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ALM First Financial Advisors
Second Quarter 2006 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
April 10, 2006
TOPICS
COVERED
First Quarter Review
Coming out of 2005, market expectations were for the economy to show visible signs of slowing. Many thought that would make the Federal Reserve pause its campaign of short-term interest-rate increases, and bond prices would rise. Instead, healthy employment expansion and other economic data released in February and March suggested the economy was still strong, which raised the specter of inflation and further interest-rate increases by the Fed.
Interest rates moved slightly higher at the end of the quarter amidst some volatility. Equities reached new highs, exceeding early 2006 levels. Gold and oil moved higher, nearing peak levels. The dollar was stronger versus the yen and weaker versus the euro.
The stock market began 2006 with a second wind, after showing signs of fatigue last year. After falling 0.6 percent in 2005, the Dow Jones Industrial Average rebounded 392 points, or 3.66 percent, in this year's first quarter, breaking a three-year streak of first-quarter declines.
The Standard & Poor's 500-stock index did slightly better than the Dow in the latest quarter, up 3.73 percent after rising 3 percent for all of last year. The Nasdaq Composite Index, whose volatile technology stocks have continued to endure sharp ups and downs, rose 6.1 percent in the first quarter, its best quarterly start to a year since 2000. Last year it rose 1.4 percent for the full year.
At the Fed's first policy meeting under Chairman Ben Bernanke, policy makers raised the target for the federal funds rate, charged on overnight loans between banks, to 4.75 percent from 4.5 percent and said in its accompanying statement that "some further policy firming may be needed" to keep inflation in check.
As a result the benchmark 10-year Treasury yield rose to levels last seen in June 2004, when the Fed began its current campaign to raise rates. From 4.39 percent at the end of 2005, the yield rose to 4.86 percent at the end of March.
The yield curve, which reflects the difference between short-term and long-term bond yields, inverted during the first quarter, meaning that short-term yields were higher than long-term yields. However, the yield curve is resisting significant inversion, with periods of flattening followed by steepening recalibrations.
It has been argued for some time that the recent curve inversion was due to supply-and-demand forces rather than those related to economic fundamentals. A similar view was conveyed in Fed Chairman Bernanke's recent address to the Economic Club of New York, where he stated that an inversion of the yield curve, if any, would not be indicative of an upcoming recession.
Last quarter, the government reissued the 30-year Treasury bond after a more than a four-year hiatus. The 30-year Treasury bond returned to the market in February and was embraced by pension funds and other investors, who didn't demand much of a premium from the government for the added risk that generally comes with owning a very long-term security. The 30-year bond yielded 4.90 percent at the end of the first quarter, not far from the yield on the 10-year note, or a 6-month Treasury bill for that matter.
Monetary Policy
At its first meeting under Chairman Ben Bernanke, the Federal Open Market Committee delivered its 15th consecutive hike in the Fed Funds rate, to 4.75 percent, and left the door open for further tightening by reiterating the statement that "some further policy firming may be needed." Although the statement was largely in line with expectations, it did contain signs of Bernanke's influence, primarily in making the first substantive paragraph more forward-looking. In it, the FOMC suggested that growth "appears likely to moderate to a more sustainable pace" as well as a slightly lengthier discussion of the inflation outlook.
Although there were no real surprises at the latest FOMC meeting the markets sold off afterward. The accompanying statement emphasized a "strong rebound" in economic growth and "solid" expansion. Prior to the report, a significant minority of economists and investors believed that this could be the end of the tightening cycle. 30 percent of economists polled by Bloomberg in early March, thought the March hike would be the last and the day before the meeting the market was pricing in a 40 percent probability that the Fed would not go beyond 4.75 percent by September. By keeping the same language, the Fed encouraged a rightward shift in the distribution of probabilities.
