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ALM First Financial Advisors
Third Quarter 2007 Economic Outlook
Prepared by: Lisa K. McDaniel, CFA
July 10, 2007
TOPICS COVERED
Second Quarter Review
The second quarter was a mixed bag as far as signals about the health of the economy is concerned. Growth slowed, but the stock market soared. The housing market is in a recession, but construction employment has yet to be affected. Employment growth was decelerating, yet weekly jobless claims tumbled in May.
Due to strong gains in April and May, the Dow Jones industrials finished the quarter up 8.5 percent, their best quarterly gain since the fourth quarter of 2003. The index peaked on June 4th, when it hit its record finish of 13,676. Since then, the industrial average has fallen about 2 percent. The Standard & Poor's 500-stock index broke through to its own new highest close in May. It was up 5.8 percent for the quarter.
During the past year, stocks have surged higher than nearly anyone forecast, amid hopes that the Federal Reserve would achieve what economists call a soft landing. The theory is that the Fed has raised interest rates enough to stave off inflation, but not enough to cause a recession. Just weeks ago, economists and investors were betting that a weakening economy, lower inflation and the prospect of a longer-than-expected housing slump would encourage the Fed to cut rates later this year. Hopes for rate cuts faded in June however, causing a sell-off in stocks and higher interest rates.
Early in May the yield on the 10-year Treasury note was 4.63 percent, but it surged during the quarter amid the mounting inflation fears. It fell back from its high of nearly 5.25 percent, but remained above 5 percent, at 5.034 percent at the end of June, high enough to keep alive worries about rising interest rates and tighter credit.
The yield curve returned to its normal upward slope in June amid signs global growth may help the U.S. economy to rebound. In fact, U.S. bond yields hit a five-year high in mid-June, as investors dumped Treasuries amid worries about rising inflation abroad and concerns that foreigners might curb their purchases of U.S. bonds, which have been an important source of support for the market.
Behind the higher rates is slowly evaporating global liquidity. This is most evident in tighter monetary policies across much of the globe. Central banks ranging from the European Central Bank to the Chinese Central Bank are in the midst of a series of tightening moves. Long-term interest rates have risen across the globe, not just in the U.S., reflecting a normalization of global monetary policy after a long period of being highly accommodative.
The fact that U.S. bond yields have jumped despite relatively weak U.S. economic growth is further evidence of how interconnected the world's markets have become. Increasingly, the U.S. market is being influenced by global investors. That is in part because the U.S. imports far more than it exports to countries like China and makes up the difference by borrowing from foreigners, who have been flocking to U.S. bonds.
Since other borrowing costs are tied to Treasury yields, their rise pushed up mortgage rates, exacerbating a potential hazard for the bond market. High rates for home loans could make it harder for cash-strapped borrowers to make their payments as adjustable-rate mortgages tick upward. That could produce more defaults and increase chances that the subprime market's problems could spread as the value of securities backed by these mortgages falls.
In fact two Bear Stearns hedge funds recently came under pressure because of investments in complex securities underpinned by bonds backed by subprime loans. As the value of the bonds fell, the funds were beset by investors and lenders who wanted to recover the money they put in.
Monetary Policy
The Federal Reserve marked the one-year anniversary of its policy pause in June. Over that period, the meeting statement consistently delivered a message that core inflation was high but likely to moderate over time. The statements also maintained a clear bias: that a failure of inflation to moderate as expected was the primary policy concern.
The most recent FOMC meeting marked a shift as the Committee refrained from describing inflation as elevated or stating that "inflation pressures seem likely to moderate over time." Instead, it recognized a recent modest improvement in core inflation, but argued that it is not yet clear that the moderation will be sustained. The Committee also implicitly indicated that the economy picked up in the second quarter and that moderate growth is likely to be sustained despite the housing correction.
At this point the Fed appears to be on hold for the foreseeable future, with inflation worries ruling out a rate cut but the deepening slump in housing and higher long-term interest rates ruling out a rate increase.
Economic Indicators
Economic news early this year has been consistently downbeat. Several indicators, however, are now pointing towards a modest turnaround.
