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ALM First Financial Advisors
Third Quarter 2008 Economic Outlook
Prepared by: Lisa K. McDaniel, CFA
July 11, 2008
TOPICS COVERED
Second Quarter Review
The second quarter began with high hopes that the worst of the credit crunch was over, earnings growth would pick up as the year went on and stocks would rise. Those hopes were shattered, however, as the effects of the credit crisis lingered and it looked like consumers might stop spending.
Overall economic activity continued to expand, but labor markets have softened and the financial markets remain under considerable stress.
The housing recession and the credit crunch turned out to be much worse than expected, and a third shock - the spike in oil and other commodity prices with a resulting rise in headline inflation - hit not just the U.S. but also the global economy.
Investors began to acknowledge this grim reality in mid-May. That is when the Dow Jones Industrial Average began its march downward, ending the quarter with an overall loss of 912.88 points, or 7.4 percent, to close at 11,350 - dangerously close to the 20 percent decline that signals the start of a bear market.
It was the third straight quarterly decline in stocks and the worst second quarter since 2002. The Dow is down more than 14 percent this year, and it appears that the problems weighing on stocks are likely to persist for the rest of the year.
The Standard & Poor's 500 stock index ended the quarter down 42.70 points, or 3.2 percent, at 1,280, also close to bear-market territory. The technology-stock heavy Nasdaq Composite, however, rose 13.88 points to 2,293, although it is off nearly 20 percent from its October 2007 high and more than 50 percent below its record close in March 2000.
Financials led the way down as banks took massive write-downs and reported disappointing earnings. An exchange-traded fund tracking the S&P's financial sector was down 18.5 percent, the worst performance of any category. The general perception was that the financials would start to turn things around by this point but that obviously has not occurred.
The biggest loser among the Dow industrials for the quarter was auto maker General Motors, which dropped about 40 percent. Of 30 Dow components, 24 ended the quarter lower. The few bright spots included Exxon Mobil and Chevron, which rose as crude-oil prices soared 38 percent to more than $140 a barrel.
For a while, it seemed that the strains of the credit crisis were easing. A variety of credit markets had righted themselves in April and May. The flight to high-quality, risk-free U.S. Treasury bonds began to unwind.
Yields on two-year Treasury notes climbed 165 basis points (bps) to three percent from their March low, while ten-year yields rose 30 bps. The two-year note ended the quarter yielding 2.63 percent, after starting out at 1.6 percent.
The Federal Reserve's actions at the end of the first quarter to shore up liquidity for broker-dealers alleviated investors' fears of a systemic financial collapse and spawned a relief rally in the markets for riskier types of debt.
However, inflation became the dominant force in fixed-income markets in June as the Fed turned its attention to the effects of high oil prices and the weak U.S. dollar, amid stronger-than-expected economic growth.
Then, as the quarter was drawing to a close, investors again pulled out of risky assets amid the possibility of more big losses at investment banks, concerns about the solvency of bond insurers and worry about the economy's ability to withstand high oil and food prices.
Monetary Policy
At its April meeting, the FOMC cut the target Fed funds rate another quarter point from 2.25 to 2.00 percent, with a corresponding cut in the discount rate. In its statement, the Committee adopted a neutral bias, stating that "the substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity." The statement pretty clearly confirmed the market's consensus that a pause in the easing cycle had begun.
At its June meeting, the FOMC did indeed leave rates unchanged, and shifted the balance of risks from recession to inflation. "Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation expectations have increased." For the first time, the statement added rising energy prices to the credit crunch and housing contraction as a barrier to growth.
The statement still reflects the sentiment that the Fed expects inflation to moderate later this year and into next year. However, the Fed has elevated inflation expectations to the top of its list of concerns, ahead of the rise in commodities and tight labor markets.
On growth, the Fed acknowledged "some firming in household spending." On inflation, it expects some moderation "later this year and next," but noted the "elevated state of some indicators of inflation expectations." There was also a subtle change in the timing of its forecast for inflation moderation from the previous "in the coming quarters" to the current "later this year and next."
Fiscal Policy
The government began distributing fiscal stimulus checks during the second quarter and is still in the process of doing so. An estimated $63 billion has been distributed so far. While the rebates are bolstering spending now, next quarter, when the impact fades, weak consumer fundamentals could soften spending significantly. The stimulus checks in 2001 - a package that was a quarter the size of this one - boosted retail sales by more than nine percent in one month, after which sales fell back to trend in the six months following.
