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ALM First Financial Advisors
First Quarter 2008 Economic Outlook
Prepared by: Lisa K. McDaniel, CFA
January 8, 2008
TOPICS COVERED
Year-End Review
The
stock market managed to end the year with gains despite the fact
that housing woes and trouble with mortgage-backed securities
spilled over into the broader credit markets and the economy in
general. The Dow Jones Industrial Average finished the year up 6.4
percent at 13,265.
The broader Standard & Poor's 500-stock index rose only 3.5 percent, to 1,468. Both indices declined in the fourth quarter, a time of year when stocks usually rise, which reflects investor worries about what is to come this year.
It is
little wonder that the strongest investment sectors last year
included utilities and consumer staples - sectors that hold up
relatively well in a period of economic weakness. Neither is it any
surprise that the weakest sectors included some that are most
exposed to U.S. economic troubles, including financials and
consumer-discretionary stocks such as retailers.
The
Russell 2000 small-stock index, which commonly outpaces the
big-stock indexes when the economy is expected to be strong,
finished 2007 with a decline of 2.7 percent. Technology stocks did
better than most, helping push the Nasdaq Composite Index up 9.8
percent for 2007 to 2,652.
Bonds
on the other hand, enjoyed stellar performance in terms of total
return. A huge and sustained flight to quality sent bond prices
soaring and yields lower. The yield of the 10-year Treasury note
finished the year at just 4.03 percent, near its low for 2007. Back
in July, before credit worries hit the markets, the yield was above
5 percent. The decline reflected the ensuing credit crisis as well
as expectations that the Fed would cut interest rates sharply in the
coming months to stimulate the economy and prevent recession.
The
shape of the yield curve has for the most part returned to a more
“normal” upward sloping curve. Remember why the curve was
inverted in the first place. Short-term rates were higher because
the Fed funds rate was at 5.25 percent but longer-term yields were
lower as the market had been calling for easing for several months
before it actually occurred. Another important point is that longer
maturities are more sensitive to inflation concerns; as inflation
becomes an issue it drives long-term rates higher.
Monetary Policy
The Fed had a busy quarter to say
the least. In October the FOMC cut the Fed funds rate target by
25 basis points, to 4.50 percent, on a 9 to 1 vote. Kansas
City Fed President Hoenig dissented in favor of leaving rates
unchanged. At that time the FOMC indicated further rate cuts were
far from certain and would be highly data-dependent.
By
December the picture had changed dramatically however. By the end of
November the markets had fully priced in a 25 basis point ease and
some were calling for 50 basis points. Chairman Bernanke himself
hinted that further easing was on the way in a speech on November
29. He said the housing downturn and related mortgage turmoil was
adding “greater than usual” uncertainty to the economic outlook,
and that “these developments have resulted in a further tightening
in financial conditions, which has the potential to impose
additional restraint on activity in housing markets and in other
credit-sensitive sectors.”
So
it was no surprise when the FOMC voted 9-1 for another quarter
percentage point ease at the December meeting, bringing the Fed
funds rate to 4.25 percent. This was the third straight reduction
since September, bringing the total cut to one percentage point.
Boston Federal Reserve Bank President Eric Rosengren dissented at
this meeting in favor of a half-percentage-point cut.
The
FOMC also cut the discount rate by a quarter-point to 4.75 percent.
The discount rate cut was requested by seven of the twelve Reserve
Banks (New York, Philadelphia, Cleveland, Richmond, Atlanta,
Chicago, and St. Louis).
The
minutes of the December FOMC meeting (released January 3rd)
showed Federal Reserve policy makers agreed that they may need to
cut interest rates again as turmoil in the credit and housing
markets began to crimp consumer spending.
Some
Fed members even saw the risk of a vicious cycle pulling down both
financial markets and the economy, and possibly requiring
“substantial further easing of policy.” According to the
minutes, the extent of the housing slump was worse than expected,
and “participants agreed that the housing correction was likely to
be both deeper and more prolonged than they had anticipated in
October.”
The
minutes also showed that Fed officials grew decidedly more
pessimistic about consumer spending, citing its “marked
deceleration” as “tighter credit conditions, higher gasoline
prices and the continuing housing correction might be restraining
growth in real consumer spending.” As recently as late October,
officials had referred to spending as “well maintained.”
