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ALM First Financial Advisors
Second Quarter 2007 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
April 12, 2007
TOPICS
COVERED
First Quarter Review
For the stock market, the first quarter brought many surprises. Blue-chip stocks lagged behind small-cap stocks, despite expectations that big-name stocks would be safer bets in a slow-growing economy. Prospects for an interest-rate cut by the Federal Reserve declined, also the opposite of what many investment professionals predicted. Furthermore a sell-off in late February tested everyone's mettle and ended what had been a steady rise since last summer.
The Dow Jones Industrial Average ended the first quarter down 108.80 points, or 0.9 percent, at 12,354, after some wild gyrations during the quarter. The index plunged 416 points, or 3.3 percent, on February 27. It has rebounded 2.5 percent since hitting a daily low on March 5th, but remains 2.2 percent below its level before the sell-off.
The Standard & Poor's 500 stock index was little changed for the quarter, rising 0.2 percent to 1,421, also after some significant volatility over the past two months. The technology stock focused Nasdaq Composite Index ended the quarter up 0.3 percent while the small-stock Russell 2000 index gained 1.7 percent.
Global markets suffered their biggest one-day sell-off on February 27, with blue-chip indexes falling between three and seven percent. The catalyst was a nearly nine percent fall in stock prices in Shanghai, one of the hottest and most volatile markets in the world. That helped send U.S. stocks on a roller coaster that ended with the Dow down 416 points, or 3.3 percent, to 12,216.
About the same time, mortgage lender Freddie Mac said it was tightening standards on subprime loans. This raised concern among U.S. investors that delinquencies in this area of the property market could spread to the broader housing sector, damping U.S. consumer appetites for foreign goods and commodities.
The turmoil in the stock market created havoc in the bond market as well during the first quarter. As investors sold stocks and weaker credit bonds and sought safety in U.S. Treasury securities, Treasury prices rose in response to the increased demand. The yield on the 10-year note slid to a 12-week low of 4.50 percent in early March, before rising to 4.65 percent at the end of the month. The 10-year yield was at 4.71 percent at the end of 2006.
In late March, the Fed's statement following the FOMC meeting sent yields on longer-term Treasuries higher as prices of current issues fell. For the first time in months, the 10-year yield crept above the two-year yield, reversing the phenomenon known as the inverted yield curve.
Subprime loans, or loans made to less credit-worthy borrowers, made a sudden leap into investors. vocabulary this year when it became obvious that many mortgage lenders, banks, and investors had significantly underestimated the risks of loans to the least creditworthy borrowers. The primary concerns were that steep losses in securities backed by subprime mortgages would prompt investors to pull away from risky assets. For the moment, that concern has receded. The second worry was that subprime woes would exacerbate the housing downturn to the point where the U.S. economy could be in serious trouble.
One difficulty in calculating the scale of the subprime mortgage fall-out is that lenders had created many new types of mortgages to meet rising demand, including loans requiring little or no documentation of borrowers' incomes and assets, and some requiring only a small down payment or none at all. Standard credit ratings such as FICO scores weren't always a good indicator of how these loans would perform. Some lenders didn't seem to recognize that borrowers who don't put any money down may behave differently from those who put down 20 percent or so when they buy a home.
Monetary Policy
Fed Chairman Bernanke, in his semi-annual testimony on monetary policy and the economy in February, announced a lower forecast for growth in 2007 than had previously been projected. He did note however, that the Fed.s .predominant policy concern is the risk that inflation will fail to ease as expected and that it is prepared to take action to address inflation risks if developments warrant..
At the March meeting the FOMC dropped a long-standing reference to the possibility of higher interest rates (.the extent and timing of any additional firming..) and stated instead that .future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth.. The Committee was no longer specifying whether the moves were more likely to be firming or easing.
The FOMC also dropped its January reference to .somewhat firmer economic growth.,. in favor of a characterization of recent indicators as mixed. However, the Committee did emphasize that its .predominant policy concern. remained the risk that inflation would continue to be elevated, reminding the markets of its primary long-term objective.
The market.s focus on the statement.s bias indicated some initial confusion over the Fed's intent. Although the Fed softened the tightening bias by replacing .additional firming. with .policy adjustments,. the essential gist of the bias was unchanged. Fed Chairman Bernanke took the opportunity at the Joint Economic Committee on March 28 to reiterate that the Fed maintained its inflation bias in the March 21st FOMC statement. His prepared testimony indicated that the Fed continues to see inflation risks as weighted to the upside but economic risks as two-sided.
