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ALM
First Financial Advisors
Economic Overview
Prepared
by: Angela Calvert
Second Quarter 2000
TOPICS
COVERED
Introduction
What a difference a few little numbers in a month have made!
Or has it? Should we go ahead and give ole' Greenspan a pat
on the back? Has he single-handedly slowed the economy since
this tightening cycle first began just one year ago, when
funds were raised to a measly 5%? At first glance, he does
have the appearance of a magician. It seems like just yesterday
the markets were bracing for another 50 basis point rate hike
with another 50-100 expected by year-end. But today, the term
"soft landing" appears to some as more of a reality
than a goal.
As impressive
as this all would be, doesn't this scenario appear a little
too perfect? Only time will tell. As we could sit here and
speculate on the future of the market, lets' look at the information
and data that has gotten us to a 6.50% Target Fed Funds Rate.
Economic
Indicators
Just as the FOMC watches the various releases in indicators
ranging from CPI to NAPM, we as investors also react heavily
to the indications. But what, exactly, are we all really looking
for? When it comes down to it, any sign of inflation is the
evil culprit that can stop the market on a dime.
After
a bubble in growth in the second half of 1999 and the first
half of the new millennium, nearly every sector of the U.S.
economy slowed during the Spring of 2000. The big question
is if this slowdown is substantial enough to satisfy concerns
of inflation. For now, the Fed appears to be giving the benefit
of the doubt.
New Home
Sales fell 0.2% last month to a seasonally adjusted annual
rate of 875,000 units from a revised 877,000 units in April.
May's rate was the slowest since September, 1999. If this
trend continues, spending that accompanies housing should
begin to suffer as well.
It is
no coincidence that as stocks began to sputter, consumer confidence
dipped, as well as consumer spending. The Consumer Confidence
Index dropped 5.9 points in growth and finally fell below
income growth in June to 138.8, as consumers became increasingly
concerned about rising gasoline prices, higher interest rates
and the recent sell-off in high tech stocks. Personal spending
rose a mere 0.2% in May for the second month in a row. The
April and May increases were the smallest in 1-½ years,
held down by consecutive monthly declines in spending for
durable goods. May spending on durable goods fell 1% after
a 0.7% decline in April. Reports for May also showed that
retail sales fell, which was led by fewer purchases of automobiles
and other big-ticket items. Is there a pattern developing?
The consumer
price index in May rose 0.1% after showing no change in April.
The core rate of the CPI, which excludes food and energy,
rose 0.2%, the same as in April. Annually, that equates to
a 3.1% increase and core increase of 2.4%.
Falling
energy prices restrained the Producer Price Index during May.
Overall finished goods prices were unchanged, as energy prices
fell 0.5% and food prices slipped 0.2%. The drop in energy
prices follows a 4.1% decline in April, which largely reflected
falling gasoline and fuel oil prices.
That was
not the case in May. Gasoline prices rose 1.3% and fuel oil
prices rose 2.5%. In addition, residential gas prices also
rose 0.3%. The financial markets initially cheered the report
that headline inflation was lower than expect but then soured
on it a bit after seeing that the core PPI rose 0.2%. But
that gain was only slightly higher than expected. This series,
which is up at a 3.6% annual rate over the past three months,
is one of the most important for the Fed because it is particularly
responsive to swings in final demand.
The Bureau
of Labor Statistics served up a huge curveball, reporting
that excluding Census workers, May had 126,000 fewer payroll
jobs than in April, that the Unemployment Rate rose sharply
to 4.1% from 3.9% in April, and that Average Hourly Earnings
(AHE) rose by only 0.1%. The financial markets had been expecting
about 200,000 new jobs, no change in the unemployment rate,
and a 0.4% rise in AHE.
Due to
the recent revision of the 1st Quarter 2000 GDP, gross domestic
product, the U.S. economy grew faster than previously estimated.
Target levels for the Federal Reserve tend to be around 3
½-4% while the 1st Quarter of 2000 grew at an annual
rate 5.5%. However, we are reminded of the considerably slower
growth we have seen during the 2nd Quarter and that we anticipate
this slowing trend to continue.
The first
half of the year witnessed a sharp change in the Treasury
yield curve. There has been a sharp inversion, with long-term
yields falling significantly below short-term yields, accompanied
by an ever seesawing of the yield spread between the 10-year
and 2-year note. The inversion appears to be a combination
of both a shrinking Treasury supply and concerns of an overly
aggressive Fed. There has already been $15 billion of securities
repurchased since mid-March, and the government plans to use
its surplus to buy back up to $30 billion of bonds this year
to pay down the national debt.
In lieu
of the softening economic data being shown to the market,
the trend toward curve flattening and spread widening may
be temporarily interrupted until policymakers renew the tightening
process.
Oil
Oil supply and high prices have been a growing concern for
the U.S. market and were not eased after a disappointing outcome
from the OPEC meeting in Vienna. There was a lower than expected
increase in OPEC supply which, it turn, have held current
high oil prices at their peak. There seem to be two schools
of thought as to how the Fed may view this surge of prices
at the pump. One view is that rising oil prices would divert
more income to gas and less to other sectors of the economy,
therefore acting like a tax increase. To the consumer, this
should slow spending and economic growth. On the other hand,
oil is used in some form in the production of nearly every
available good and service, whether we are talking about running
machines at factories or the high gasoline cost of delivering
goods and services to all areas of the country.
If these
increases in oil are passed through to us as consumers, prices
could rise across the board. If the latter is true, this would
give the Federal Reserve more inflation fears and reason to
continue their currently stalled tightening trend.
Japan
The Japanese economy and its effects on U.S. interest rates
has seemingly been pushed out of the spot light due to Japan's
economic expansion. However, huge public debt continues to
provide formidable obstacles for the economy, following two
years of negative or flat growth. Capital spending remains
robust and projected growth of 1.8% is moderate. One key factor
in Japan's economy continues to be weak consumption. Ten years
of rapid public spending have pushed the debt-to-GDP ratio
from 58% in 1991 to 1.16% this year. With nominal growth less
than the meager real growth, the burden of debt will continue
to increase. There seems to be no easy way to reduce this
debt burden. With consumer confidence likely to remain low,
the prospect for a deficit-reducing tax hike is nearly unthinkable.
Although
Japan appears to be slowing recovering, it is an aspect worth
mentioning and keeping on the watch list.
Forecast
Based on the economic data we have received over the past
six weeks, there appears to be a trend developing. The U.S.
economy is showing emerging signs of a slowdown while maintaining
low inflation. Throughout the next quarter, we expect to see
more of the same. Although the Fed remained somewhat hawkish
in their June meeting, upcoming data is expected to show a
continual slowdown in the U.S. economy. However, by year-end,
the Fed could get a little anxious so Funds are expected in
the range of 6.50% - 7%.
As for
the Treasury Curve, expect to see some correction in the inversion
of the curve. We expect the 2-Year to trade in the range of
a high at 6.75% to a low of 6.25%.
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