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ALM First Financial Advisors
Second Quarter 2008 Economic Outlook
Prepared by: Lisa K. McDaniel, CFA
April 11, 2008
TOPICS COVERED
First Quarter Review
The stock market took a real beating in the first quarter, with the Dow Jones Industrial Average down 7.6 percent, its worst quarter in 5½ years. In fact, over the past three months, the Dow lost 1,002 points. The S&P 500 Index, which is heavily weighted in financial stocks, took an even bigger hit. It was down 9.9 percent in the first quarter 2008, and 16 percent from October 2007. The Dow has also not had a positive month since October.
Despite the losses and the magnitude of volatility we have seen over the past several months, neither the Dow nor the S&P 500 have reached the 20 percent decline from their last peak that is the traditional definition of a bear market. This is largely due to the Fed’s moves to improve liquidity in the credit markets.
The reverberations from the U.S. financial crisis left no region of the world untouched as global stocks also had pretty poor performance in the first quarter. The Dow Jones World Index, excluding the U.S., fell 8.7 percent in dollar terms. This is in contrast to the past five years when foreign shares have generally outperformed relative to the U.S. The recent declines illustrate how much more correlated different countries’ markets have become. Also, the turmoil in credit markets spread beyond the U.S., battering shares in places such as Europe and Australia.
The bond market continued to unravel in the first quarter as the financial system faced historic challenges. Only the pristine Treasury market had positive returns. Credit markets, such as municipals and mortgage debt, experienced fire sales as investors backed away from risk and brokerage firms and hedge funds were forced to take write-downs or liquidate positions.
Debt-market woes, which gathered steam in January with the disclosure of huge new losses on mortgage assets at Citigroup, UBS and Merrill Lynch, dominated the psyche of all investors across the capital structure. The only fixed-income market where investors found solace was in Treasury securities. The shortest-duration government debt was the most sought after, sending the yield on the three-month T-bill to a low of 0.5 percent during the quarter. The 30-year bond reached a low of 4.1 percent, although yields rose to 1.3 percent on the three-month T-bill and 4.3 percent on the 30-year by quarter end.
Risk premiums (spreads over Treasury bonds) for investment-grade bonds, jumped one percentage point in the quarter and junk bonds added an additional two percentage points to their risk premiums, according to Merrill Lynch. Municipal bonds were already under pressure on concerns about bond insurers’ credit quality. It didn’t help that as part of the fallout of the subprime debacle, bond insurers faced credit-rating downgrades and had to rush to shore up their capital base. Both MBIA and Ambac raised $1.2 billion, and still lost their AAA ratings. This had the effect of tainting even the highest quality insured debt.
The credit crunch proceeded to freeze entire markets, including the auction-rate securities market, where many municipalities and student lenders financed significant portions of their portfolios. The $330 billion market (of which $86 billion is student loan debt) collapsed as investors failed to make bids and broker/dealers could no longer step in, resulting in failed auctions and leaving investors stuck with securities they believed were highly liquid.
Student loan lenders’ troubles began last fall, when the College Cost Reduction Act slashed the subsidy the government paid to private lenders by more than $20 billion. But their greatest difficulties hit in February when the markets where they finance their lending went against them. At this point at least 26 lenders have stopped providing loans through the Federal Family Education Loan program (FFELP), due to developments in the credit markets.
A wave of selling swept the mortgage-backed-securities market when jumbo-mortgage lender Thornburg Mortgage and investment firm Carlyle Capital failed to meet margin calls from several banks, sending the risk premium on mortgage debt (backed by loans guaranteed by government-sponsored entities Fannie Mae and Freddie Mac) over comparable Treasury bonds to levels not seen since mid-1980. This resulted in several government measures to lower capital requirements for Fannie and Freddie so they could buy more securities.
Higher yields on mortgage-backed debt means banks have to pay more to sell packages of mortgage loans, resulting in higher mortgage rates for consumers who may be trying to refinance. Since hitting a high March 6, the average premium on a 30-year mortgage bond has fallen 0.61 percentage points to 2.32 percentage points over Treasury bonds, according to FTN Financial.