The economists had evidently expected a shift to a softer tone at Mr. Bernanke's first meeting as Chairman, despite repeated assertions over the past few months that Bernanke would make a seamless transition from the Greenspan Fed. The March statement was quite similar in tone to the January statement and signaled the likelihood of further tightening.
For much of this tightening cycle, the markets have been chasing, rather than anticipating, Fed moves. The Fed has been telegraphing its moves one or two meetings ahead, but beyond that time-frame the markets have repeatedly predicted that the Fed was done.
Due to the stimulative effects of long-term rates remaining low, despite a substantial amount of tightening by the Fed, monetary conditions have effectively remained accommodative for a much longer period than would be the case otherwise. By the end of 2005, despite the Fed Funds rate having risen by 325 bp (from 1 percent to 4.25 percent), 10-year yields were still at similar levels to when the Fed first began tightening at the June 2004 meeting. In a historically traditional environment where longer term interest rates tend to rise as the Fed tightens, some of the Fed's "work" is usually accomplished for it by an increase in long-term rates. But since longer term rates have remained relatively low during this cycle despite substantial tightenings, the Fed has been forced to attempt to achieve the desired effects of removing accommodation using short rates alone (up until this year).
In 2006, the Fed has finally successfully enlisted the market in its goal to remove monetary policy accommodation and reduce the risks of an increase in inflation and inflation expectations. By raising the Fed Funds rate to a level where rates across the curve (from the target Fed Funds rate all the way out to the 30-yr bond) are at very similar levels, the Fed now appears to have gained control over the longer end of the curve. Therefore, as long as the economy remains relatively strong, yields across the curve should continue to rise for now along with the Fed Funds rate.
After the January 31st move, the yield curve flattened, with the short end selling off and the long end rallying. Yet after the March meeting there was a steepening sell-off. The causes of the pattern the sell-off aren't clear, but it does seem to represent a substantial break with past tightenings. In fact, it may be the first sign that the rate hikes and the withdrawal of liquidity are finally starting to take effect.
To end the tightening, however, the Fed will have to view financial conditions as sufficiently tight to secure a slowing in demand, thereby restoring two-sided risk to the inflation outlook. At this point, the Fed is still focused on upside inflation risks and has hinted that rates probably will rise again at the next meeting.
The burden of proof is therefore on the economic statistics to convince the Fed to stop tightening (rather than the burden being to convince them to continue tightening). Either core inflation needs to decrease more towards the middle of the Fed's comfort zone or the economy needs to show substantial signs of weakening; otherwise, the Fed is likely to continue tightening.
As long as core inflation remains toward the upper end of its comfort range, and it does not perceive any significant signs of weakening in the economy, the Fed is likely to continue to slowly raise rates. During the first part of the tightening cycle, the Fed was not data dependent. It was raising rates for many reasons including the desire to move to a more neutral rate, to slow the housing market boom, and to keep inflation and inflation expectations under control. Now, the Fed is focused primarily on only one of these reasons, preventing a rise in inflation and inflation expectations. Although core inflation remains contained at the moment, it still perceives significant upside risks. As long as the economy remains strong, the Fed has the opportunity to take out further insurance against these risks and is likely to do so.
Therefore the market is likely to begin pricing in a higher probability of additional Fed rate hikes to 5.25 percent and maybe beyond, in addition to pushing back the likely date of any potential easing cycle by the Fed.
Economic Indicators
The economic expansion remains on a solid track after receiving a jump-start at the beginning of the year by recovering energy output and the effects of a mild winter on a range of activities. The data for February fell back somewhat from the weather-supported levels in January, and it seems that the housing sector continues to cool. However, taking January and February together, the U.S. economy still appears to be growing at a trend pace or above.
Chances of a significant slowing appear small, as inflation expectations remain checked, businesses have not over-expanded despite record profits, and export prospects have brightened somewhat. Recent indicators point to strength in business investment but not enough to keep the expansion in overdrive if household spending cools. Outside of energy production, recovery in hurricane-damaged areas is proceeding slowly.
