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ALM First Financial Advisors
Third Quarter 2005 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
July 11, 2005
TOPICS
COVERED
Second
Quarter Review
Low long-term interest rates did little to restrain economic growth this quarter despite Fed tightening of 2.25% since a year ago. Instead, the housing market continues to sizzle, with home sales, new construction, building permits, and price appreciation at or near record levels. Similarly, with after-tax income growth of 6%, strong home wealth gains, and an improvement in consumer sentiment, there are no signs yet that higher energy prices are restraining consumption.
At the beginning of the year, a consensus of economists predicted that in 2005 the dollar would fall, long-term interest rates would rise, economic growth would slow and the bond market would tumble. It now looks like what the consensus predicted for 2005 will not occur until 2006, and maybe even the second half of 2006.
Nevertheless, continued worries over oil prices, slowing economic growth and the Federal Reserve's plans for raising interest rates have combined to hold stocks back for most of this year. In the quarter just ended, the Dow Jones Industrial Average fell 2.18%, to 10,275.
Including the first quarter's decline, the industrial average is down 4.7% for 2005. In fact the Dow is now back where it was at the end of 2003, a level it first crossed six years ago in early 1999. The Standard & Poor's 500-stock index was up slightly for the quarter, rising 0.91%, but it remains down 1.7% for the year.
Bond prices held up surprisingly well in the second quarter after credit ratings for General Motors Corp. and Ford Motor Co., two of the world's biggest issuers of corporate debt, came crashing down. Standard & Poor's Corp. downgraded GM and Ford simultaneously, dropping about $85 billion of their traded debt into the market for the low-rated high-yield or "junk" bonds.
Meanwhile, the Treasury market continued to shrug off the Fed's tightening of short-term rates, apparently on perceptions that the U.S. economy is losing steam and that this will cause the Fed to stop raising rates at some point short of 4%. The price of the 10-year Treasury note went up, pushing down its yield (which moves inversely to price) to as low as 3.89% in May, compared with 4.50% on March 31. The 10-year yield ended the second quarter at 3.92%.
Other reasons for the rally include the fading of exaggerated fears, i.e., near-term inflation and 50-basis-point moves from the FOMC. But more recently, the rally has gone well beyond mere relief, and the market now seems to discount only one additional 25-basis-point rate hike by the end of 2005.
Some also attribute the rally to foreign investors, including Asian central banks, piling into U.S. bonds. At the beginning of the year economists expected foreign central banks to move funds out of dollar denominated investments and into other currencies. Political uncertainty surrounding the Euro however, has prevented this movement. Still others see the flattening yield curve as a sign that the market expects the Federal Reserve's interest-rate increases to keep both inflation and economic growth in check - or even provoke a recession.
Investment and savings patterns around the globe also appear to have contributed to lower interest rates. In industrial countries, business profitability has recovered significantly, but investment remains relatively low by cyclical standards. This has helped to offset declines in personal savings in both the United States and Japan. Inflation performance has improved markedly around the world and this has probably contributed to the current low level of long-term interest rates as well.
Monetary Policy
The FOMC raised the funds rate target by 0.50% during the second quarter to 3.25%, as expected, and maintained both the "measured" and "accommodative" language.
The Fed made no changes to the key elements of its statement: it maintained its characterization of policy as accommodative; it retained its judgment that the upside and downside risks surrounding its goals are roughly equal, conditional on appropriate policy action; and it retained its statement "that policy accommodation can be removed at a pace that is likely to be measured."
There are some economists and market participants who hold the view that the Fed will stop raising rates when the fed funds target reaches 3.50%. Since the Fed raised the funds rate to 3.25% on June 30th, this would imply only one more rate hike this year. However seeing as the Fed gave no indication of a pause in its last statement, it is far more likely that the Fed funds rate will rise to 3.75% or 4.00% by the end of 2005.
The Bond Market vs. The Fed
Given the reaction of the bond market to higher short term interest rates, it is safe to say that the Federal Reserve and the bond market don't seem to be speaking the same language these days.
The Fed keeps indicating it's worried about inflation and that it's going to keep raising rates at a measured pace to combat it, while bond investors seem to be more focused on the economy's recent slowdown than on inflation. The yield on the 10-year Treasury note remains well below where it was before the Fed started hiking short-term rates last year, even though Alan Greenspan and other Fed members have said that was a "conundrum."
The bond market response to Fed tightening has been without precedent. Despite a 200-basis-point rise in the Fed's target federal funds rate, 10-year Treasury yields have fallen about 70 basis points. As a result, financial conditions have eased, indicating that the interest rate environment is still supporting economic activity. Lower bond yields are usually associated with a weaker economy, especially when short-term interest rates have been rising.