Other legislation to help the economy includes a bill signed by President Bush which extends unemployment benefits. There is also legislation sponsored by Congressman Frank and Senator Dodd to expand the role of the Federal Housing Administration (FHA) - Congress is ironing out the final details. Whether it will rescue the housing market remains to be seen but it seems doubtful.
The goal of the housing aid bill is to stem foreclosures by allowing distressed borrowers to refinance into more affordable mortgages. The plan will allow qualified borrowers to refinance into an FHA-guaranteed mortgage, with the new loan reduced to 13-15 percent below the reappraised value of the house. The plan is voluntary and therefore will only affect a large number of homeowners if it provides an effective incentive to both the lender and the borrower. Clearly it provides a great deal to borrowers - big debt forgiveness, with much lower monthly payments and no blemish on their credit record.
The bigger issue is on the lenders' side. It is by no means obvious whether lenders would accept a 13-15 percent haircut on a loan that has already been discounted to the new appraised value of the house. In other words, lenders will take the deal only if they are extremely negative on the housing market or strongly risk averse.
The Congressional Budget Office (CBO) expects the plan to reduce foreclosures by about 500,000. But with slow implementation, very few mortgages will be affected this year, and the plan will offset only a part of the 1.4 million in single-family foreclosures expected in 2009. As a result there is a fairly high probability of a second bailout plan - one that is more costly to taxpayers - at the start of next year when a new Congress and president tackle a still-festering housing problem.
Currency
The dollar showed surprising stability over the second quarter, ending at pretty much the same level where it began. That is a pronounced change for a currency that until recently only seemed to go down.
Several factors played a role in steadying the shaky dollar. For one thing, U.S. policy makers have become more vocal about the risks posed by inflation, raising the prospect that they may increase interest rates as early as August. That, in turn, would make short-term dollar deposits more attractive to investors.
Those who aren't confident about the dollar's prospects point to coming changes in the relationship between interest rates on both sides of the Atlantic. Sticking to its mandate to curb inflation, the European Central Bank (ECB) recently increased its key interest rate from 4.0 to 4.25 percent.
The changes in the dollar's exchange rate against the Euro have tended to reflect the spread between the ECB policy rate and the Fed funds target. At a record wide of 225 bps, a reversion to the mean would tend to indicate further weakening in the dollar.
Economic Indicators
First quarter GDP was initially reported at 0.6 percent and was subsequently revised up to 0.9 percent and then 1.0 percent. The details of the report portray a decelerating path of growth despite the better-than-anticipated growth in consumer spending. Net exports added an additional 0.2 percent to GDP. Exports have been a source of offset to weakness elsewhere. Inventory investment fell by $19.6 billion while final sales rose 0.9 percent.
Nonfarm payrolls were originally reported at negative 20,000 in April, but later revised to a decline of 67,000. May nonfarm payrolls were reported at negative 49,000 and were revised to negative 62,000. The unemployment rate jumped from 5.0 to 5.5 percent in May, reflecting a 577,000 rise in the labor force.
In June, nonfarm payrolls declined another 62,000. This reading marked the sixth consecutive month of declines for a total drop in payrolls since December 2007 of 438,000. Weakness in employment was concentrated in the good-producing sectors of manufacturing and construction, as well as the business services sector.
The unemployment rate unexpectedly held steady in June at 5.5 percent. Many expected the unemployment rate to fall in June to reflect a decline in the teenage unemployment rate after the typical sharp increase in May.
As a result of easy monetary policy, inflation has picked up significantly in the U.S., and (partly due to the weakening dollar) across the globe. Economists at Merrill Lynch estimate the global inflation rate is at 5.5 percent, up from 3.5 percent at the beginning of the year, thanks to soaring food and energy costs.
Following a relatively modest 0.2 percent increase in April, the producer price index (PPI) rose 1.4 percent in May, the largest increase since last November. Gasoline costs rose 9.3 percent, and natural gas rose 3.8 percent. The PPI is up 7.2 percent over the past 12 months.