Monetary Policy
Since the start of the year, the FOMC has lowered the Fed funds rate by two percent - from 4.25 percent to 2.25 percent.
The first easing of the year was an inter-meeting cut on January 22nd. The Fed announced a 75 basis point (bps) cut of both the Fed funds and the discount rate. This decision came a day after turmoil in the overseas markets. In the key sentence, the statement noted the continued deterioration in financial conditions and a further tightening of credit and noted these as the “increasing downside risks to growth.”
The FOMC followed this up the next week with another 50 bps ease at their regular meeting on January 30th, bringing the Fed funds rate to 3.00 percent.
The Fed’s next move was to lower the discount rate to 3.25 percent at an emergency weekend meeting on March 16th.
The last rate cut took place on March 18, in the amount of 75 bps, bringing the Fed funds rate to the current level of 2.25 percent. The discount rate was also cut 75 bps to 2.50 percent. Fed president Richard Fisher and Charles Plosser dissented in favor of a less aggressive cut.
The FOMC continued to stress economic weakness, saying “the outlook for economic activity has weakened further.” The statement specifically noted that growth in consumer spending has “slowed” and labor markets have “softened.” But, on the other hand, the Committee showed concern about inflation, enough so that it had more to say about inflation than growth.
The Fed also offered new lending options, including allowing brokerage firms to access its discount window for the first time and helped to orchestrate the buyout of Bear Stearns by J.P. Morgan Chase.
Here is a timeline of events:
March 11: The Fed responded to the recent widening of mortgage bonds by introducing a new Term Securities Lending Facility (TSLF). Under this arrangement the Fed will auction Treasuries for 28 days in exchange for agency MBS, agency debt, AAA-rated private label residential MBS and commercial MBS. Some hedge funds had to unload securities in order to meet margin calls, causing a glut of supply in agencies and a corresponding shortage of Treasuries. The TSLF differs from the Term Auction Facility (TAF) created in December in that the TSLF exchanges bonds for bonds, while the TAF exchanges bonds for cash. The announcement of the plan sparked the biggest one-day gain the Dow has seen in five years.
March 14: Bear Stearns said its cash position had deteriorated significantly, causing the Fed to extend emergency funding through J.P. Morgan.
March 16: The Fed agreed to provide up to $30 billion to JPMorgan Chase to help it finance the purchase of Bear Stearns rather than let the firm go into bankruptcy. In doing so, the Fed made some unprecedented moves, including taking over a $30 billion portfolio of rather illiquid securities, with the potential for either profit or loss, and offering direct loans to Wall Street firms.
JPMorgan agreed to acquire Bear Stearns for about $240 million, or $2 per share, when Bear was trading at $30 the previous week. The difference was mainly a $6 billion restructuring charge. The offer was later raised to $10 per share as outraged shareholders threatened lawsuits. Furthermore, JP Morgan struck a deal with Bear Stearns’ board to purchase about 40 percent of the company in a transaction that wouldn't require shareholder approval.
The Fed’s role in helping Bear Stearns avoid bankruptcy, though it remains contentious, was interpreted as a sign the central bank will take whatever steps necessary if officials believe the financial system is in danger of unraveling.
The Fed also introduced the Primary Dealer Credit Facility (PDCF). This program allows all primary dealers, not just banks, to borrow from the discount window. However, pledged securities must be investment grade and while they can be rolled for up to 28 days without incurring penalties, the maximum extension is 90 days.
April 2: Fed Chairman Bernanke spoke to the Joint Economic Committee in Congress. He said the “financial markets remain under considerable stress” and he acknowledged for the first time that the U.S. economy may contract in the first half of the year. He discussed inflation, but did not cover any new ground. He also said that the Fed has already done a significant amount of easing and that conditions should improve later this year, suggesting there may not be much need for additional monetary stimulus. Importantly, he did not repeat the promise that the Fed would act in a timely manner to support growth.
Regulatory Policy
Not to be left out, the Treasury was also quite busy during the first quarter. The Office of Federal Housing Enterprise Oversight (OFHEO) announced on February 27th that it was lifting the caps on investment portfolios for both Fannie Mae and Freddie Mac. The inability of both firms to file their audited financial statements in a timely fashion a few years ago was one of the major reasons OFHEO had placed a cap on the companies’ retained mortgage portfolios in he first place. Now that Fannie Mae and Freddie Mac are able to successfully file on time, the caps are no deemed longer necessary.