Inflation hawks note that even though the Fed has raised the fed funds rate by 2.25% since June, it is still at the relatively low level of 3.25%. There is no operating manual that says what the neutral funds rate is, but the Fed knows that it is higher than 3%. And with oil prices remaining high, inflation is something to worry about.
Then there is also the matter of Greenspan's legacy. His tenure as Fed chairman ends next January and several analysts believe Greenspan would prefer to err on the side of caution - and keep raising rates to ensure inflation doesn't make an ugly comeback - even if it means sacrificing a bit of economic growth.
Still, bond investors have legitimate reasons to be more worried about a slowdown than about inflation. For one, many say inflation readings are a lagging indicator and are not helpful in predicting where the economy is heading.
Another cause for concern is that the difference between short- and long-term rates is minimal—a phenomenon known as a flattening yield curve.
A year ago, the yield curve was very steep because the federal funds rate of 1% was far below the level consistent with a neutral monetary policy. Bond yields were high relative to the federal funds rate because investors expected short-term rates to rise. The bond risk premium was also higher than it is now because investors were worried that a 1% federal funds rate would prove inflationary.
Since then the yield curve has flattened considerably. As measured by the spread of 10-year Treasury-note yields to two-year Treasury note yields, the curve has narrowed to about 28 basis points from 190 basis points a year ago. Some argue that this flattening implies a sharp slowdown in economic activity because the yield curve spread is considered a leading indicator of future economic performance.
The argument has also been made that the low level of interest rates around the world reflects weak growth prospects for the global economy. In the past the slope of the yield curve has been a cyclical indicator. That is, a flat or inverted yield curve tended to be associated with a subsequent slowdown in growth. Yet while it is much flatter than a year ago, the yield curve is not unusually flat by historical standards. Just because the yield curve has been flattening does not mean that it will invert.
The current implications of the flat yield curve, at least in the United States, appear to be different from past norms in an important way. Usually when the U.S. yield curve has been flat or inverted, broader financial conditions have also been quite tight. But currently financial conditions are notably stimulative, despite the flat yield curve.
In this case it is the unusual decline in bond yields rather than the rise in short-term rates that has caused the yield curve to flatten so much over the past 12 months. If the yield curve is flattening because the bond risk premium is falling, then the flattening does not imply slower growth. We can infer that the decline in 10-year Treasury-note yields is due primarily to a narrowing in the bond risk premium because the rally has occurred at a time that short-term rates were rising in line with expectations and the expected end-point of the tightening process has not changed much.
The persistence of narrow credit spreads supports the conclusion that financial conditions, not the yield curve, are sending the right message on growth. If markets truly judged monetary policy as tight and expected the economy to slow sharply, then credit spreads should have widened significantly.
In recent testimony before the Joint Economic Committee of Congress, Chairman Greenspan made it clear that he would not necessarily interpret a flat yield curve as signaling economic weakness. He implied that the shape of the yield curve would not deter the Fed from tightening further. Thus, far from implying slower growth, the yield curve flattening can be interpreted to imply that growth will be well-maintained despite monetary policy tightening.
Economic Indicators
Economic news was mixed in June, revealing conflicting outlooks for the economy. Month-to-month economic activity has continued to follow an up and down pattern. After a strong April, May looks softer. Yet looking through the ups and downs, the underlying trend in economic activity appears reasonably solid.
Real GDP growth was solid in the first quarter, at 3.8%, but higher oil prices, difficulties in the auto sector, and a widening trade gap may present challenges in the second quarter.
It appears that slack in the economy has diminished, which suggests that growth has been faster than potential. Since the end of 2004, the unemployment rate has fallen, while capacity utilization has edged up to 79.4% from 79.2%.
Steady gains in income and employment, as well as improved consumer sentiment, signal underlying strength. Firming in these areas bode well for consumption and business investment, and is consistent with the expectation that expansion is well supported.
Growth in the US labor market continues to be healthy, with average nonfarm payroll gains of 181,300 per month so far in 2005. Nonfarm payrolls for April grew by a less than expected 78,000, while in May the jobs number rose to 146,000, continuing a frustrating pattern of alternating strength and weakness.
The unemployment rate dipped from 5.1% to 5.0% but wage growth remained soft at 0.2%. The unemployment rate has fallen steadily to 5.0% in June from a peak of 6.3% in June 2003.
