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ALM
First Financial Advisors
Economic Overview
Second Quarter 1999
TOPICS
COVERED
Introduction
Some
of the best stories ever written seem to always play along
the theme of good versus evil. For example, we have David
and Goliath, Moses and the Pharoh, the jedi knights and the
evil empire, and finally Rudolph and Hillary. In these epic
struggles it is always easy to cheer for the good guy. In
the never ending story of economics the line between good
and evil is not so easy to see.
As you
have read in past overviews the continued conflict between
the old school, rooted in the Keynesian model, and "new
era" economics continues to entertain those that care
to follow the story. The reports of this battle have even
spilled over into the mainstream press. For stories about
economic theory to show up on your morning doorstep is indeed
a triumph for the art of econometric forecasting.
As we
find ourselves on a swell of higher interest rates at the
the end of the second quarter I get the distinct feeling that
we are on the verge of discovering the villan of this story.
To quickly
summarize, for fixed income investors such as ourselves, the
evil outcome is incipeint inflation. This is the stuff the
eats away at our contractual cash flows and real rate of return
that we invest in through loans and securities. The adage
that too many dollars chasing too few goods is a truism that
will survive regardless of the victor in our ongoing saga.
The Keynesian school for decades has warned us that an economy
that runs too fast is what causes too many dollars. To them
we have been running our engine at full tilt for a while now
and we are in danger of overheating. The fright that we will
see inflation soon through this model is what has pushed market
interest rates substantially higher over the past quarter.
The new
era camp says growth by itself is not a bad thing. Growth
through productivity gains, brought on through a new era of
technology advancement, has enabled the domestic economy to
become really an integrated world economy and enabled it to
run at a higher rate of speed than we have grown accustomed.
The measurement
of inflation through economteric indicies such as CPI, PPI,
gold, oil and wages are the official scorecard for this match.
So far the facts reside with the new era camp. While we had
an uptick in CPI during one month of the second quarter, inflation
data has continued to exhibit a very docile temprament. To
the Keynesians it is like the calm before the storm.
ALM First
has been a member of the new era camp for some time now. The
lack of upsetting inflation data has led us to continually
forecast lower interest rates and for most quarters we have
been right. This last quarter we saw the market and the FOMC
sway towards the Keynesian camp, and send interest rates higher
and our forecast for lower rates overboard.
Last
Quarter
The Federal Reserve ended the first quarter with a rate hike
of 25 basis points. This was a clearly telegraphed move that
was made evident during the Greenspan testimony to the JEC.
This reinforced the markets recent laments and solidified
its new higher levels.
This came
on the heels of another outstanding quarter of results coupled
with a shocking April CPI of +0.7%. Indeed, the first quarter
GDP recorded a very respectable 4.1% increase. This is slower
than the 6.0% the economy generated during the fourth quarter
of '98 but is still higher than the Fed's target. Second quarter
GDP is anticipated to be +3.7%.
This quarter
has witnessed a slow down in housing as higher market interest
rates have pushed up mortgage rates. This has had the expected
impact to housing turnover and development.
Retail
Sales has also visited slower growth as an unstable equity
market rocked the consumer during the first quarter. Consumer
credit, the ballast of the current boom, is still growing
slightly but has become volatile and is showing the signs
of topping off.
This has
slowed the level of car sales to less than 7 million units
per year and has even forced some equity analysts to downgrade
domestic car manufacturers forecasted earnings because of
a perceived lack of pricing power.
The one
economic release that causes the most anxiety among market
participants is payroll growth. As can be seen from the accompanying
graph job growth continues to be strong averaging almost 200,000
new jobs per month for the first six months of the year. Strength
however, does not appear to be building.
This has
caused the unemployment rate, a huge indicator for the Keynesians,
to remain at its low average of 4.3% for the second quarter.
While
employment growth continues to be strong and the unemployment
rate low, the employment cost index (one of our scorecards)
has fallen in the first and second quarters from its growth
in the middle of last year.
Many
factors relate to consumer confidence. Job security is chief
among them but increasingly the average consumer is becoming
more closely tied to the performance of the equity market.
Never in the history of our country have equity investments
constituted such a large position of the population's wealth.
The crash of '87 witnessed the market's short-term but severe
correction, while having little real impact on the domestic
economy. Should such a similar event occur today the impact
to the domestic economy would be more dramatic. While the
favorable employment and equity markets have continued to
buoy consumer confidence to its lofty height, the rise in
confidence seems to have leveled off.
On the
wholesale side, industrial production has moderated with capacity
utilization dipping down to lowest levels seen over the last
several years. This argues for the new era theory that investment
into new plants and technology has increased our ability to
produce and reduce the probability of bottlenecks occurring.
The data
to this point shows a strong economy that may be slowing slightly
from its current trend. We look at these fundamental economic
inputs in order to gauge the probability of an unexpected
increase in inflation.
As mentioned
above, the scorecard for inflation utilizes the general price
indices as well as the prices for gold and oil. While they
are not perfectly accurate gauges of inflation and often show
inflation after it hits, they are the best measures that we
have.
 Also
mentioned above was the April CPI release that sent shivers
down the backs of market participants. From the accompanying
graph it is easy to see that in relation to the other monthly
releases of this index that the April result appears to be
an aberration. Indeed, the May release of CPI was 0.
Oil has
climbed over the past several months to the highest levels
seen in a couple of years. This is largely a function of the
recent OPEC agreement that for the first time in years, has
fostered cooperation among its members. From our review of
various oil analyst's reports, the price of oil is not expected
to climb much higher due to the fundamentals of the OPEC agreement.
The price
of gold, a precursor to inflation, to many in the new era
camp, has reached 30 year lows. Central banks have taken to
selling huge stores of the precious metal. This again argues
for what appears to be the prevailing trend on the inflation
scorecard, no visible up trends in inflation.
The
Forecast
In order to make a market interest rate forecast an analyst
has to decide which side of the theory battle he or she feels
will prevail. We at ALM First feel that while the economy
continues to push forward, the preponderance of inflation
data argue for the new era viewpoint. This in turn would argue
for lower interest rates.
That said,
it is evident that the bond market is battling this same schizophrenia,
moving between bulls and bears as economic data unfolds and
the FOMC acts. From this we grow hesitant about the market's
ability to move higher in price (lower in yield).
We believe
that the FOMC is facing internal pressures to increase the
Fed Funds rate one more time in 1999 -- another 25 basis points.
This action, should it occur, is largely priced into the market
already and should not cause term rates to increase significantly.
ALM First however, does not feel that the FOMC will make a
second tightening move this year.
The two-year
Treasury rate ended the second quarter at 5.53%, almost 60
basis points higher than where it ended the first quarter.
We continue to look for a slight downward drift in the two-year
rate over the quarter due to slowing growth and a continued
favorable inflation picture. Our projected trading band for
the June - August period is 5.70% - 5.35%.
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