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ALM First Financial
Advisors
Third Quarter 2001 Economic Overview
Prepared
by: Thomas Manley, CFA
July 4, 2001
TOPICS
COVERED
Introduction
The
2nd Quarter of 2001 started on the right track when the Federal
budget resolution was passed. This removed the possibility
of Democrat filibuster. With the imminent passage of the Bush
tax package the equity market as well the general tone of
market participants began to improve.
As you
know, that same week Senator Jeffords bolted from the Republican
Party, handing control of the Senate to Democrats. The market
rally stopped. It makes you wonder why we have two Senators
from Vermont.
On top
of this, the Bush Administration made a poor decision in establishing
a protectionist position in favor of the U.S. steel industry.
This coupled with the European decision to disallow the GE
Honeywell merger left the marketplace ith the bitter taste
of too much government intervention.
This taste
was soothed somewhat by the reversal of some of the bizarre
rulings/actions of our old friend, Judge Thomas Penfield Jackson,
in the Microsoft antitrust case.
On a more
tangible basis, the FOMC acted for the sixth time this year
in dropping the Fed Funds rate 25 basis points to 3.75%. This
means that in just about six months time the Fed has lowered
Fed Funds 275 basis points, a significant easing in magnitude.
Indeed, from the Outlook that I wrote last quarter I mentioned
the latitude the Fed had in maneuvering because of the premium
that the then Fed Funds rate had over a zero real rate of
interest. It is obvious that the Fed is aware of this and
has acted accordingly.
Another
interesting aspect of the Fed action at the last FOMC meeting
is the use of a 25 basis point move rather than the 50 basis
point move that had become customary. There have been many
discussions and writings on this subject since it has occurred.
One opinion states that the Fed knows that the act of easing
is more important than the actual change in interest rates.
Therefore, at a 3.75% Fed Funds rate they only have so many
bullets left in which to act before the target rate falls
below 3%. So, better to use a 25 basis point shot to conserve
ammunition.
The other
opinion is that the Fed is signaling the end of this easing
cycle. In other words, trying to psyche the economy into feeling
good about itself.
Some of
you may remember an invigorating discussion about Fed mechanics
from the conference call that we had with Dallas Federal Reserve
Bank President Bob McTeer. Prior to this call Emily Hollis
and myself spent 30-minutes with Dr. McTeer discussing topics
ranging from poetry, to credit unions to the California power
crisis and finally the actions of Federal Reserve Policy.
He indicated that the Fed was studying the effect of reducing
the absolute magnitude of Fed actions at the end of tightening
or easing cycles. You may recall that this call took place
before the latest FOMC meeting. This, of course, gives a lot
of support to those that subscribe to the second opinion,
that the Fed is nearing the end of its cycle.
Second
Quarter Review
To review what the FOMC is considering let us now look at
some of the economic data from last quarter.
Wholesale
Productions
As was the case last quarter, the consumer has
been the salvation for this economy, which at a wholesale
level, has collapsed. Observers do not have to look very far
to see indications of devastating destruction in the manufacturing
sector, particularly in the tech sector. Outlays for non-defense
high-tech goods contracted for the fifth consecutive month
in May, bringing the year-to-date decline (not annualized)
to more than 22%.
Indeed,
moving into a broader measure, it is easy to see the actual
negative growth of Industrial Production. Eight months straight
of negative reports has culminated into an annualized decrease
of 5%. You may recall from the last Outlook that a string
of consecutive declines of this magnitude has been a good
predictor of economic recession.
Also of
value in predicting economic recession has been the Capacity
Utilization ratio of our nation's factories and plants.
A drop
below 80% has been a fairly good indicator that economic recession
is near. Beginning in the summer of 2000 the dramatic drop
off in capacity utilization is evident. In fact, last month
the cyclical low 77.4% was recorded.
Included
in the wholesale slowdown is the decreased demand of vehicles.
Looking at the sales of domestic cars, it is evident that
a slowdown has occurred.
Indeed,
the average annualized sales volume of 7 million units has
fallen to just over 6 million units, a 14% degradation.
These
and other indicators, that are equally as alarming, have been
steadily transmitted to the consumer in the form of job weakness.
350,000 manufacturing jobs have been lost this spring with
40% of these losses coming from the industrial machinery and
electronic equipment sectors.
Indeed,
the past quarter has witnessed an average job loss of 90,000
jobs per month. This works out to 1.1 million jobs per year.
As
job losses mount, the psychologically important unemployment
rate has been steadily rising.
Consumers
Make no
mistake, consumer activity has been bruised but you can see
from the accompanying graph that consumer confidence took
a fairly large hit as the economic slow down took hold. As
the equity markets found some footing earlier in the 2nd Quarter,
consumer confidence has shown remarkable resilience.
Coupled
with surprisingly strong consumer confidence, lower market
interest rates have helped fuel strength in the housing market.
On more
of a retail level, retail sales have not been nearly as strong
as in the housing area however; they have not been overly
weak either.
In summary, it is easy to see that the somewhat positive consumer
economic releases are absolutely mitigating the disaster occurring
at the wholesale level.
These
economic releases culminate into a reduction in economic growth
as measured by GDP, but it is important to note that we still,
as of now, have positive economic growth. Indeed, most are
forecasting the 2nd Quarter GDP to post about a 1.7% annualized
growth rate. While this is anemic compared to the super growth
recorded in quarters past, I suppose most of our trading partners
in Europe and Asia would jump at the chance to record such
growth.
Third
Quarter Forecast
Based
on what appears to be the bottoming of several of the economic
releases that are showing the largest declines, coupled with
the market's anticipation of this being close to an interest
rate trough, we at ALM First expect the 2 year Treasury note
to fall slightly lower.
Our
3rd Quarter forecast for the 2-year Treasury note is for it
to trade between 3.75% and 4%.
The
cornerstone of this forecast is the anticipation that we will
have two FOMC meetings during the quarter culminating in two
more rate actions of 25 basis points each. We continue to
see that the Fed has the latitude to be easy with liquidity
given that inflation problems are not on the horizon. This
is obvious when you look at the inflation indices, the Produce
Price Index (PPI) and the Consumer Price Index (CPI).
Both
releases continue to show benign readings. Looking at more
fundamental price indicators such as the prices of gold and
oil, we again see that the Fed is not currently in danger
of igniting inflation. This coupled with the expectation that
our major trading partners' respective economies are showing
very stagnant growth, the Fed has a large comfort zone in
which to manage short-term interest rates.
Given
that we think that the Fed will act two more times rather
just once, as is the broader opinion, you may ask, "why
don't we think the 2-year Treasury note will trade lower than
3.75%?" As the market anticipates the end of an easing
cycle, the term structure of rates (those rates past overnight
in term) become "sticky" and may even begin to rise.
We think that this will be the case as the Fed Funds rate
dials in at 3.25% at the end of September.
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