The employment report epitomizes the up-down pattern of recent data releases. May was a bad month, with soft readings for many indicators, including the two most important statistics: payroll employment and non-auto retail sales. By contrast, the early data for June have improved significantly.
The rise in employment growth is further evidence that productivity growth is slowing. Output per hour in the nonfarm sector continues to decline and rose only 2.5% over the past year. Conversely, unit labor costs continue to climb and have risen 2.4% over the same time period.
Consumer confidence climbed as labor prospects improved. The University of Michigan said its measure of confidence rose to 96.0 in June from 86.9 in May. The preliminary June reading was 94.8.
Personal income rose 0.2% in May, as wages and salaries rose only 0.1%, the smallest rise since last June, after a robust 0.7% rise in April. Personal spending was essentially flat in both dollar and inflation-adjusted terms in May.
Sustained economic growth has boosted business confidence and improved labor markets in the past year and a half. With businesses less cautious, hiring has picked up, and measured productivity growth has cooled toward a still respectable trendline.
Retail sales showed a larger than expected 0.5% decline in May. But this follows a revised 1.5% gain in April, the largest monthly increase in over a year. The drop was primarily due to weakness in auto sales, which fell 1.6%. Excluding autos, total retail sales fell 0.2%. Year to date, retail sales excluding autos have expanded at an annualized rate of 7.5% compared to an increase of 8.9% in 2004.
Housing activity is still at record levels as the most interest rate sensitive sector of the U.S. economy has shown no signs of pulling back in 2005. Total single-family home sales in the first five months of 2005 have run at a record annualized pace of 7.34 million, compared to 7.11 million in 2004. Housing starts averaged 2.05 million in the first five months of the year versus 1.95 million last year. Average mortgage rates remain below 6% as the bond market has rallied and homebuyers have moved down the yield curve and embraced adjustable-rate mortgages in greater numbers.
Durable goods increased by a larger than expected 5.5% in May on a large gain in civilian aircraft orders. However, excluding the volatile transportation category, orders for durables goods slipped unexpectedly by 0.2%.
The ISM Non-Manufacturing index grew more strongly than expected in June, bolstered in part by stronger employment. The index rose to 62.2 in June, well above Wall Street forecasts of 58.0 and stronger than the reading of 58.5 posted for May.
The industrial sector, however, appears to have slowed relative to the overall economy, perhaps reflecting the impact of higher oil prices. Manufactured output growth in the first five months of the year grew at an average annualized rate of 2.6% versus an increase of 5.1% in 2004.
The Producer Price index (PPI), a measure of the prices paid by businesses, fell sharply in May (-0.6%) compared with a 0.6% rise in April. The decline was due to lower oil prices, as the "core" PPI (excluding food and energy costs) rose 0.1%. The survey was taken in the middle of the month, just as oil prices bottomed out at less than $50 per barrel.
Consumer prices also fell in May for the first time in almost a year. The consumer price index unexpectedly fell 0.1%, led by a drop in energy prices. Core consumer prices rose 0.1% in May after no change a month earlier. So far this year, consumer prices are rising at a 3.7% annual rate compared with a 5% increase at the same time last year. Core prices are rising at a 2.4% annual pace, down from a 2.5% rate.
Rising unit labor costs are likely to put pressure on profit margins and eventually on prices. Historically, when labor costs rise faster than core inflation, core inflation tends to pick up - a point that will not be lost on Fed officials.
Pricing power - defined as the ability of firms to pass on increases in their input costs - has been extraordinarily weak in recent years, helping to keep inflation muted and bond yields low. The principal reason for this weakness has been a surplus of capacity, exacerbated by technological innovation (resulting in increased productivity) and import competition. With signs of renewed life in factory output in the U.S. and abroad, the possibility of slightly firmer import prices, and fewer opportunities for productivity gains, pricing power is apt to make a comeback.
After easing early in the second quarter, oil prices increased substantially in June to close the quarter at $56 per barrel. Moreover, the futures market does not anticipate substantial price declines over the medium term.
Rising energy goods and services costs have taken a considerable chunk out of household budgets, representing 25% of the increase in nominal expenditures in April and May. But consumer resilience in the face of higher energy prices is evident from fairly solid spending on other components throughout the quarter.
Since it is strong demand for products rather than supply shocks that is lifting the price of crude oil, the impact on growth will continue to differ from that of the past in that the restraining influence on consumer spending and the economy has been mitigated. As a result, the increases in energy costs (to date) are likely to have only a modest restraining impact.