Gross domestic product, the broadest measure of the nation's goods and services, grew at a 1.7 percent annual pace in the fourth quarter, up from a previous 1.6 percent estimate but showed more inventory accumulation and less final demand than before (final demand actually decreased slightly versus the quarter.)
Growth was lackluster compared with the 4.1 percent pace in the third quarter. Economists say, however, that the economy recovered from Katrina and Hurricane Rita in strong fashion.
U.S. corporate profits surged at the fastest pace in four years during the final months of 2005, but inflation also jumped as the nation grappled with the aftermath of Hurricane Katrina. After-tax adjusted profits are up 14.6 percent year-over-year and pretax adjusted profits a whopping 21.3 percent. Strong profit growth continued in spite of an unfavorable GDP mix.
Businesses enjoyed a 13.8 percent increase in after-tax profits in the fourth quarter of 2005, a sharp rebound from the 4.3 percent decline in the previous quarter. The pace of growth was the fastest since an 18.1 percent rise in late 2001.
Labor markets continued to gradually strengthen, with a solid rise in nonfarm payrolls and another small decline in the unemployment rate to 4.7 percent. Nonfarm payrolls rose 211,000 in March, while modest downward revisions to January and February subtracted 34,000. Over the last three months, nonfarm payroll gains have averaged 197,000 per month.
Inflation news has been mixed. On the one hand, the final data on fourth-quarter GDP contained sizeable upward revisions to inflation (the core PCE price index was revised up to a 2.4 percent annualized pace from 2.1 percent previously) and price pressures remain elevated in recent factory surveys. On the other, current core consumer price measures have been steady - the core PCE price index rose only 0.1 percent in February, keeping its year-over-year increase at 1.8 percent.
The Consumer Price Index, the key measure of inflation at the retail level, edged up 0.1 percent in February, after a 0.7 percent rise in January. The more closely watched core CPI, which excludes often volatile food and energy prices, rose 0.1 percent, which was less than the 0.2 percent rise forecast by economists, as well as the 0.2 percent rise seen in January.
U.S. manufacturing growth slowed somewhat in March amid renewed inflation pressures. The Institute for Supply Management said Monday that its index of manufacturing activity for last month stood at 55.2, down from 56.7 in February. Despite the slide, readings above 50 indicate expansion.
Meanwhile, the ISM non-manufacturing survey showed strong growth in the large service-producing sector of the U.S. economy last month.
Consumer confidence moved up in March, with the Conference Board's monthly survey rising to 107.2, a new high for this business cycle and the highest level in four years as economic activity gained momentum.
Rising energy costs, long part of the background of the expansion, have reappeared again in recent weeks. While the total rise in energy costs has been very large, it has occurred at a sufficiently gradual pace to permit economic adjustment and continued growth, while steadily promoting a less energy-intensive economy as firms and households respond to market prices.
As energy prices continue to grind higher, the lesson for the current economy may well be that what does not end an expansion often serves to make the underlying economy even more resilient.
Housing Market
For many months economists have been speculating that the housing market was about to change course - from a seller's market to a buyer's market, from a bubble to a bust. The favorite slowdown thesis is the impact of a downturn in the housing market on consumer spending. It presumes that the consumer is in a fragile state. Yet the role of housing in the overall economic expansion in recent years has been significantly overstated by some economists.
The statistics refuse to definitively indicate the direction of the market. The Conventional Mortgage Home Price Index for the fourth quarter of 2005, showed that annual growth in home values hit 13 percent nationally. Housing starts in January hit 2.28 million units, the highest pace since 1973. But sales of both new and existing homes fell in January and the inventories of existing single-family homes and condominiums for-sale rose to their highest levels since 1999. These contradictory statistics are typically signs of a slow down.
The rise in inventories of unsold homes, the decline in mortgage applications and builder sentiment, and the poor performance of housing-related stocks indicate that the housing slowdown has started.
