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ALM
First Financial Advisors
Economic Overview
First Quarter 1998
TOPICS
COVERED
Introduction
Growing up in a small town at the foot of the
Wasatch Mountains, the local veterinarian (a family friend)
gave me some wise counsel. "Never marry a girl from Southern
California because no matter how good it gets they have always
seen it better. Always marry a girl from Southern Idaho because
no matter how bad it gets they have always seen it worse."
(Personally, I made a compromise and married a girl from Northern
California.) This advice for marital bliss is all about expectations
and has some implications in the current economic environment.
Investing as well as beginning a marriage with the wrong expectations
can be a distressing experience.
Three
months ago the popular expectations for the bond market were
very bullish. Everyone was talking about 5% on the long Treasury
and how Asia's chaos would bring down the world economy and
reduce interest rates.
Popular
expectations have now swung around the other way. Everyone
is worried about inflation and tight labor markets again.
They fear that the strong U.S. economy will push up interest
rates.
To get
a better understanding of the current economic picture and
hopefully an impression of what the next quarter has in store
we will take a brief look at last quarter's rates and a more
detailed look at the data on the various economic sectors.
Last
Quarter
Just as we predicted, the huge bond market rally and subsequent
free-fall in rates the first week of January was temporary.
The two-year note yields recovered to 5.35% by mid January
and then stayed in the 5.30% to 5.63% range for the remainder
of the quarter. The upper band of our forecast was 5.60%.
The rate continued to move around within this band based on
economic statistical releases and testimony from the Federal
Reserve Chairman.
The
Consumer Sector
Consumer confidence set a record in February and, as can be
seen from the table, dropped only marginally in March.
The confidence
of the consumer seemed to be evidenced in fairly strong retail
sales numbers. However, these numbers might not be as strong
as they appear because the warm weather experienced throughout
most of the country drew more people out of their homes than
during previous surveys.
There is some evidence that the confidence of consumers may
have peaked. The employment growth number released in early
April was a big surprise to the market. The consensus was
for a growth of 233,000 jobs in the non-farm payrolls number,
but actually a 36,000 decrease in jobs was reported.
The unemployment
number as a result backed off of its six-year low of 4.6%
in February to 4.7% in March. Although it is too early to
tell, the possibility is that the impact of the Asian crisis
is beginning to be felt. If the problems in Asia continue
to worsen, U.S. firms could start to experience serious declines
in their overseas businesses and start cutting back on spending
and personnel. This would result in a decline in consumer
confidence and a potential reduction in consumer spending.
The current
level of consumer confidence, however, along with low mortgage
rates is definitely having an impact on the housing market.
 The
record existing homes sold number in February and a projected
high number of housing starts for the year should keep the
demand for consumer durable goods high. Sales of homes usually
result in the purchase of durable goods as the new owners
take possession and begin to upgrade, which leads us to the
business and manufacturing sector of the economy.
The Business Sector
The only current drag on the economy is coming from trade.
The worsening Asian situation is cutting exports while the
strong dollar is increasing the affordability of imports.
 Business
performance, as measured by changes in industrial production,
broke out of its 1997 band in the first quarter of 1998. Throughout
1997, the percentage change in industrial production remained
within a tight range of +0.2% to +0.8%. In January, the industrial
production only increased by 0.1% and in February it was flat.
Business investment is continuing to be strong as businesses
are responding to their strong profit margins and backlogs
of orders. Tight labor markets are encouraging businesses
to continue to substitute capital for labor. As a result productivity
growth has been high. This can be seen from the relatively
flat capacity utilization figures over the last few years.
Even though output has been increasing, industry has been
able to continue operating at about 83% of capacity.
The continued
tight labor market remains a worry to almost all observers
of the economy. The 4.6% unemployment rate reported in February
was the lowest in 24 years. As can be seen from the accompanying
graphic, the employment cost index seems to be showing signs
of this pressure with increases over the last three quarters.
The increasing employment cost does not seem to be affecting
prices, however. Higher compensation costs are seemingly being
offset by lower import and commodity prices. In fact, wholesale
prices, as measured by the Producer Price Index (PPI) turned
in a year-over-year change for 1997 at negative 1.21%.
With
no price inflation, it is not difficult to see why the FOMC
has refrained from raising rates, even with an acceleration
in wages.
Government
Sector
Many analysts are now expecting a federal budget surplus in
fiscal 1998. This expectation in based on the sharp rise in
capital gains tax revenue. The actual tax collection data
will be available later this month and will provide a clearer
picture of the budget situation.
The ramification
of the emerging budget surplus is that it should reduce the
Treasury's bond offerings in the months ahead. This leads
to the basic economic theory that a reduction in supply with
continued strong demand should lead to higher prices. Higher
prices, of course, mean lower yields. The stickler in this
pure theory approach is that the shorter end of the curve
is somewhat tied to the 5.50% federal-funds rate. This will
make it more difficult for these rates to drop too far.
Summary
Now that we have looked a little more closely at the current
economic environment, it is difficult see a clear trend in
the data. Making it easy to see why popular expectations change
so quickly.
A case
could easily be made that the economy will continue to roll
with confident consumers buying houses and other goods and
forcing businesses to continue to grow, putting more and more
pressure on wages and hence inflation.
The problem
is that there has been no inflation. Moreover, leading inflation
indicators such as oil and gold prices do not show any inflation
on the horizon. Although oil prices have crept up in the last
few weeks they are still well below their levels of a year
ago.
Gold Prices are also well below recent levels.
And as discussed earlier, producer prices have actually fallen
over the last year. With no price inflation, it would be difficult
for the Fed to justify a tightening. The added uncertainty
of the Asian markets, make it especially difficult. Businesses
are just beginning to report lower earnings because of decreased
sales in Asia.
 We
believe that the Fed will not raise rates this quarter because
of the lack of any evidence of inflation. They also will be
reticent to lower rates because of the tight labor market.
The Fed should remain neutral throughout the year with a chance
of easing policy in the 4th quarter as evidence of slowing
growth begins to emerge.
ALM First continues to project that the two-year Treasury
Note yield will stay within its current trading band of 5.30%-5.65%
in the 2nd Quarter of 1998. In the second half of 1998, we
expect the two-year Note yield will trend lower as the economy
slows and the market begins to anticipate of a Fed easing.
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