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ALM
First Financial Advisors
Economic Overview
Prepared
by: Angela Calvert
Third Quarter 2000
TOPICS
COVERED
Introduction
Good Times. That should sum up the past couple of quarters.
After all of the hoop-la about slowing down the economy and
the fear of rising prices spurring inflation, market participants
should be elated to see that a lot of those worries appear
to be put to rest. So why all the long faces? Other than the
Fed announcing that they will continue to watch for signs
of inflation, aren't things exactly as they should be? Perhaps
in this "Revolutionary Age" where it's all about
speed, we have all become so accustomed to hyper growth, that
slow and steady have come to seem dull and boring.
Let's
take a look at some of the changes we have seen in a very
short period of time. Last years' yuletide season brought
us a 5.50% Fed Funds rate, a neutral economic assessment,
and a 24 basis point spread between the 30-year US Treasury
bond and the 2-year US Treasury note. The economy seemed to
be growing by leaps and bounds with both the Dow and the NASDAQ
on fire, with no end in sight. This years' holiday season
is on quite a different note. The current market has a 6.50%
target funds rate, a watchful eye on inflation, and an inverted
spread of 15 basis points between the 30-year and the 2-year.
Growth has clearly slowed, which is reflected in the Dow and
NASDAQ, as their previous fires seem to have become more of
a smolder. With the FOMC increasing the Fed Funds target rate
by 100 basis points in 9 months, it seems only natural that
the market will have to have time to absorb it all. Welcome
to "The Adjustment Period."
Black
Gold, Texas Tea
With most inflationary indicators that are so closely watched
in today's market behaving just as they are suppose to, the
one thing that is keeping some sort of excitement and fear
alive, is the ever rising price of oil. At around historical
highs in the mid $30s per barrel, the recent surge in crude
oil is one factor that keeps a reality check on the market.
Historically speaking, past jumps in oil prices since the
1970's were associated with eventual recessions.
However,
these business downturns also reflected other recessionary
forces that are largely absent today. During those previous
hikes in the cost of petroleum prices, the market displayed
higher overall inflation and higher interest rates. The economy
experienced a lagging productivity exhibited in both falling
wages and less attractive potential returns from capital investment.
In today's marketplace, the U.S. economy has become more efficient.
The direct effects of higher priced energy on both growth
and inflation have become more controlled as the US has been
using less energy to produce a given amount of output. For
example, in the manufacturing sector, the ratio of energy
usage per unit of output in the late 1990s was 15.8% less
than during the mild 1990 recession and 26.9% less than during
the more serious 1981-82 recession.
Growth
Over the past year, the U.S. economy already has demonstrated
that it can absorb a large rise in crude oil prices without
much of a negative growth impact. At the end of the second
quarter, 2000, there was a $53.5 billion rise in seasonally
adjusted imports of petroleum products that accompanied an
almost $14 per barrel rise in the price of imported petroleum.
Despite these happenings, the U.S. real GDP still grew 6.0%.
With much
of the third quarter data in hand, estimates for third quarter
GDP are around 3-3.5%. This rate of growth is generally considered
the highest level of growth consistent with low inflation.
Over the past six quarters, however, GDP growth has averaged
5%, yet inflation remains close to a 10-year low. The issue
of slower growth and its effect is twofold. First, it gives
credibility to the fact that higher oil prices are not being
solely passed through to consumers through higher prices,
and secondly, it gives an overall statement that other key
factors, such as wages and personal consumption, are keeping
pace and absorbing higher energy costs. As the equity market
has taken quite a blow this past month, it could also be taken
as another sign of less than exuberant growth.
Labor
Concerns
Despite tolerable growth, the concerns of inflation will remain
on the forefront for Alan Greenspan and his clan because of
tight energy and employment markets. Job growth data and unemployment
are two numbers that get a lot of attention. The number of
new non-farm jobs being added each quarter has remained in
check. In September, non-farm payrolls rose 252,000, which
was slightly higher than expected, but higher than the yearly
average of 242,000. The two negatives of the employment report
were the decline in the unemployment rate and the drop in
the pool of available workers.