Gross domestic product rose at a 0.7 percent annual rate in the first quarter, a far cry from the fourth-quarter's 2.5 percent climb. The 0.7 percent increase marked the weakest increase since a 0.2 percent creep upward at the end of 2002. Nominal GDP was revised to 4.9 percent from 4.7 percent.
The first-quarter plunge in housing took a bite of 0.89 percentage points out of GDP and served to counteract the momentum provided by the biggest component of GDP - consumer spending. First-quarter spending by consumers was equal to the fourth quarter's strong advance. Consumer spending accounts for about 70 percent of economic activity. It made a contribution of 2.89 percentage points to GDP in the first quarter.
Non-farm payrolls rose 132,000 in June, which was about in line with expectations. There were significant upward revisions to the prior two months totaling 75,000 as April payrolls were revised to 122,000 from 80,000 and May jobs were revised to 190,000 from 157,000. The latest news and revisions raised the year-to-date average employment gain to a solid 145,000 per month, down modestly from a strong 189,000 reported in 2006.
The price index of real personal consumption expenditures (PCE) increased 4.2 percent at a seasonally adjusted annual rate in the first quarter, compared to the 4.0 percent initial estimate and equal to the 4.2 percent rate for the last quarter of 2006. The core number - the Fed's preferred measure of inflation which excludes food and energy prices - was revised up to a 2.4 percent annualized rate from the previous 2.2 percent estimate. The overall PCE deflator rose a further 0.3 percent in April, and 0.5 percent in May compared to 2.3 percent from a year earlier. Excluding food and energy, the "core" index rose 0.1 percent in April and May and 1.9 percent from a year earlier, the first reading below 2 percent since April, 2004.
Overall prices were up 0.5 percent on a 9.9 percent surge in gasoline, for a year-over-year gain of 2.3 percent. Thus far in the second quarter, real PCE is up 1.6 percent at an annual rate versus the first-quarter average.
The Producer Price Index rose 0.9 percent in May (up from an unrevised 0.7 percent gain in April) on a 4.1 percent jump in energy. The rise in energy was led by a 10.2 percent leap in wholesale gasoline prices. Wholesale food prices surprisingly fell 0.2 percent, despite clear near-term input cost pressures in agricultural commodities. While commodity input costs have surged over the past year, the pace of gains appears to be deteriorating. The core PPI, which excludes food and energy, was up 0.2 percent in May after holding steady the previous two months.
The consumer price index rose 0.7 percent in May, also on surging gasoline, up from a 0.4 percent rise in April and the highest gain since September 2005. Energy prices jumped 5.4 percent in May. Yet the core CPI, which excludes volatile food and energy prices, advanced just 0.1 percent, down from the previous month's 0.2 percent increase. Overall consumer inflation was up 2.7 percent from a year ago. The core CPI, in contrast, was up just 2.2 percent compared to a year ago.
The most likely cause for this decline in pass-through is increased Fed credibility. One of the most popular explanations for rising inflation during the 1970s was accommodative Fed policy, leading to the expectation that increases in energy prices would be met with relatively loose monetary policy which then would feed through into core inflation. However, Fed policy since then has responded much more aggressively to core inflation, probably reducing expectations of pass-through of energy price inflation into core inflation.
Somewhat surprisingly, the estimated pass-through of food price inflation into core inflation is higher than that for energy or import prices in both periods. A possible explanation of this is that the lower volatility, and higher persistence, of food prices means that changes in them are viewed as permanent - unlike energy prices whose high volatility means that changes are viewed as likely to reverse themselves quickly.
The ISM manufacturing index was stronger than expected in May, rising to 55.0 from 54.7 in April. It rose even further to 56.0 in June. Inventory declines in the first quarter have given way to a production rebound in the second quarter. According to the ISM, "Following a weak first quarter, the manufacturing sector rebounded in a strong fashion during the second quarter. This performance appears sustainable in the third quarter due to the current strength in New Orders and Production."
The non-manufacturing ISM index also improved more than expected in April, rising to 56.0 from 52.4. The index was significantly stronger than expected in June, rising to 60.7 from 59.7 in May.