Though
the policy makers decided against issuing a balance-of-risks
assessment last month, the tone of the minutes suggests risks are
heavily weighted toward economic weakness, and not a quick rebound
in economic activity that might lead to inflation.
Fed
officials said that while inflation readings were “slightly less
favorable” between the October and December FOMC meetings, they
still expect core inflation, which excludes food and energy prices,
to “trend down a bit over the next few years.” Overall headline
inflation, meanwhile, should slow “more substantially from its
currently elevated level,” according to the FOMC minutes.
In
mid-November Fed Chairman Ben Bernanke unveiled the FOMC’s new
communications procedures for monetary policy. The Fed will
now reveal more about its views on the economy than before by making
public four forecasts per year going forward rather than the
previous two forecasts. The forecasts will cover a three-year
horizon with the first forecast release (on November 20) going out
to 2010.
In
addition to forecasting real GDP growth, unemployment and core PCE
(personal consumption expenditures) price inflation, the Fed will
add forecasts for overall PCE price inflation. The Fed will also
provide a narrative to accompany the forecasts, which will describe
the forces shaping the FOMC’s forecast views, and “qualitative
information” about the uncertainties and balance of risks
surrounding the outlook.
In
December the Fed announced the establishment of a Term Auction
Facility (TAF) designed to auction term funds to depository
institutions against the wide variety of collateral that can be used
to secure loans at the discount window. This a was huge move which
virtually eliminated the stigma of borrowing at the discount window.
The
initial provisions were for two auctions of $20 billion each on
December 17th and 20th. Based on the positive
reception, the Fed said it would continue the Term Auction Facility
offerings biweekly “for as long as necessary to address elevated
pressures in short-term funding markets.” It has already set
dates for January auctions.
The
investor base eligible to participate in the TAF is restricted to
primary creditors in good financial shape. The term of funding is
for 28-days and 35-days respectively. The collateral is the same as
the collateral for the discount window, which is far wider
(including CMOs, ABS commercial paper, etc.) than for open market
operations and auction winners’ anonymity is preserved.
Economic Indicators
The
U.S. just completed its sixth year of economic expansion. After
surprisingly robust growth in the middle quarters of 2007, the
economy slowed substantially in the fourth quarter, led by a rapidly
shrinking homebuilding sector and increased consumer and business
caution.
Real
GDP was revised up to show a 4.9 percent gain from the 3.9 percent
estimated previously for the third quarter 2007. The upward
revision was led by inventories, whose contribution was 1.0 percent.
Other sources of revision included net exports, which added 1.4
percentage points to the overall growth measure compared to 0.9
percent in the advance estimate.
Recent
growth did not seem as rapid as the official data show, partly
because growth was supported by a set of temporary influences that
are likely to end or reverse themselves this quarter. In the middle
two quarters of this year, real government military spending
increased at a 9.3 percent annual rate, relative to trend growth of
only 1.4 percent over the previous two years.
Employment
growth, one of the primary lynchpins of continued economic growth,
showed signs of slowing this quarter. December nonfarm payrolls were
weaker than expected, rising only 18,000. October payrolls
were downwardly revised to 159,000 from 170,000, and November jobs
were upwardly revised to 115,000 from 94,000 (the net upward
revision was 10,000 over the last two months).
The
unemployment rate rose 0.3 percent percentage points to 5.0 percent
in December from 4.7 percent in November. This was the result
of a 436,000 decline in household employment that was not
accompanied by a drop in labor force participation (the labor force
expanded by 38,000).
The
rise in the unemployment rate is very disturbing. Over the
last year, the unemployment rate has risen 0.6 percent points from
its low and since 1949 the unemployment rate has never risen by this
magnitude without the economy being in recession.
Producer
prices trended upward over the past quarter, rising an average of
4.4 percent for the three months ended November. September’s PPI
release was significantly higher than expected, rising 1.1 percent
as food prices rose 1.5 percent and energy prices jumped 4.1
percent. The year-over-year change in overall PPI prices
picked up to 4.4 percent in September from 2.2 percent in August.
The number stabilized in October, rising just 0.1 percent, and was
flat excluding food and energy.