On March 19th, OFHEO announced it was reducing the surplus capital requirement for Fannie Mae and Freddie Mac to 20 percent from 30 percent. In return, the Government Sponsored Enterprises (GSEs) agreed to raise a “significant” amount of new capital. Combined with a lifting of portfolio caps and the companies’ existing capabilities, this should allow Fannie Mae and Freddie Mac to buy or guarantee about $2 trillion in mortgages a year.
The Federal Housing Finance Board agreed to allow the 12 Federal Home Loan Banks to increase their holdings of mortgage securities issued by the GSEs by more than $100 billion. The home-loan banks previously could have holdings of mortgage securities of no more than three times their capital. This limit was raised to six times capital for the next two years. At the end of 2007, the banks had combined capital of about $54 billion, and they held $136 billion of mortgage-backed securities as of September 30, the latest data available. In theory, the new rules would allow the banks to increase their holdings of the securities by about $160 billion, but it is considered very unlikely that they will bump up against their limits.
On March 31 Treasury Secretary Paulson presented his “Blueprint for Regulatory Reform,” which detailed plans for a broad overhaul of financial regulation. He said that the current structure of regulating banks, securities firms and insurance companies is outmoded and that the Federal Reserve should expand its oversight beyond banks. In fact, the Fed would become a “market stability regulator,” gaining oversight over anyone with access to its discount window. Furthermore, the SEC and Commodities Futures Trading Commission would be combined, as would the FDIC, OTS, the OCC and the NCUA. All banks would be subject to national supervision under a single regulatory body.
Also under the plan, which would take years to implement, a mortgage commission would create Federal licensing standards and track states’ regulatory oversight.
Opposition to the plan was immediate from several angles, including lawmakers, regulators and administration officials. Will it ever come to pass? Issues closer to the core of the current crisis, such as streamlined bank regulation may be easier to get through Congress, but the plan will undoubtedly go through many changes and permutations before anything gets enacted.
Currency
If there was one constant this past quarter, it was the continued slide of the dollar. U.S. currency has fallen 10.5 percent against the yen this year, reaching levels not seen since 1995. This makes Japanese exports to the U.S. more expensive in dollar terms, which can hurt spending and therefore economic growth.
The dollar also managed to set new lows against the Euro, causing fears that a strong Euro will create difficulties for European companies that sell overseas - just as their economies begin to show signs of slowing.
Some currency analysts think the end is in sight for the dollar’s bear market, saying it is as under-valued against other major currencies as it has ever been. They believe that the U.S. slowdown will affect Europe later this year, forcing the ECB to lower its interest rates. If this happens, then the dollar will be poised to rally. Others say however, that until the U.S. economic slowdown and housing slump show signs of bottoming, the dollar will remain under pressure. In part, that is because further deterioration in these areas would keep heat on the Fed to further reduce interest rates in an effort to ease the downturn.
Economic Indicators
The final report of fourth quarter GDP was unchanged at 0.6 percent. Consumer spending and investment was revised lower, while the trade deficit was smaller than initially reported. The details showed personal consumption was slightly higher, probably due to energy consumption. Total corporate profits declined by 3.3 percent from the previous quarter, but remained up 3.3 percent from a year earlier.
Employment took a nosedive in the first quarter. Non-farm payrolls fell 76,000 in January, and February, and then a whopping 80,000 in March. Net revisions to the previous two months subtracted 67,000 jobs, giving us a 3-month average of negative 74,000.
The unemployment rate fell to 4.8 percent in February; the decline was the result of a 450,000 drop in the civilian labor force as labor force participation fell to 65.9 percent from 66.1 percent. It then jumped to 5.1 percent in March as household employment declined by 24,000 and labor force participation increased 410,000.
The PCE deflator, the Fed’s preferred measure of inflation, rose 0.2 percent in January, just 0.1 percent in February, for a year-over-year increase of two percent.