Both manufacturing and non-manufacturing surveys point to the economy picking up momentum as the second quarter drew to a close. This is an encouraging sign for growth in the third quarter.
Consumer confidence was significantly stronger than expected in May but then posted a sharper than expected decline in June in the wake of higher gasoline prices and mortgage rates. The University of Michigan's consumer sentiment fell to 85.3 in June from 88.3 in May, posting a 10-month low.
The Conference Board's measure of consumer confidence was also lower than expected, falling to 103.9 in June from 108.5 in May (upwardly revised from 108.0).
Consumers' assessment of the labor market was less positive in June as the percentage reporting jobs as "plentiful" fell to 27.0 percent from 29.1 percent, while the percentage seeing jobs as being "hard to get" rose to 21.1 percent from 19.7 percent.
Despite a hit from higher energy prices, consumer confidence is not necessarily weak at current levels. For example, confidence is in line with the average level seen over the 12 months ended September 2006. To the extent that consumers' spirits (if not spending) have been diminished by new highs in gasoline prices this summer, futures markets predict a 34 cent decline in wholesale gasoline over the remainder of this year. Such an outcome, however, hinges on a relatively glitch-free hurricane season.
After coming in below expectations in April, retail sales surged 1.4 percent in May, the first month after the weather-related swings of early spring. Sales excluding autos were up 1.3 percent, well above consensus. Gas station sales rose a large 3.8 percent in May, as national average gas prices reached well over $3.00 per gallon. But this did not impair purchases elsewhere. Sales of building materials grew 2.1 percent, reversing April losses. All other major categories had gains, with clothing (2.7 percent), sporting goods (1.8 percent) and electronics (1.3 percent) in the lead.
Durable goods orders in May were below expectations, falling 2.8 percent following strong gains of 1.8 percent and 5.1 percent in April and March, respectively. For the quarter thus far, however, durable goods orders are up at an annual rate of 16.5 percent versus a decline of 9.6 percent in the first quarter.
Wall Street expected a drop in overall durables for May because demand had gone up in the prior three months. But the 2.8 percent decrease far exceeded expectations.
The durables report did provide evidence that inventory investment has picked up in the second quarter and an expected swing in inventories will also add to growth. Barring signs of further weakness, May's declines can be seen as pullbacks reflecting normal volatility the underlying trends as positive for the sector.
Oil prices closed above $70 a barrel on June 29 for the first time in 10 months following a price-supportive Department of Energy report inventory released earlier in the week and two foiled car bomb attacks in London on Friday.
The run-up of gasoline prices in the first half of 2007 sharply curtailed household purchasing power, reversing the boost from lower prices during the last half of 2006. The recent increase largely reflected a record jump in the markup over crude oil whereas in the past such price increases were more likely due to a shortage of supply.
World oil demand is rising twice as fast as a year ago, straining the petroleum industry's ability to keep up with global needs and likely resulting in higher and more volatile prices for some time to come. And because the global economy continues to expand at a robust rate, demand for oil to fuel activity continues to rise, quickly taking up capacity increases.
On a short-term basis, many industry specialists see prices rising further in the second half of the year unless the Organization of Petroleum Exporting Countries (OPEC) relents from its recent stance and starts pumping more crude oil soon, and unless refiners can churn out more products such as gasoline and diesel. Longer term, the trends suggest the global economy has adapted to the doubling of oil prices during the past three years, bolstering demand and paving the way for higher prices in coming years.
Housing Market
According to Freddie Mac, fixed mortgage rates have risen by some 60 basis points (bps) over the past month to as high as 6.75 percent. Given that 80 percent of mortgage loans are fixed rate loans, this will be another significant hurdle for the housing market to overcome.
The slump in housing, which has lasted almost two years, is restraining economic growth even as inflation is too high for the comfort of Federal Reserve officials. Meanwhile, the average rate on a 30-year fixed mortgage has jumped to the highest in more than a year, putting pressure on first-time buyers and raising the prospect of additional defaults.