The consumer price index (CPI) was also pretty benign in April. In May, however, the headline CPI index rose 0.6 percent, an increase of 4.2 percent year-over-year, compared to 2.7 percent a year ago. Needless to say, energy prices accounted for the majority of the increase.
Core inflation has so far remained relatively modest, with the core CPI at 2.3 percent vs. 2.2 percent a year ago. Remember "core" inflation readings exclude food and energy price changes - the two most significant inflationary forces consumers are now facing.
Manufacturing activity data have been more upbeat in the second quarter, pointing to marginal growth. The ISM manufacturing index was unchanged in April at 48.6. It then rose to 49.6 in May and 50.2 in June indicating a slight expansion. A rise in inventories accounted for the entire increase in the headline ISM index, suggesting that inventory investment has picked up and customer inventories are now well above desired levels. This may act as a brake on manufacturing growth in the coming months.
The ISM non-manufacturing index fell 3.5 percentage points to 48.2 in June from 51.7 in May and 52.0 in April. The drop in June resulted from declines in business activity, new orders and employment.
Consumer confidence continued to deteriorate in the second quarter. Shrinking home equity, mounting job losses and soaring food and energy prices are causing consumers to tighten their belts.
The Conference Board's index fell to 62.3 in April from a revised 65.9 in March. It fell further to 57.2 in May and then plunged eight points in June to 50.4, marking its lowest level since 1992. A substantially weaker assessment of labor market conditions was a key factor in the deterioration in consumer sentiment. At the same time, consumers' inflation expectations continue to be elevated.
The University of Michigan's consumer sentiment also declined steadily over the quarter, from 62.6 in April to 59.8 in May. The survey hit a 28-year low in June, falling to 56.4. The University of Michigan survey also found inflation expectations for the year ahead jumped from three percent to 5.2 percent in May and fell only one-tenth to 5.1 percent in June.
After a moderate 0.4 percent increase in April, retail sales rose 1.0 percent in May, the largest monthly rise since November 2007, as stimulus checks began to show up in consumers mailboxes. Gasoline sales rose 2.6 percent, while vehicle sales rose a paltry 0.3 percent. Meanwhile, apparel, autos and other items are being aggressively discounted in an increasingly fierce battle for discretionary dollars.
The short-term boost to disposable income resulting from the income tax rebate checks has provided a lift to consumer spending in the second quarter. However high and rising energy prices are taking a significant bite out of real disposable income, wage growth is sluggish, asset prices (housing and equities) are declining and lending standards continue to tighten. It is doubtful that the recent strength in consumer spending can be maintained.
New orders for durable goods fell 0.5 percent in April, but were stronger than expected - estimates called for a 1.5 percent decline. Orders excluding transportation actually rose 2.5 percent. Durable-goods orders were unchanged in May. Excluding transportation, the number was down 0.9 percent. Year-over-year orders are down 2.8 percent.
Oil prices continued to soar, ending the quarter at $140 per barrel. Oil futures rose 38 percent in three months, registering the best quarterly performance since the first quarter of 1999. Corn surged about 28 percent and for the first time passed the $8-a-bushel mark.
As gasoline prices rose to $4 per gallon, Americans began to buy smaller and more fuel-efficient cars, according to auto makers' sales results. Total U.S. vehicle miles traveled posted a 4.3 percent decline in March from a year ago, the biggest year-on-year drop since the data were first reported in 1942. It dropped again in April, by 1.8 percent.
During the past several months, lawmakers, economists and business people tried to do their part to balance supply and demand. World-wide, countries made efforts to reduce consumption.
There has been a lot of speculation as to whether the run-up in commodity prices - particularly oil - is truly being driven by supply issues or by speculators. Congress is even looking into the matter, proposing laws to curb commodities speculation. Senator Joseph Lieberman claimed that excessive market speculation has inflated the price of oil and other commodities beyond reason.
The fact of the matter is there is little convincing evidence to support the claims that the oil market is being manipulated to any significant degree. Speculators mostly use futures contracts to gamble on oil prices, and have no interest in buying or selling real barrels of oil. These transactions don't directly determine the "spot" price of oil - that is set by those who are really buying and selling actual barrels of petroleum.