However
headline PPI prices surged upwards 3.2 percent in November,
massively above expectations. This pushed the year-over-year
overall PPI inflation rate to 7.2 percent in November (the highest
since October 1981) from 6.1 percent in October. Core PPI
(excluding food and energy) prices jumped 0.4 percent in November,
also above expectations. Volatility in vehicle prices (which
held back the core PPI in October) added 0.3 percent points to the
core PPI in November. The year-over-year core PPI inflation
rate moderated to 2.0 percent in November from 2.5 percent in
October.
Consumer
prices were a little more benign, with an average increase of 1.4
percent for the last three months. October CPI prices were in line
with expectations, rising 0.3 percent, which raised the 12-month
inflation rate to 3.5 percent from 2.8 percent. Energy prices
rose 1.4 percent in October with gasoline prices up a like amount.
Food prices also continued to push up overall inflation rates,
rising 0.3 percent in October.
Core
CPI inflation (excluding food and energy) posted another 0.2 percent
increase, which resulted in the 12-month change edging up to 2.2
percent in October from 2.1 percent in September.
A
5.7 percent rise in energy prices and a 0.3 percent gain in food
prices resulted in a 0.8 percent increase in the overall CPI in
November. The 12-month overall CPI inflation rate jumped to
4.3 percent in November.
In
November core CPI was higher than expected, rising 0.3 percent,
which pushed the year-over-year inflation rate to 2.3 percent.
Over the last three months, core CPI inflation has run at a faster
annualized rate of 2.6 percent.
The
inflation reports for November have shown a sharp pickup in overall
inflation. Moreover, this report shows that core CPI inflation
has edged higher for two consecutive months. Higher inflation could
become an impediment to further Fed easing.
The
October ISM manufacturing index fell to 50.9 in October from 52.0 in
September; November’s figure showed little change at 50.8.
December
was a different story however as the ISM manufacturing index was
much weaker than expected, falling to 47.7 in December.
Remember that figures below 50 indicate contraction. This is the
weakest reading we have seen since April 2003. This report suggests
that manufacturing activity contracted significantly in December and
overall economic growth slowed sharply. While the ISM index at
this level suggests slow growth rather than declining economic
activity, there have been only three episodes in the last 12 years
where the ISM has been weaker than this but recession did not follow
(1995, 1998, and 2003).
The
ISM non-manufacturing index has held up a little better than its
manufacturing counter-part. The October reading was stronger than
expected, rising to 55.8 from 54.8 in September. In November,
the index fell by more than expected, to 54.1 but is still safely in
the expansion territory.
Consumer
confidence has suffered with recent economic conditions. The
University of Michigan consumer sentiment index fell to 75.0 in
early November. The second November reading was slightly
better at 76.1. Consumer expectations fell to 64.7 in November and
current conditions fell to 91.0 from 97.6.
The
index added modestly to its large November decline in December
coming in at 75.5, but up from the preliminary 74.5. This was the
lowest value since October 2005 and second lowest since the early
1990s. The decline from November was evenly split between
expectations and current conditions as expectations rose from the
preliminary report. Inflation expectations also rose modestly from
November.
Consumer
confidence as measured by the Conference Board also took a
substantial hit in November, falling to 87.3 from 95.2 in October.
Most of the decline was in consumer expectations, which plunged to
68.7 in November from 80.0 in October. Energy prices and
concerns about financial market volatility weighed heavily on
consumers' perceptions of the outlook.
In
December consumer confidence was modestly higher than expected,
rising to 88.6, but the present situations index fell to 108.3 in
December from 115.7 in November; expectations rose to 75.5 from
69.1.
Despite
signs of weakness nearly everywhere else, November retail sales were
significantly stronger than expected, rising 1.2 percent after a 0.2
percent increase in October. Excluding autos, sales rose 1.8
percent, also much stronger than expected. Retail sales excluding
autos, building materials and gasoline (the component of retail
sales that most closely correlates with consumer goods spending in
the GDP report) rose a robust 1.1 percent in November.
To
this point, evidence of a spillover from housing to consumer
spending remains tenuous. However November retail sales may
have been boosted by the early Thanksgiving, which might not be
properly captured in the seasonal adjustments. If this is the
case, December spending could be quite soft.
