatively strong, with gains in housing over recent years leaving net worth near record levels despite softening home prices. Corporate balance sheets also remain strong, with near record levels of cash. These signal a much stronger economy than the one faced by the Fed in 2000, for instance, after the bursting internet bubble drew down consumer wealth and eventually trimmed capital investment.
Housing activity has been declining for more than a year, and the economy's performance through the housing downturn to date provides ample evidence of its underlying health. Corporates and households have continued to expand, reflecting their strong balance sheet positions. The Fed paused before pushing policy into restrictive territory, allowing a soft landing to occur.
Over the next several quarters, housing will again be key to the outlook, as a prolonged downturn could threaten more severe consequences for the overall economy, while a housing recovery could produce a broader upturn.
The U.S. housing slump is probably at its worst point in the current quarter and is likely to cool, not crush, consumer spending. The drag on growth from housing investment should subside gradually over 2007, while consumption and business investment hold up, given solid fundamentals outside housing.
We view the housing market as undergoing a one-time adjustment from unsustainable levels of construction and price appreciation. Keep in mind that residential real estate constitutes one-third of all household assets, about the same share as in the 1980s and early 1990s, while financial holdings account for the largest shared of household wealth at 50 percent. Also helping growth is a reduced drag on real incomes from energy prices, which have pulled back significantly in recent months.
A key element of this view is that the slide in home sales is almost over. This development, which is a precondition for a bottoming out of activity, is already being signaled by a number of indicators. Mortgage applications for home purchase, the timeliest measures of housing demand, have been stable since late July and then turned up in November. New home sales have bounced around a stable trend since August. Even the Homebuilders survey, the weakest of housing market indicators, points to a rise in builders expectations of home sales during October and November.
Meanwhile housing starts should continue to decline in the first quarter of 2007 as homebuilders try to clear their inventories, but the drag from construction should taper off later in the year. Homebuilders have slashed housing permits and starts over the past year. At recent levels of home sales, construction activity has come down enough to reduce the number of unsold homes on the market in the coming months. As inventories correct, the drag on economic growth from housing construction is expected to be completed by the middle of next year. On a regional level, construction will remain depressed in the "bubble" markets but will otherwise enter a recovery stage.
The biggest risk to this outlook is that the housing contraction becomes deeper than we currently anticipate and that this spills over into consumer spending. If the housing slump turns out to be much longer and deeper, and house prices overshoot on the downside rather than just correct, there is a risk of the household and corporate sectors being infected and the economy being pushed into a more serious downturn or even recession. Adverse spill-over to the rest of the global economy might be expected in such a scenario, given the importance of the U.S. as an engine of global growth.
Bond investors enter 2007 divided about the prospects for the U.S. economy. For much of the past year, Treasury bonds have been signaling the possibility of an economic recession, or at least slower expansion. Yet an accommodative monetary policy has cushioned the economy in the face of adjustments in housing and autos whereas in 2000, just before the rate cuts and recession in 2001, tight monetary policy provided no support to growth as the technology bubble burst and cash-strapped corporations were forced to slash capital spending.
The bond market is looking for the Fed to cut interest rates - if this happens, it will lead to a steepening in the yield curve. Those looking for rate cuts expect a sharp slow-down in economic activity - a spillover from the housing correction into other areas of the economy. This view assumes the consumer has been fueled by asset price gains and has tapped into mortgage equity in order to spend at an unsustainable pace.
The bullish outlook, on the other hand, calls for a bond market environment similar to what we saw in 2006. This means continued yield curve inversion with the market caught between a Fed trying to contain inflation (keeping short yields relatively high) while demand from Asia keeps yields on the long end of the curve lower. Under this scenario, consumer spending has been driven not just by mortgage equity take-out, but by employment and income gains, as well as a rising stock market - and is therefore sustainable.
The Fed in 2007 is likely to find itself in a continuing fight with the market over expectations about policy, with most of the impact coming on the short end of the Treasury curve. Taken at face value, everything the Fed says suggests that through most of next year it expects to keep fed funds at least at 5.25 percent; yet there is pervasive doubt about the Fed's willingness and ability to avoid a rate cut. Foreign investment in U.S. debt should again keep long-term rates well below levels indicated by economics alone, but flows should lighten as the cost of servicing U.S. foreign debt continues to rise. The yield curve looks likely to rise modestly from current levels and remain inverted with volatility generally lower and spreads tighter at least through the first half of the year.
If rate cuts fail to materialize, we would expect yields to drift higher - a move that is likely to gain momentum if the market begins to anticipate rate hikes. However, unless there is a major change to exchange rate policies, especially in Asia, continued strong official flows into the U.S. bond market will support the intermediate to long-end of the yield curve. It seems likely, therefore, that the yield curve will remain inverted throughout 2007 and that the degree of inversion might increase.
The Fed has made it clear that policy adjustments are dependent on incoming data relative to its forecast and the three primary variables that the Fed publishes in its forecast are real GDP growth, the unemployment rate and core PCE inflation. In July 2006, the FOMC's central tendency ranges for these variables for 2007 were: 3 -3¼ percent for real GDP growth; 4¾ - 5 percent for the fourth quarter unemployment rate; and 2 - 2¼ percent for core PCE inflation. The Fed has lowered its estimate for potential growth since July; however if unemployment remains lower than forecast and core PCE is higher, then the Fed could actually raise rates again.
However, before another rate hike takes place, growth would have to have picked up to about 3 percent, the housing market would have to have clearly stabilized, and that core PCE inflation would have to have edged up to at least 2½ percent. The earliest FOMC meeting at which these conditions would be satisfied is likely to be the May meeting.
Market expectations for inflation also point to a Fed at least on hold. The likely tension between the Fed path and a market anticipating an ease should drag yields along the short end of the Treasury curve higher - with a little kicking and screaming along the way.
Summary
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