The minutes of the March 21st FOMC meeting show that the Fed boosted its first-half 2007 forecast for overall inflation between the January and March meetings, due to higher energy prices, but continue to expect that the Fed's key measure - the price index for personal consumption expenditures excluding food and energy (core PCE) . .would edge down over the remainder of this year and next.. Core PCE is now running at a 2.4 percent annual rate.
The Fed regards near-term housing prospects as uncertain, with additional questions arising from recent subprime developments. Mr. Bernanke cited the role of declining home prices in increasing delinquencies, as well as questions about the adequacy of underwriting standards in the subprime market. However, the Fed continues to see the impact of the correction in housing as .likely to be contained.. It also continues to see the risks with respect to inflation as weighted to the upside, with its greatest concern that inflation will fail to moderate as expected.
Economic Indicators
The economy continued to expand in early 2007 as consumer spending rose at a robust pace boosted by solid gains in income and employment. In February consumer confidence is at is highest level in five-and-a-half years.
The final estimate of GDP for the fourth quarter was revised upward to 2.5 percent from a previous estimate of 2.2 percent. The upward revision was mainly a consequence of stronger inventory building. At the same time, corporate profits flattened out in the quarter.
Corporate profits remained very strong through third-quarter 2006, rising significantly faster than GDP, a typical cyclical pattern. From fourth-quarter 2001, when the recession ended, profits have risen to record-breaking levels in each succeeding year; in the two years ending third-quarter 2006, operating profits rose at an average of 18 percent annualized.
Underlying the strong profits was robust growth in top-line revenues and widening margins. These favorable trends reflected healthy economic expansion and constrained increases in operating costs
However in the first quarter of this year corporate profits with inventory valuation and capital consumption adjustments declined 0.3 percent on a quarter-to-quarter basis, as profits flattened out following their 19.7 percent annualized average growth over the previous eight quarters.
The employment situation continues to be robust. Nonfarm payrolls grew at a monthly average of 152,000 during the first quarter. In February, nonfarm payrolls rose 113,000, less than in previous months, but upward revisions continued as January payrolls were restated at 146,000 and December payrolls were revised to a whopping 226,000.
In March nonfarm payrolls were once again stronger than expected, rising by 180,000. In addition, for the tenth consecutive month, the prior two months' payrolls readings were revised higher. The unemployment rate fell to 4.4 percent in March from 4.5 percent in February
The unemployment rate has hovered around 4.4 - 4.6 percent for the past few months. The labor market continues to tighten and average hourly earnings increases remain elevated at a time when productivity growth may be slowing, which could cause inflationary wage pressures.
After a 0.6 percent drop in January, producer prices jumped 1.3 percent in February as food and energy prices soared. Energy prices surged 3.5 percent while food prices rose 1.9 percent. This pushed the year-over-year headline PPI up 2.5 percent. Core finished goods (excluding food and energy) were also higher in February, rising 0.4 percent on a jump in cigarette and light truck prices.
Overall CPI prices rose 0.2 percent in January as food prices increased 0.7 percent, while energy prices declined 1.5 percent. In February, headline CPI rose 0.4 percent as energy prices reversed themselves, rising 0.9 percent, and the previous month.s elevation in food prices continued. Meanwhile core CPI (excluding food and energy) edged up to 2.7 percent in January from 2.6 percent in December.
Reports from the Institute for Supply Management (ISM) for the manufacturing and non-manufacturing sectors both suggest a moderation in growth. While the ISM manufacturing index jumped to 52.3 in February from 49.3 in January, the index for March indicated that activity expanded, but at a slower pace than February as the reading softened to 50.9. Nonetheless, this is the second consecutive reading above 50 and the average of the ISM index for the first quarter, at 50.8, is virtually unchanged from the fourth quarter. Inflation pressures rose sharply in March, however, as the prices paid index jumped to 65.5 from 59.0. This is the highest reading on prices paid since August 2006.
The ISM non-manufacturing index has been on a gradual downward trend since early 2004, and hit a four-year low in March. The non-manufacturing survey fell for a second consecutive month, hitting 52.4 in March, its lowest level in almost four years. Fuel price increases pushed up business costs and employment gains slowed, while export activity unexpectedly softened. Vehicle sales declined modestly in March for a third consecutive month, although sales for the quarter actually rose.
Consumer confidence continued to improve early in the year as the Conference Board.s index increased to a five-and-a-half year high of 112.5 in February from a reading of 110.2 in January.