Durable
goods orders started the fourth quarter on a weak note and the
capital goods shipments data, at this time, point to only a modest
gain in business equipment spending. Durable goods orders fell
0.4 percent in October and by 0.7 percent excluding transportation.
In
November durable goods orders were weaker than expected, rising only
0.1 percent. Transportation orders rose 1.9 percent in November
(durable goods orders excluding transportation fell 0.7 percent in
the month).
The last
three months have seen no growth in durable goods orders, either
overall or excluding transportation. These data and survey
data suggest that manufacturing activity has slowed and is likely to
remain sluggish in the months ahead. However, government and
industry data suggest that inventory levels are relatively lean,
which should limit the downside for manufacturing.
The
price of crude oil has risen from an average of about $75 per barrel
in the third quarter to a level averaging more than $90 during the
month of November and ended the year at $96.
With
oil near $100 a barrel, gold crossing $800 an ounce and wheat
flirting with $10 a bushel last month before a slight drop, there is
beginning to be concern about higher commodity prices feeding
inflation.
Worries are mounting that expensive commodities will ignite
long-running inflation, after last year's bull runs in oil,
agriculture and precious metals fed on each other in a global chain
reaction.
Housing Market
The
mortgage credit crunch continued to deepen the housing downturn in
the fourth quarter. The liquidity squeeze in the mortgage market
caused a sharp pullback in mortgage issuance, particularly for
non-conforming loans, making financing difficult. In addition, the
expectation of falling home prices has encouraged buyers to sit on
the sidelines, pushing home sales down 33 percent from the summer of
2006.
Home
prices are likely to remain under pressure as long as inventories
are high. The Case-Shiller index is already down five percent from
its peak in the second quarter of 2006. Further depressing home
prices are foreclosures, which typically sell at a 25-30 percent
discount from market prices.
October
housing starts posted an unexpected gain of 3.0 percent, to 1.23
million units from 1.19 million units in September. However,
the gain was entirely in multifamily starts, which surged 44.4
percent, following September's 35.9 percent decline.
Single-family starts fell 7.3 percent in October, to 884,000 from
954,000 in September. At an annualized rate housing starts
have fallen at a 35.4 percent rate over the last three months versus
a decline of 16.4 percent over the last year.
November
housing starts fell 3.7 percent to 1.19 million, led by a 5.4
percent decline in single-family starts. Indeed, single family
starts have plunged 55 percent from their January 2006 peak. Thus
far in the fourth quarter, housing starts are falling at a slightly
slower rate than that seen in the third quarter. Nonetheless,
residential investment appears to be on track to subtract
significantly from GDP growth again in the fourth quarter.
Existing
home sales fell 1.2 percent in October to 4.98 million units from
5.03 million units in September. Single-family home sales were
unchanged in October, while multi-family sales fell 9.1 percent. In
November, existing home sales rose 0.4 percent to 5.00 million
units. Single-family home sales rose 0.7 percent in November,
while multi-family sales fell 1.6 percent.
Although
existing home sales rose slightly in November, given the evidence
from other housing reports, it is still too soon to talk about
stabilization in the housing market. While existing home sales
account for approximately 85 percent of total home sales, the
figures act as something of a lagging indicator since sales are
measured at closing, which typically occurs one to three months
after the contract is signed.
New home
sales on the other hand, measures sales as the contract is signed.
However they comprise only 15 percent of total sales and tend to be
more volatile and prone to revision.
New home
sales rose slightly in October following a virtually flat reading in
September, but the level of home sales was significantly lower than
expected and there were substantial downward revisions to home sales
readings in the prior two months. New home sales rose 1.7 percent in
October to 728,000. August new home sales were downwardly
revised to 717,000 from 735,000 and September sales were revised to
716,000 from 770,000.
November
new home sales were much weaker than expected, falling 9.0 percent
to 647,000 in November. Also, September new home sales were
revised again to 699,000 from 716,000 and October sales were revised
down to 711,000 from 728,000.
Total Home Sales in the U.S.  Source:
Citigroup and Moody’s Economy.com
First Quarter Outlook
After
six years of uninterrupted growth, the outlook for the U.S. economy
has darkened considerably in just the past month. While many
economists say it’s too soon to know whether a recession is
coming, forecasters say the latest economic figures don’t look
promising. As we move into 2008, the economy faces a protracted
downturn in housing resulting in credit tightening as well as a
short-term drag from higher energy prices.