The January Producer Price Index (PPI) was higher than expected, with increases of 1.0 percent for the headline number and 0.4 percent for the core (excluding food and energy). Food prices were up 1.7 percent in January and 8.3 percent year-on-year. Energy rose 1.5 percent in January and 22.6 percent year-over-year.
The PPI rose 0.3 percent in February, a tenth lower than expected, which puts it up 6.4 percent year-over year. Surprisingly, food prices fell 0.5 percent while energy prices rose 0.8 percent. The real surprise, however, was in the core, which was up 0.5 percent - more than double the consensus estimate of 0.2 percent - pushing up the year-over-year rate to 2.4 percent.
The Consumer Price Index (CPI) rose 4.1 percent for 2007, which was the fastest rate since 1990. In January, nominal CPI rose 0.4 percent while the core reading was up 0.3 percent. Both nominal and core CPI were unchanged in February. Year-over-year CPI is up four percent while the core is up 2.3 percent.
One of the first releases of the New Year, the ISM manufacturing report was much weaker than expected, falling to 47.7 in December from 50.8 in November. This was the weakest reading since April 2003. The index then proceeded to fall below 50 in February to 48.3. Remember that a level below 50 indicates contraction, while a level above 50 indicates expansion.
The index recovered slightly in March, coming in at 48.6. The prices paid index spiked from 75.5 to 83.5 as energy prices, which briefly declined in February, rebounded in March. The employment index rose to 49.2 in March from 46.0 in February.
The ISM non-manufacturing index rose from 44.6 in January to 49.3 in February. The orders index rose from 43.5 to 49.6, the supplier deliveries index rose from 49.0 to 50.0 and the employment index rose from 43.9 to 46.9. In March the index, which captures almost 90 percent of the economy, rose to 49.6.
Consumer confidence fell more than forecast in February to the lowest level in five years. The Conference Board's index decreased to 76.4 from 87.3 in January. In March the Conference Board’s reading hit a five-year low, as the index fell to 64.5
Consumers are worrying more about the economy because the housing market is in its third year of decline, employment has dropped and gasoline and food prices were elevated.
Retail sales were stronger than expected in January as both overall and non-auto sales rose 0.3 percent. Americans spent more on cars, clothes and gasoline, a sign that at this point the biggest part of the economy was holding up even as the housing slump deepened. The 0.3 percent increase followed a 0.4 percent decrease in December.
That turned around in February however, as retail sales fell 0.6 percent. Auto sales were down 1.9 percent, accounting for most of the weakness, but even excluding autos, sales were down 0.2 percent.
Nominal consumer spending in January rose 0.4 percent) and real consumer spending was flat. In February, consumer spending rose at the slowest pace in more than a year, providing more confirmation of an economic slow-down, with a 0.1 percent.
Durable-goods orders fell more than expected to 4.7 percent, in January as companies reduced spending. However most of the decline was accounted for by declines in orders for civilian aircraft and military capital goods following good gains over the prior two months. New orders excluding transportation equipment declined 1.4 percent.
Durable goods orders fell another 1.7 percent in February. This time, when the volatile transportation sector was excluded, orders fell 2.6 percent as companies cut back on equipment purchases.
Commodities prices finished the quarter substantially higher, but tighter credit and concerns about economic growth caused prices to decline in the latter half of March.
Before that, however, there were some historic highs: crude oil rose above $110 a barrel, topping the inflation-adjusted high set in 1980; gold prices exceeded $1,000 per ounce for the first time; and agricultural products such as wheat and other precious metals hit new highs.
However the credit crisis and fears of a deep U.S. recession may put an end to the bull market in commodities. They sold off sharply after the Bear Stearns bailout, as many speculators chose to take their profits and cash out, or worse, had to sell to raise liquidity.
Housing Market
Housing starts rose 0.8 percent in January, but then dropped to their lowest level in 16 years, falling 0.6 percent to 1.06 million for the month of February. Construction on single family homes fell 6.7 percent.
Existing home sales fell 0.4 percent to 4.89 million in January. Single-family existing home sales rose 0.5 percent, while multi-family sales fell 6.5 percent. Multi-family sales, i.e. condos and co-ops, are down 30 percent year-over-year.