September's
unemployment rate is back down to the record low of 3.9%,
while the pool of available workers it also at a 30-year low.
With the low, but steady unemployment rate and the lowest
amount of available workers in thirty years, another important
factor to keep a watchful eye on is Average Hourly Earnings.
This number, as well, was in line with expectations at a modest
quarterly increase of 0.2%.
Inflation,
Inflation, Inflation
As referenced so many times before, the big boogey man for
market participants is inflation. With the steady climb in
oil prices coupled along side low unemployment and continued
economic growth, the prudent person would have anticipated
the appearance of the ever-frightening boogey man by now.
But thus far, our base inflation indicators suggest we are
still safe for now. The three biggest inflation indicators
are Producer Price Index (PPI), Consumer Price Index (CPI),
and the Employment Cost Index (ECI). PPI is an area where
the market has experienced some effects from the recent hike
in energy prices. With the well-behaved August number of -0.2%,
the course reversed somewhat in September with the higher
than expected 0.9%. However, the main emphasis tends to lead
toward the core PPI, which excludes food and energy, and came
in stronger than anticipated with a rise of 0.3%. This number
is more of a check on how much of the rise in energy costs
is being passed on to the consumer.
The Consumer
Price Index will be a critical issue for the Federal Reserve
on the subject of whether this year's energy-led rise in CPI
will necessitate much accelerated upcoming wage inflation
in a still-tight labor market. For the year through August,
while overall
CPI inflation
has picked up to 3.4% from 2.7% last year, non-energy CPI
inflation has picked up to a more moderate 2.5% versus 1.9%
last year.
3rd
Quarter 2000
The ever-changing yield curve makes buying securities seem
like a game of cat and mouse. Over the past 9 months, we have
seen dramatic changes in the shape of the curve. At the beginning
of the new millennium, the yield curve exhibited a normal,
although not too steep, shape. There was a 24 basis point
spread between the 2-year note and the 30-year bond. Since
that time, several factors have contributed to last quarter's
and this quarter's sharp shifts along the curve. Since the
previous curve inversion last quarter, we have seen both the
initiation of curve steeping trades and the unwinding of curve
inversion trades. There are many components that make up these
changes, but some of the main ones are Fed policy changes,
equity market volatility and fiscal policy.
With the
latest FOMC meeting behind us and the vagueness as to their
next move, the overall perception seems to be one of neutrality,
at least through the elections. As this appears to some as
the end of a tightening cycle, it is typical to see the curve
begin to steepen. However, shifts along the curve may have
been somewhat exaggerated due to debt paydown. As investors
were faced with a shrinking supply of US Treasury Bonds, they
were forced to overweight the long end of the curve, thereby
driving up the price and depleting the yield. As the tightening
cycle drew to a close, some of those positions were unwound.
To add
to these corrections in the shape of the curve, came the announcements
of earnings disappointments and reports of softening of demand
in the tech sector. Stock prices have taken it on the chin
and left investors running for a safe haven. Hence, the sudden
influx of cash seen by the short end of the yield curve.
And one
last push of the curve in the same direction comes from the
two possible future leaders of the great old USA! There is
concern that with all of the promises of tax cuts and increased
spending, that the current surplus will be depleted thereby
offering no deduction in the stock of Treasury debt. It all
comes down to Economics 101 - Supply and Demand.
The
Forecast
Based on the current data at hand, there doesn't appear to
be much cause for change. As the Fed has dually noted after
their past few rendezvous', they remain aware of inflation
lingering in the background. Greenspan doesn't want anyone
getting too comfortable! For the time being, the rising costs
of energy are seemingly being absorbed by a less energy sensitive
U.S. As we are nearing the end of the confession period of
earnings, the pressure within the equity markets is likely
to become less acute. As emotions and fears die down, the
front end of the curve should see some repricing. We expect
funds to remain at 6.50% through the end of the year and the
two-year to trade somewhere between 6-6.35%.
As it
has come to pass, the market reacts to the smallest of changes
in economic data so we must remain acutely aware of just how
quickly predictions can change. With that being said, let
us beware that we have not seen the last of potentially market
moving data for this quarter.
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