So far the rise in mortgage rates has been relatively small. The last time 80 percent of consumers expected rates to rise, in 1999-2000, fixed mortgage rates rose by one-and-a-half percentage points. This time, mortgage rates have risen by half that amount. However, the perception that rates may move higher could help constrain consumer spending.
So is the housing market turning down? While the home sales and inventory data are volatile and could yet be revised, taken at face value they currently point to a sharp slowdown. Second, shorter-range leading indicators, such as mortgage applications and the homebuilders' survey, have also fallen significantly since last summer.
Against this, the housing indicators that are most important for GDP growth are still firm. Housing starts in February gave back only a bit of their January surge and remain above their average level for all of 2005. Meanwhile, year-on-year home price inflation still remains in double-digit territory.
This strength is due to three factors: (1) the usual lags in the housing market, (2) an unusually warm winter, and (3) the beginning of hurricane rebuilding in the Gulf region. We expect the direct and indirect effects of housing to start turning negative in the second half of 2006.
Second Quarter Outlook
The national economy is expected to bounce back strongly in the first quarter of 2006 from the hurricane-battered, dismal showing in the fourth quarter. Although fourth quarter real GDP growth was revised upwards, productivity growth fell for the first time since the first quarter of 2001 while labor costs accelerated to 3.3 percent on an annualized basis, the biggest jump in a year and troubling for those worried about accelerating inflation risks.
Early April's economic releases exhibited continued solid and resilient expansion, with early signs that adjustment could enhance the cycle's sustainability. Energy costs continue to trend higher, but the economy's flexibility and rising productivity have sustained growth.
The first-quarter's 5 percent-plus burst in consumer spending owes much to one-off influences, which should give way to more trend-like growth and an easing in overheating concerns as midyear approaches. Housing markets hint that rising interest rates will dampen the expansion's leading edge, and surveys indicate that persistent rate hikes have begun to temper income expectations.
The near-term data remain on a very solid track. The Fed has finally achieved control of longer term interest rates in 2006. With the economy remaining relatively strong and core inflation still well contained at the moment, yields across the curve have and should continue to steadily climb as the Fed raises rates. The upward movement in yields has been due to an increase in the real yield component as the Fed has raised rates while inflation and inflation expectations have remained contained.
Even with further rate hikes, overall financial conditions are likely to remain only modestly restrictive. Moreover, with inflation trending up, it is likely the Fed will want to stay on the tight side of neutral for an extended period.
Judging from recent events, prolonged and material technical yield curve inversions appear unlikely. Therefore, as short rates rise in response to Fed interest rate hikes, long rates are likely to rise as well, with yield curve shape relatively flat.
The housing market is arguably the single biggest variable in terms of the economic outlook, as strength in the residential sector has added considerably to the GDP numbers on both the consumption and investment fronts. Although the housing market is cooling off, the process is slow and so far the housing data have slowed in a very choppy fashion. Sales are down and the supply of homes on the market has risen, but prices have maintained much of their strength. Even if there is a sharper drop on the residential side, Fed Chairman Bernanke has already said that the Fed would likely not act quickly to cushion a cooling housing market.
Energy prices also remain on the radar in terms of key risks to the outlook, although oil prices in February completely reversed their January increases. Higher energy and commodity prices could feed through into the core CPI in the form of surcharges and rising transportation costs.
Wage pressures appear to be rising as the labor market reaches full employment. Average hourly earnings growth is expected to accelerate to over 3.5 percent this year.
There are early but important signs that the U.S. economy is now adjusting in desirable ways that can enhance the sustainability of the business cycle. With interest rates rising and the yield curve now historically flat, housing demand is showing signs of moderation, with new and existing home sales more than 10 percent below earlier peaks.
Limited economic slack will help to moderate growth near trend for much of the year. The combination of relatively strong demand and declining labor slack has sharpened the focus on inflation risks despite reasonably contained core price measures.
Summary
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