Fundamental reasons for higher oil prices aren't that hard to find. Between 2000 and 2007, the world's demand for petroleum rose by nearly nine million barrels a day, yet OPEC has consistently been unable or unwilling to significantly increase supply. Production by non-OPEC members has risen by four million barrels a day, but is far short of increased demand. Meanwhile, emerging-market demand shows no signs of subsiding. China's latest trade data show that in May it became a net importer of gasoline for the first time.
Furthermore the possibility of military action against Iran, which would disrupt global supply, seems greater than it did a few years ago. The plunging value of the dollar has also caused the cost of oil to jump more in the U.S. in the past year than in countries with stronger currencies.
Another theory is that the price of oil isn't based solely on supply and demand, but also factors in people's expectations about future supply and demand. Currently, the market is assuming that oil will become more limited as global demand continues to rise, especially in developing countries like China and India.
Housing Market
The housing recession appears to be evolving into its next phase, in which home sales may even out but prices continue to fall and foreclosure sales soar. A record number of foreclosure proceedings were started in the first quarter, accounting for nearly one percent of the stock of mortgages, or 516,000 homes. The distress is particularly acute in the subprime adjustable-rate mortgage market; nearly a quarter of subprime mortgages outstanding are delinquent, and roughly six percent had foreclosures started in the first quarter. Foreclosures tend to add to inventory and crowd out regular sales.
The surge in foreclosures also adds to the downward pressure on home prices. Housing wealth is shrinking steadily. According to the S&P Case-Schiller index, housing wealth has already dropped 13 percent from a peak of $22 trillion in the second quarter 2006 to $19 trillion in the first quarter 2008 and some expect it to bottom at $16 trillion by the end of 2009.
In general the housing picture looked slightly better in April, but then reverted to trend in May. Housing starts were much stronger than expected, jumping 8.2 percent to 1.03 million units in April. However, the increase was entirely due to a 36 percent rebound in volatile multi-family starts- single-family starts fell 1.7 percent, the twelfth consecutive monthly decline.
In May multi-family starts dropped eight percent, causing housing starts to fall 3.3 percent, to 975,000 units, while single-family starts fell one percent. This was the thirteenth consecutive monthly decline and marked a 17-year low.
Inventories of new homes have been falling for more than a year, but it looks as if there is still about eighteen months to go before they correct to the long term trend.
Existing home sales fell one percent in April and then rose two percent in May. Total existing home sales rose to 4.99 million units in May from 4.89 million units in April. Single-family existing home sales rose 1.6 percent in May, while multi-family sales increased 5.5 percent.
The level of new home sales was higher than expected in April, as sales rose 3.3 percent to 525,000. However, the increase in April followed a downward revision to March sales to 509,000 from an originally reported 526,000.
In May new home sales fell 2.5 percent to 512,000. New home sales are now 40.3 percent below year-ago levels and are showing few signs of stabilization.
Pending home sales fell 4.7 percent in May while the previous report was revised up to a gain of 7.1 percent in a departure from recent trends. Pending home sales have fallen 14.6 percent over the last 12 months.
Total Home Sales in the U.S.
Source: Citigroup and Moody's Economy.com
Cash-strapped U.S. consumers hurt by the weak economy continued to fall behind on credit payments during the first quarter. The American Bankers Association (ABA) said several loan categories showed an increase in the percentage of accounts at least 30 days past due during the quarter, including personal loans, bank credit cards and mobile-home loans.
Of note was the sizable increase in the percentage of home-equity lines of credit that were considered delinquent. The ABA said 1.1 percent of home-equity lines of credit were at least 30 days past due on a seasonally adjusted basis during the first quarter, up 0.14 percent from the previous quarter. In the first quarter of 2007, delinquencies stood at 0.6 percent. Bank credit-card delinquencies showed a similar quarter-to-quarter increase, climbing to 4.51 percent in the first quarter from 4.38 percent at the end of 2007.
Third Quarter Outlook
Half way through 2008, the same concerns continue to prevail: weak housing, tight credit and surging oil prices. The main surprise is the surge in oil and other commodity prices, which has created even greater uncertainty about the outlook for both growth and inflation.
The U.S. economy may not be formally in a recession, but it certainly feels like one. Energy prices are spiking, the labor market continues to soften, and mortgage and credit card delinquencies are still rising. Policy makers appear to be backed into a corner with few options for escape.
