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ALM
First Financial Advisors
Economic Overview
Second Quarter 1998
TOPICS
COVERED
Introduction
Last year I had the opportunity to listen to a
speech by Peter Lynch, the famous portfolio manager of the
Fidelity Magellan Fund. He spoke at some length about his
method for picking stocks. But when asked about the usefulness
of economic analysis, Mr. Lynch stated; "If you spend
half an hour a year performing economic analysis, you have
wasted fifteen minutes."
Although
economics is much more important to the bond market than it
is for stock picking, we tend to agree with Mr. Lynch for
our current quarter interest rate forecast. This quarter,
the dominant factor in preparing our forecast is not the domestic
economy but rather the impact of foreign demand.
The U.S.
economy remains very strong. Over the next quarter, we do
not anticipate any changes of enough magnitude to move Treasury
yields out of their current trading bands. There are, however,
some early signs of an economic slowdown on the horizon.
The real
wildcard for the next three months is the level of foreign
demand for U.S. Treasuries. The Asian crisis and the strong
dollar have made foreign investments in U.S. bonds very attractive.
This has the potential to drive yields substantially lower
over the next few months.
The other
pertinent factor in our economic overview is the shape of
the yield curve. The curve is very flat - the average rate
in June for both Federal Funds and the 30-year Treasury bond
was 5.60%. Some people have begun to discuss the possibility
of an inverted yield curve.
Last
Quarter
The yield on the two-year Treasury Note stayed within our
projected trading band of 5.30% to 5.65%. Inflation worries
dominated the market for most of the quarter until recently
when concerns over the Asian crisis were renewed.
Domestic
Economy
GDP growth for the first quarter of 1998 was revised upward
to 5.2%. This healthy growth rate is the main reason that
inflation worries were so prevalent during the second quarter.
The revision was heavily concentrated in exports and inventories,
while the other components as a group were revised downward.
The inventory component included a record $105 billion of
inventory accumulation in the first quarter, an amount which
cannot be maintained. A slowdown in inventory accumulation
will create a drag on production. Meanwhile, the strong dollar
and Asian troubles will naturally slow the growth of exports
over the coming months. Based on this information the upward
revision that sparked renewed inflation concerns has been
discounted and the consensus forecast calls for GDP growth
of 2.3% for the remainder of the year.
Consumers
continue to lead the expansion. Housing starts and sales are
at a ten-year high. Home ownership costs as a percentage of
income are the lowest in post-war history. And more and more
people are feeling the benefits of the continued strong stock
market.
Consumer
confidence, as measured by the Conference Board, reached a
new high in June. A continued low saving rate gives no indication
that consumers are backing away from spending.
The labor market continues to be very tight. The May unemployment
rate was the lowest level since 1970.
Employment
growth continues to average 250,000 jobs per month. Many economists
believe that the labor force growth is one of the major surprises
in this economy, reflecting more immigration and higher labor
force participation rates.
Weak fringe
benefit growth and declining import prices are offsetting
higher wages to limit the impact on prices, however.
The
percent change in both the CPI and PPI continues to be small,
a signal of very little inflation.
The two
primary constraints on the U.S. economy are the tight labor
markets and the high level of inventories.
One indicator
of a possible slowdown was the recently released National
Association of Purchasing Managers (NAPM) Survey. A reading
of 50, in this survey, can be thought of as a "swing
point"-above 50 implies an increase in manufacturing
activity, while below 50 implies a decline. The June reading
was 49.8, the first dip below 50 in two years.
In summary,
the U.S. economy continues to look strong and healthy. There
are some early signs of an economic slowdown, however. As
mentioned in the introduction, neither the economy's strength
or the indicators of a slowdown are major factors in the forecast
of the current quarter. Over the next six to twelve months
however, we continue to believe that rates will trend lower
as the economy slows.
Yield
Curve
One very interesting aspect of the current interest rate environment
is the very flat yield curve. The second quarter was characterized
by more good news about the federal budget and hence a more
flat yield curve. A possible yield curve inversion is a concern
for financial institutions when the curve is this flat. An
inverted yield curve would have a major impact on net interest
income. Many institutions are already feeling the pinch of
a flat curve in the form of contracting net interest margins.
Historically,
both rising short rates and bearish short-rate expectations
have been required for the yield curve to invert. This has
not been the case in this cycle. The current flattening has
occurred primarily as the federal budget and the outlook for
anticipated inflation has improved, leading to a flatter curve
in a declining rate environment.
Traditionally,
an inversion would occur once short-term rates had risen enough
to slow growth. This would diminish the effects of inflation
and other risk premiums that contribute to a positively sloped
yield curve. This, in turn, leads to expectations of lower
long-term rates, causing the curve to invert.
We do
not see an increase in short-term rates on the horizon and
therefore, do not predict much more of a flattening or an
inversion. The fact that much of the current growth has been
led by inventory as well as the turmoil in Asia should work
to inhibit growth without the need for increased short-term
rates. The more likely scenario is for short-term rates to
fall as the Asian crisis continues to spill over into the
worldwide financial markets.
Asia
Two aspects of the Asian crisis are having an impact on U.S.
interest rates. First, the flight to quality issue brings
a lot of foreign investors worried about economies in their
own countries to the U.S. market. Second, the strong Dollar
and potentially weakening Yen makes investing in the U.S.
very attractive to Pacific Rim investors.
Both of
these aspects of the Asian crisis increase the demand for
U.S. Treasury securities. The supply of Treasuries is already
low due to growing tax revenues and the shrinking budget deficit.
A significant increase in demand coupled with this reduced
supply would drive Treasury prices higher and yields lower.
The July
12 election and resultant loss by the ruling party in Japan
adds to the instability of this situation. The prospect of
an entirely new government in Japan increases the chance that
no new government programs will be enacted in the near future
to tackle their economic problems. There is a fear that the
government will go through a stage of policy paralysis during
the transition period.
A perceived
inability of Japan to put its financial house in order would
aggravate the Asian recessions and make the spillover from
Asia worse than expected. U.S. firms would then experience
serious declines in their overseas business, leading to layoffs
and a decrease in consumer confidence. This
scenario along with the increased demand for safe U.S. securities
could push rates down considerably.
3rd
Quarter Forecast
Our analysis of the current domestic economy alone leads us
to believe we are at the bottom of the trading range for the
two-year Treasury. Making our views for the coming quarter
slightly bearish. However, when the worsening Asian troubles
are taken into consideration we realize the possibility of
further rate decreases.
For the
3rd Quarter, we believe that the two-year Treasury Note will
remain within its current trading band. However, our fears
about the possible impact of the Asian economic turmoil have
caused us to widen the band of our forecast. ALM First projects
that the two-year Treasury Note yield will trade within a
band of 5.10% to 5.60% during the 3rd Quarter with the lower
yields hinging entirely on Asian ramifications.
Over the
next six to twelve months, we believe that the domestic economy
will experience slower growth and lower rates.
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