However subprime real estate issues, related stock market volatility and rising gasoline prices contributed to a decline in consumer confidence in March. The Conference Board reported that its Consumer Confidence Index fell from a revised 111.2 in February to 107.2 in March. The decline in confidence was due to lower consumer expectations, as this index fell to 86.9 from 93.8. The present situations index, however, improved slightly to 137.6 from 137.1. Labor market trends remained positive, while inflation expectations nudged higher.
Retail sales rose by a less than expected 0.1 percent in February and non-auto retail sales were reported down 0.1 percent. Rising energy prices and generally poor February weather most likely contributed to the deceleration in spending. Despite broad-based weakness in February retail sales, consumer spending still appears to be solid and retail sales should bounce back in March as retailers reported improved merchandise sales in late March.
Durable goods have demonstrated weakness as orders dropped 7.8 percent in January, and durable goods orders excluding transportation were down 3.1 percent in the month. Non-defense capital goods orders excluding aircraft dropped 6.0 percent in January, and shipments of these capital goods fell 2.7 percent.
Durable goods rebounded in February, but were still weaker than expected, rising 2.5 percent vs. a consensus forecast of 3.5 percent. The increase was due to a rebound in aircraft orders, as the rest of the report was relatively weak.
Housing Market
In Fed Chairman Bernanke.s semi-annual Humphrey-Hawkins testimony he stated that, .some tentative signs of stabilization have recently appeared in the housing market. and that .household finances appear generally solid.. Yet homebuilders continue to describe the spring selling season as soft. Inventories remain high and builders are offering price reductions and other incentives.
The housing starts data thus far in the first quarter suggest that residential construction activity may subtract less from GDP growth in the first quarter than the drag from housing seen in the second half of 2006.
While January housing starts were much weaker than expected, falling 14.3 percent, to 1.4 million units, they rebounded in February, rising nine percent to 1.5 million. Single family starts rose 10.3 percent after falling 11.2 percent in January, but remained 32.7 percent below year-ago levels.
Colder than normal weather probably suppressed starts in the Northeast and Midwest last month, where they declined 29.7 percent and 14.4 percent respectively. However, these two regions comprise less than one-fifth of all U.S. housing start activity. In the much more active South and West, starts rose 18.0 percent and 26.4 percent, respectively, following weather-induced weakness in January.
New and existing single-family home sales combined appear to have bottomed out in the last few months. Existing home sales increased 3.0 percent to 6.46 million in January, from 6.27 million in December. The median resale price fell 3.1 percent from January 2006.
New home sales fell 15.8 percent in January, and were weak again in February, falling 3.9 percent to 848,000 units from 882,000. This is the lowest level of new homes sold since 2000.
There were also significant downward revisions to new home sales for the prior two months - January was revised to 882,000 from 937,000 and December was revised to 1.05 million from 1.12 million.
Most analysts expect a more hospitable environment later this year; however there is still considerable concern over the shakeout in the subprime mortgage market. Official government figures report that unsold new homes peaked in July 2006 and have since declined modestly, but actual inventory levels are likely far higher due to cancelled sales contracts, which are not accounted for in sales and inventory numbers.
While the optimistic scenario is that low mortgage rates and continuing job growth will enable the market to work off these inventories gradually, the process will be slow and prices remain vulnerable to shocks in the meantime. Early payment defaults on subprime loans through mid-2006 rose to more than triple the rate of early 2005, and some lenders specializing in subprime have declared bankruptcy or closed up shop.
Despite the pullback by subprime lenders, there are no signs of a general drying up of liquidity that could develop into a broader .credit crunch. in the prime mortgage market. Mortgage rates moved back down in recent weeks, with the rate on 30-year, fixed-rate mortgages touching their lowest rates of the year.
Second Quarter Outlook
The current expansion has faced its fair share of trials and tribulation. In the five- and-a-half years since the last contraction, the economy has had to cope with war, hurricanes, a tripling of oil prices, 17 Fed rate hikes, and a rash of corporate malfeasance. Currently the economy is facing not one, but several stresses. The ongoing correction in housing now faces the added strain of a tightening in standards for subprime borrowers. Further, a worsening geopolitical situation has pushed the price of petroleum up once again.
A sharp decline in new home sales so far this year, continued softness in capital goods activity and a steep rise in energy costs raised questions about a bottom in housing and the health of other sectors. In contrast, the labor market remains relatively healthy, although higher unit labor costs appear to be flattening corporate profits.
Nonetheless the expansion of the overall economy seems to be intact. Mortgage applications for home purchases are holding in a narrow range, a sign that home sales are stabilizing, at odds with the new home sales report. The economy has been expanding at a moderate pace over the past two quarters, despite weak housing and equipment spending. Indeed, the unemployment rate is still near its low for the expansion and corporate profit margins are near their highs.