Housing starts declined 2.1 percent in May, but they have held in a narrow range over the past few months, stabilizing at levels 30 percent below their first quarter 2006 peak. Housing starts hit their low for the cycle in January and have stabilized in a narrow range over the four months since. Starts through the first two months of the second quarter averaged 1.49 million, a pace that was higher than in the first quarter for both the single-family and multifamily parts of the market.
Thus far in the second quarter, housing starts have risen 10.1 percent at an annual rate (despite the decline in May). While it's too soon to say that housing has stabilized, it appears that the rate of decline is slowing and, therefore, the drag on the economy from housing may be diminishing.
Sales of new and existing homes eased modestly in May. Existing home sales were about in line with expectations, slipping 0.3 percent to 5.99 million units in May from 6.01 million units in April (upwardly revised from 5.99 million units).
May's new home sales were moderately below expectations, falling 1.6 percent from a downwardly revised 12.5 percent surge in April. The supply of unsold new homes fell 1.1 percent to 536,000 in May, while the months' supply of new homes edged up to 7.1 months in May from 7.0 months in April.
The declines corroborate anecdotal and survey data showing a further, sequential decline in home sales in 2007, but not at the peak double-digit pace of 2006. In May, the year/year decline in new home sales was 15.8 percent. In July 2006, the same measure had fallen 30.2 percent.
According to the Mortgage Bankers Association, credit conditions continue to worsen for homeowners with conventional adjustable-rate mortgages (ARMs). The serious delinquency rate, which counts loans that are 90-days or more delinquent or in foreclosure, rose to 1.66 percent in the first quarter of 2007 for prime ARMs, up from 0.82 percent for the same quarter in 2006. For subprime ARMs, the serious delinquency rate rose to 10.13 percent from 6.28 percent over the past 12 months. However, delinquency rates for conventional fixed-rate mortgages generally improved over the same period, remaining at 0.68 percent for prime loans and falling to 5.89 percent from 6.00 percent for subprime mortgages.
The downturn in housing has had relatively little impact on the overall health of the U.S. economy. Although the housing industry is in severe recession, the overall unemployment rate is near its low for the expansion and corporate profit margins are near their highs. Both households and businesses continue to fare pretty well. The same also applies to regional economies.
While the even weaker housing market should not undermine the expansion later this year, it will be a measurable impediment to better growth, particularly if it weakens the resolve of consumers to keep spending aggressively, which remains a considerable risk.
Third Quarter Outlook
The growth outlook thus far this year has been mixed. Housing data continue to disappoint, but the labor market remains solid and manufacturing has picked up. Q1 GDP grew only 0.7 percent, but trade and inventories accounted for most of the weakness while domestic demand actually picked up. Similarly, after two quarters of sharp inventory cuts, firms should be restocking.
As the year reaches its midpoint, economic growth in the first half of 2007 is shaping up to look much stronger than seemed likely a few months ago. Economists expect the first-quarter GDP reading to mark a low point of the current cycle. Second-quarter growth is expected to show a marked improvement over the first-quarter as the drag from housing and trade slows and inventories go from a negative to a positive.
Economic growth in the U.S. is likely to continue to recover as the year goes on. Having faced various threats to its health, the nation's economy is in a better place than it was just a few months ago. In the consensus forecast, the moderate rate of growth will generate an average of almost 115,000 jobs a month over the next year. If the housing market merely stabilizes, growth would accelerate. Moreover, the last Fed rate hike is now a year behind us so the negative impact on growth of monetary policy should be fading.
Although some investors are turning more fearful, many money managers still believe in the soft-landing scenario, noting that the strong world economy and low interest rates have helped the U.S. economy avoid a much-feared recession. Corporate profits have continued to rise, although no longer at the double-digit rates that had wowed investors in previous years.
Forecasters, however, also see a mounting risk: thanks to longer-term shifts in the U.S. and global economic landscapes, even a little growth could lead to a resurgence of inflation.
So far this year, core CPI inflation has moderated substantially - falling from a high of 2.9 percent to 2.3 percent on a year-over-year basis. However, increasing food and energy prices have raised fears of pass-through into core inflation.