A common theory was that the economy dodged a bullet in the first half of this year, avoiding negative GDP growth and setting itself up for a gradual recovery. Now those hopes are fading fast. A second potentially bigger challenge lies ahead when the tax rebate stimulus fades in the fourth quarter.
The economy is slowly responding to a series of shocks - arguably the worst post-war housing recession, distressed financial markets and record energy prices. The housing recession has been a drag on growth for the past year and half. Housing starts have fallen 60 percent from their recent peak, and residential investment has plunged to only 3.2 percent of GDP. Home prices are down about 16 percent from their recent peak and are likely to fall another 15 percent before bottoming at the end of next year.
A toxic brew of sluggish economic growth, rising unemployment, and spiking inflation - otherwise known as stagflation - is prompting market watchers to backpedal furiously on earlier predictions of a market rally later this year.
Much of the malaise, of course, stems from the credit crunch, which will soon mark its one-year anniversary. The rise in energy prices, along with the attendant rise in inflation expectations, is a double blow to the economy, straining consumer income while possibly constraining the Fed from easing further. Rising inflation in a recessionary or very weak economy creates quite a dilemma for a central bank with the dual mandate of growth and price stability.
As the second half gets under way, investors worry that central banks around the world will be forced to raise interest rates to abate rising commodities prices, even though the global financial system is still vulnerable to a broken U.S. mortgage market. Most of these central banks have only a single mandate to fight inflation, so they will be less hesitant to act, as demonstrated by the ECB.
The U.S. economy may skirt a formally declared recession, but the best that can be expected is a protracted period of sluggish growth. Economic projections show weakness throughout the rest of this year and into the first quarter of 2009.
Labor market indicators continue to point to recession-like conditions with payrolls falling for the sixth consecutive month and the unemployment rate rising about one percentage point over the last year.
The Fed's recent anti-inflation rhetoric has led to market expectations of one or more rate hikes by the end of the year. The Fed funds futures market is currently pricing in 25 to 50 bps tightening.
Yet amid concern about rising unemployment, tanking consumer confidence and a growing fear that a recession has not been avoided but merely postponed, the Federal Reserve may not be able to raise rates anytime soon, even if inflationary expectations start to spin out of control.
On one hand the rise in actual inflation and expectations regarding future inflation pose a threat to the credibility that the Fed has established over the past two decades for vigilance in controlling inflation. On the other hand, the remedy for rising inflation - higher rates - isn't really feasible. Sub-par growth and the ongoing slump in the real estate market have tied the FOMC's hands.
The lesson of the 1970s is that the Fed should not accommodate a sharp rise in oil prices. Monetary policy is currently accommodative; therefore, all else being equal, the Fed would be justified in moving toward a more neutral policy position. However, all else is not equal as the Fed is charged with the dual mandate of balancing downside risks to growth with a more immediate threat of rising inflation.
Added to this it has also taken on the role of bringing order to the financial markets. In fact Chairman Bernanke indicated in a recent speech that the Fed may extend securities dealers' access to direct loans from the central bank into 2009 as long as emergency conditions "continue to prevail." We believe it unlikely that the Fed will be able to tighten this year given the current scenario.
The labor market should continue to weaken with a steady decline in non-farm payrolls. Higher unemployment reduces employee bargaining power, leading to slower wage growth. This adds to the downward pressure on already burdened consumers.
The University of Michigan survey shows overall consumer sentiment is at its lowest level since 1981. The survey also produces the strongest evidence of deteriorating inflation expectations, with the one-year measure above 5 percent - a level not seen since 1982.
Some economists and Democrats are rumbling that the government needs to again intervene to prop up the flagging economy. However, there is little agreement about what form a second stimulus effort should take or how quickly it should happen. Some favor another round of rebate checks, while others advocate investment in infrastructure.
There are also plenty of people, including some economists, who think another short-term stimulus package is the wrong way to go, arguing that it does little to fix the underlying problems plaguing the economy.
The third quarter is sure to offer many distractions. The official presidential campaign is heating up, and investors will be digesting specific proposals on issues that affect corporate profits, including trade, taxes, health care and defense spending. The summer Olympics will put the spotlight on China, pointing to the good and bad of that country's explosive growth. Once the dust settles however, it is doubtful the picture will look much better than it does now.
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