Furthermore we are making good progress toward absorbing a substantial downturn in housing. Residential investment sliced more than one percentage point from GDP growth in the second half of 2006, yet there were only limited signs of spillover from housing weakness in final demand, employment growth, or financial market conditions. We expect the drag from construction on economic growth to be less this year.
While demand indicators were softer than expected in February, there are good reasons to discount these data readings as a result of stormy weather and general month-to-month volatility. This view is reinforced by the data we have seen so far for March, which do not validate the notion that business is retrenching or that a new leg down in home sales is under way.
Despite concerns about collateral damage from the housing market, consumption actually accelerated over the last three quarters of 2006. The U.S. has not had a consumption-led slowdown since the 1990-1991 recession, when spending fell amid a massive drop in consumer confidence as oil prices soared during the first U.S. invasion of Iraq. Fundamentally, the continued strength in the labor market, with a mild pick-up in wages offsetting a mild slowdown in employment growth, implies that consumption should not have the kind of sharp drop that would pull the economy down. Since then, the consumer has been extraordinarily resilient, even around recent downturns.
The job market should remain healthy, with the unemployment rate hovering around 4.7 percent. This sub-NAIRU unemployment rate (NAIRU is the non-accelerating inflation rate of unemployment or the lowest unemployment rate that the economy can accommodate without causing inflation) should put further pressure on wages, and lower productivity growth makes it harder for firms to offset these costs. This should keep core inflation above the Fed.s implicit target zone for the next year.
With a moderately tight labor market and recent cost of living increases, we expect a continued acceleration in the growth in average hourly earnings. This would point to upward, albeit more gradual, increases in labor cost pressures, which should continue feeding into trend inflation.
Core inflation has been consistently elevated above two percent, which presents a significant hurdle to Fed rate cuts. The recent inflation news and fundamentals continue to point to upside price pressures. Compared with the Fed.s .comfort zone. of 1-2 percent for the core PCE deflator, inflation is running high. Yet financial markets have taken the inflation news in stride, continuing to expect at least one rate cut by the end of the year, despite the Fed.s affirmation that its .predominant policy concern remains the risks that core inflation will fail to moderate as expected..
The recent inflation numbers are hardly an aberration. While the data naturally fluctuate on a monthly and quarterly basis, the annual numbers show two key features. First, the elevated state of inflation is not a temporary phenomenon: inflation has been on the strong side for the past three years. Second, a core PCE deflator running above two percent is not the normal state of affairs: inflation was below two percent for eight straight years before its recent elevation. Thus the Fed cannot ease up on fighting inflation without taking a severe hit to its credibility.
While growth indicators have gradually declined, input prices have moved in the other direction. Oil and gasoline prices are up substantially over the past two months. Oil prices rose 7.9 percent in the quarter to $65.87 a barrel and gasoline prices are up more than 20 percent from their recent low. Higher energy costs have offset the beneficial growth impact of a slight easing in financial conditions
Expectations in the stock market for the next few months are modest at best, with little hope for a significant rally as investors battle fears about the impact of mortgage defaults and the housing downturn on the economy. Other looming hazards include slowing corporate earnings growth, higher energy prices and lingering uncertainty about the Fed's next move.
In late December, Fed funds futures contracts indicated that a rate cut by the middle of 2007 was a near certainty. Futures traders now place the likelihood of a Fed cut by July at less than 10 percent. If the Fed is going to ease, there will first have to be some visible sign of consumer retrenchment. Second, there will have to be much more deterioration in financial conditions than we experienced in March. And third, officials will likely need signs of softening in the labor market such that a key source of risk to the inflation outlook begins to recede.
Firms are continuing to hire and labor markets are continuing to tighten, even as homebuilding goes through a severe and protracted downturn. Average payroll growth of 152,000 per month in the first quarter reflects moderate slowing from the 189,000 per month pace last year. As long as payroll growth remains solid, the economy.s deceleration is likely to be gradual and limited. Expanding jobs and rising compensation add to real disposable income and support continued firm consumer spending.
The downside risk to this outlook is the housing situation. Home sales are at a critical juncture, as further declines this spring would likely extend the drag on economic growth from residential construction into the second half of the year. Therefore housing indicators continue to be a matter of intense interest. Reports over the past month have been mixed, but the latest news on pending home sales and mortgage applications for home purchase is broadly consistent with the view that home sales are stabilizing.
Summary
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