The
most important negative for U.S. growth is still the downturn in the
housing market. Homebuilding has been contracting over the past two
years, but the outlook for housing has gotten even worse in the past
few months. The turn in credit conditions in the home mortgage
market, from overly easy through the subprime boom of 2005 and 2006
to much more restrictive, especially since August, has led to
continued declines in home sales.
Rising
foreclosures and falling home prices have also put something of a
damper on consumers, many of whom funded a large portion of their
spending in recent years with gains on the value of their homes.
Coupled with higher energy prices, many consumers are feeling
squeezed; any resulting slowdown in spending could also present the
economy with a substantial headwind.
The
forecast for the housing market has two parts. On the demand side,
the forecast looks for new home sales to drift below their recent
pace over the next six months and then gradually improve through the
second half of next year. The impetus for a stabilization of sales,
and then a gradual recovery, comes from improving housing
affordability. Home prices are already running below year-ago levels
and declining at about a 6-7 percent annual rate (according to the
Case-Shiller index).
The
supply side of the housing forecast looks for an extended period in
which housing starts and permits hold at severely depressed levels.
With inventories high, prices falling, and many homebuilders in
rocky financial condition, builders are likely to be extremely
cautious about bringing new supply on to the market. Starts have
been plunging since July, and there is little reason to expect them
to stabilize until they reach even lower levels.
Consumer
spending begins 2008 on a weak trajectory, constrained by high
energy costs, a slowing labor market, falling house prices and
household net worth, and tighter credit conditions. Employment
gains are expected to slow significantly and push the unemployment
rate near 5.25 percent by midyear.
As
the economy downshifts, weakness could feed on itself as business
and households reduce spending. In this scenario, credit
fundamentals would likely deteriorate further, adding a new wave of
tightening financial conditions.
Another
important drag on growth is the ongoing rise in the price of energy.
In the near term, energy prices will be the key determinant of
consumer spending while over the longer term it will be income
growth. In the background, the effect of the housing downturn
should weigh on consumers, though the importance of housing will not
be as critical as the performance of the labor markets.
Furthermore,
2008 is a presidential election year, and presidential elections can
be tricky for stocks. Election uncertainty could put a lid on stock
gains until late summer. If the incumbent party seems headed for
re-election, keeping change to a minimum, investors may look past
the election and bid stocks higher. However if markets remain
nervous about the election, stock trading could remain volatile well
into the fall.
Although
the risk of a faltering expansion or even recession is an immediate
concern, there remains a looming medium-term inflation risk if the
economy is able to maintain its footing in the coming months.
Restraint on growth from the housing downturn has so far brought
very little moderation in core inflation.
The
question of whether the economy dodges a recession won’t be
answered until several trends become clearer - starting with signs
of life in the housing market. Another key ingredient is the impact
of recent moves by the Federal Reserve to lower interest rates.
Higher
oil prices could limit the Fed’s rate-cutting options if higher
energy prices begin to work their way into the cost of other goods
and services and drive inflation above current levels. The antidote
for an outbreak of inflation is usually to raise (not lower)
interest rates. That could force the Fed to choose between raising
rates to contain inflation and lowering them to promote growth - a
choice made more difficult by the political pressures of the
presidential campaign season.
The
Fed’s baseline forecast for the economy looks for a near-term
slowdown in growth, but a slowdown that is relatively short-lived.
Even so, the Fed is sensitive to significant recession risks and to
stress in the funding and credit markets.
If
the baseline forecast proves correct, Fed easing, combined with
cushions from a healthy corporate sector and solid global demand,
will be successful in preventing a recession. Under this scenario,
important drags on growth will fade next spring, paving the way for
a recovery in activity into the second half of 2008.
The
key to a more benign outcome lies with business behavior. The
forecast sees the business sector in a relatively favorable
position. As a result, it is likely to make modest adjustments and
not shift in a behavioral manner that magnifies downward growth
momentum.
A
successful navigation around a recession would likely be followed by
a rebound in growth. By the middle of next year, drags from
declining housing activity and rising energy prices should fade and
the lagged benefits of lower interest rates and a weaker dollar will
build.
SUMMARY
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