Furthermore, continued strength in the labor market points to upward, albeit more gradual, increases in labor cost pressures, which should continue feeding into trend inflation.
Economists are particularly concerned about inflation in part because the prices of food and energy have been rising so quickly for so long. The persistent divergence between headline and core inflation points to evidence of a longer-term trend, in which the emergence of new industrial bases and consumer demand in developing nations such as China are driving up global energy and food prices. Food and energy prices are also increasingly linked: in the U.S., government efforts to promote home-grown ethanol as an alternative to imported oil have driven up the price of corn, as well as the price of meat from animals that eat it. At the end of the day, food inflation is something that hits the average consumer pretty hard, as does energy.
Continued resilience in the broader economy has provided much-needed support for the housing sector. A return of GDP growth to trend levels (at or above a 3 percent annual rate) later this year should bolster jobs and incomes, ultimately supporting housing demand. The housing outlook remains fragile, though, and the recovery will be an uneven one.
The US housing recession, which was expected to represent a prolonged but not debilitating drag on economic growth, has been a bit deeper than expected and now, with the sub-prime mortgage shakeout, looks set to cast an even longer shadow on the economy.
These troubles appear to be having little to no direct spillover into the prime mortgage market, however. According to the Fed's most recent Senior Loan Officer Survey, while a considerable number of institutions tightened their lending standards on non-traditional and subprime mortgages, credit standards for prime mortgages have remained basically unchanged. Nonetheless, excess inventories and soft demand should keep homebuilders from increasing construction until after next year.
The troubles in the subprime-mortgage sector continue to hang over markets, with investors trying to figure out what the consequences will be for the financial system, the U.S. economy and asset prices.
The first cracks in the subprime mortgage market appeared late last year, forcing several lenders into bankruptcy. Last month, two hedge funds operated by Bear Stearns fought for survival as lenders (other investment banks such as Merrill Lynch, JPMorgan Chase, and Citigroup) sold off collateral or asked Bear to put up additional capital.
In the last month, spreads on subprime securities issued in late 2005 have widened almost 500 bps (as measured by the ABX index's BBB- rating tranche) while spreads on securities issued during 2006 have widened over 600 bps.
Obviously the problems with the subprime market are not over and will probably get worse before getting better. But beyond that, the contagion should remain modest. The U.S. housing crash has been around for over a year; it has been given ample time to do damage to the U.S. and global economy, not to say the markets, yet so far it has failed to do so.
A key question heading into the second half of 2007 is which quarter, the first or second, better reflects the economy's underlying state. The latest employment report - coupled with other data like the Institute for Supply Management's June purchasing managers indices suggest it's the second.
The markets have moved closer to an on-hold view and there are now even expectations of possible rate hikes. While both manufacturing and capital expenditures have improved, the housing outlook appears to have worsened. Moreover, the inflation picture is confusing, to say the least - core measures may have cooled, even as fundamentals worsen. The Fed will most likely wait for clear signs that the housing recession is ending and core inflation is staying too high before moving. Meanwhile, inflation expectations have risen, which should be enough for the Fed to retain its inflation bias.
For the bond market, opposing forces suggest a classic tug of war. The solid economy means hopes of a Federal Reserve rate cut remain somewhat remote - a factor that has pressured government bond prices lower, lifting yields during the past couple of months. Yet with investors watching nervously to see what will happen next in the subprime story, there's every chance of further buying of government bonds by investors seeking relative safety.
Volatility has picked up in the last few months across a range of markets, with recent moves in equity volatility particularly striking. Rate volatility has also jumped from historic lows. With credit markets wobbling on subprime and corporate loan jitters, and a recent repricing in global bond yields, the sense that we are living in a more volatile world is now palpable in a number of different markets. It is not unusual for volatility, particularly in equities, to be low early in expansions and to pick up as the cycle matures.
While inflation risks are to the upside, the biggest risk to the growth forecast remains a double dip in the housing market. Although new home inventories have been slowly falling, existing home inventories surged this spring. The housing market should continue to be a drag on growth through next year, but the pain should subside.
SUMMARY
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