Third Quarter Outlook
The U.S. recovery appears to remain on track though high oil prices could pose new risks. The Fed should continue to raise short-term interest rates into the fall. Meanwhile a benign inflation outlook, shifts in savings and investment patterns, and greater capital mobility are holding down global interest rates.
Although the current quarter begins on a strong note, reacceleration in economic growth in the second half of the year will likely be constrained, as higher energy prices are expected to weigh on consumer spending growth while gains in business fixed investment remain moderate.
Stocks have been caught in the doldrums, with investors blaming the Fed, oil prices and slower economic growth for lackluster returns. Yet hope remains that stocks will imitate last year's performance, staging a strong advance in late summer or in autumn. Their path will be determined by expectations about corporate profits and the overall level of nervousness priced into the equity risk premium.
Bond prices have rallied on signs the economy was weakening, which made sense when reports were pointing to a further slowdown in growth. But now, with more and more signs pointing to a rebound after a "soft patch" in March, long-term yields as low as they are have some investors scratching their heads.
Longer-term fixed-income securities are still vulnerable to a significant sell-off in coming months, although we have softened the expected increase in yields. This adjustment is largely in deference to the market's apparent conviction that U.S. growth will slow to the point of causing the Fed to pause. Nonetheless Greenspan has given no hint that he is likely to slow down the pace of rate hikes and, with the exception of Dallas Fed President Fisher, neither has any other member of the FOMC.
Recent economic data and comments from Greenspan greatly diminished investor concerns regarding a prospect of a sustained economic slowdown in the U.S. Most of the economic news indicates that the economy has regained its momentum following this spring's "soft patch." In particular, there are indications that retail spending has picked up again, despite the restraint exerted by higher oil prices. Mortgage rates haven't risen yet, and at this point the momentum in the housing market looks strong enough to carry us into 2006.
An improving labor market and favorable conditions in financial markets have helped consumers, but a persistent rise in short-term interest rates should finally slow household spending. Consumption growth should decelerate from 3.8% growth in 2004 to 2.5%.
Motor vehicle sales responded positively to incentives in June, registering sizable gains over May levels, and chain store sales reportedly strengthened toward month-end. However, a material reacceleration in growth in the second half of the year likely will be constrained, as higher energy prices weigh on consumer spending growth while gains in business fixed investment remain moderate.
This leaves an economy that continues to grow modestly above trend, with a falling unemployment rate, rising unit labor costs, and probably more monetary policy tightening than discounted in the bond market.
The view on inflation remains a major point of contention among investors and analysts. It is a key determinant of the monetary policy forecasts, direction of longer interest rates and financial markets overall.
A tighter labor market and a stronger economy may put upward pressure on inflation. Wage inflation as measured by average hourly earnings is gradually drifting up.
Strong global demand, low inventory levels and a lack of new refining capacity will keep energy prices high through 2006. Higher energy prices will keep pressure on the CPI - directly through gasoline prices and indirectly through shipping costs and fuel surcharges.
There are some legitimate downside risks to U.S. growth from higher energy prices, slower growth abroad, and from protectionism.
Persistent high energy prices could persuade the Fed to lean harder against inflation. A high price of oil is a duel edged sword for the Fed. On the one hand, there is the negative impact on growth. However, oil has averaged $50 per barrel over the last nine months and growth has remained fairly solid. On the other hand, there is the impact on inflation, especially the risk that high energy prices could push up core inflation.
A modest upward drift in core finished goods inflation will likely continue over the remainder of the year, as service price increases continue to creep higher while goods prices inflation shows signs of peaking.
Asia's swing to a substantial current account surplus, and the recycling of this surplus into U.S. bonds, has undoubtedly held down real interest rates in recent years. However, the question is whether this "savings glut" is structural or cyclical. If it is structural, then global real rates could indeed stay low for a long time yet.
Although the Federal deficit is likely to be smaller this year than in 2004, the personal savings rate remains dismally low, and there are signs that higher unit labor costs are eroding growth in profits, so that the U.S. remains extremely dependent on ever increasing foreign capital flows.
We remain confident that the U.S. economy remains on a path of sustainable, durable expansion. Recent weakness in the manufacturing sector has not affected other sectors of the economy. Recent increases in oil prices, however, will likely restrain demand going forward. According to Greenspan speculations regarding the housing bubble and its potential impact on the overall economy and consumer are exaggerated.
We expect to remain within current ranges of interest rates and spreads until some catalyst occurs. Given that the Fed is increasingly unlikely to change its status quo, other "usual suspects" include a pickup in core inflation numbers, a material revaluation of Yuan, and a decline in foreign demand for U.S. assets.
Summary
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