Existing home sales rose 2.9 percent to 5.03 million in February, primarily due to the decline in home prices. The median price of an existing (previously owned) home was down 8.2 percent from a year ago and is expected to fall further.
New-home sales fell in January to the lowest level since February 1995 even as prices slid by a record 15 percent from a year ago.
New home sales were also lower in February, falling 1.8 percent, bringing them to their lowest level in 13 years. The report did contain some positive news; the number of new homes for sale at the end of February dropped to 471,000, the fewest since July 2005, indicating builders are making headway in clearing out the inventory glut. Still, the decline in sales kept supply at 9.8 months, the same as in January and the highest since 1981.
The Mortgage Bankers Association (MBA) announced that U.S. mortgage foreclosures rose to an all-time high at the end of 2007 as borrowers with adjustable-rate loans walked away from properties before their payments rose. New foreclosures jumped to 0.83 percent in the fourth quarter, the highest ever, from 0.54 percent a year earlier. About 40 percent of all foreclosures are homeowners with prime or subprime loans who couldn't make their payments before they reset, according to the MBA.
Second Quarter Outlook
When the first quarter began, there was still hope that the U.S. economy would avoid a recession. However, the distress in the financial markets proved to be broader and deeper than anyone could have predicted. Despite aggressive monetary easing and other unprecedented measures by the Fed to provide support, financial market conditions continued to worsen. Now the debate is over how long and how deep the downturn will be.
Continued deterioration in financial markets is going to weigh on an economy that is already contracting. First- and second-quarter earnings are expected to decline, and capital spending is likely to soften. The question is whether an expected big rebound in the second half of the year will materialize.
There are still definite downside risks to the economic outlook. The credit crunch could intensify, which would further depress domestic demand. Moreover our troubles could spill over into other regions, particularly Europe, through financial conditions and earnings.
The housing market has fallen deeper into recession. Home sales have continued to fall while inventories remain high, forcing builders to cut construction further. Home prices are down 10 percent from their peak in 2006 and are still falling.
Employment has declined for three consecutive months, signaling retrenchment by employers and depressing income growth. Further labor market deterioration is likely in coming months, judging from the sharp jump in both initial and continuing jobless claims in late March. However, the level of declines in employment has, believe it or not, been relatively mild in comparison with the past two recessions.
Consumer spending, which has been the lynchpin of economic growth, is slowing sharply. Given that employment and income growth are decreasing, the pace of consumer spending should continue to slow even further. Fiscal stimulus in the form of tax rebates will help with spending in the second half of the year, but it depends on how much of the tax rebates are spent rather than put into savings. The uptick in spending is likely to be pretty modest for the rest of the year once the positive effects of the tax rebates fade.
The anticipated pain of upcoming mortgage resets is now less than it was last year. Now that interest rates have declined, the incremental payments will be much less than was originally estimated. The average rate on outstanding subprime ARM loans is around eight percent. With six-month LIBOR around 2.5 percent, adding the typical 600 basis point margin will not cause the reset rate to be that much higher. In contrast, reset rates were projected to rise to around 11 percent last year.
Optimists on Wall Street think the turning point in the economy will come sooner rather than later, thanks in large part to the Federal Reserve's aggressive efforts to stabilize the financial system and reduce short-term interest rates.
Pessimists contend however, that job losses are only just beginning, and home-price declines appear to be accelerating. Meanwhile, raw-materials costs remain stubbornly high, despite the slowdown in the U.S. economy, which will likely pinch consumers more and crimp corporate profits. These market watchers say the bulls are jumping the gun.
While the future course of Fed policy will obviously depend on incoming data and financial conditions going forward, we think it is safe to say the period of aggressive easing is over. Fed officials will want to assess the impact of both monetary and fiscal stimulus before deciding how much more easing is needed.
Current expectations for the Fed funds rate show a cut of 25 basis points at the April meeting. However we still have a long way to go before the end of April and expectations could shift back toward 50 basis points. There seems to be some resistance to going below two percent on the Fed funds rate, but our current forecast contains one more cut after the April meeting to a trough of 1.75 percent.
Summary Chart
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