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ALM
First Financial Advisors
Economic Overview
Third Quarter 1998
TOPICS
COVERED
Introduction
You
may recall that the rallying cry in the George Bush campaign
for reelection in '92 was to label all opponents with the
"L-word"… as in liberal. The message would
be something along the lines of "Bill Clinton speaks
a centrist's language but he really is a "L" and
we all know that we don't want an "L" setting domestic
policy".
Six years
later and the debate still rages as to if the President is
really a true liberal or a centrist/New Democrat. However,
that argument has taken a back seat because Mr. Clinton has
developed his own new meanings to the "L-word".
I will let you decide what new "L-word" may now
apply.
In the
financial markets today the current fuss surrounds two other
"L-words", leverage and liquidity. Leverage can
be a wonderful tool. As credit unions, everyday we practice
the science of developing and managing leverage for our members.
In the financial markets leverage is used to change the risk
profile of a portfolio. Sometimes this can produce lavish
returns, other times it produces spectacular failures.
Liquidity
is the grease that makes the wheels of finance turn easily.
To carry that analogy further, if you get too much of it things
start to turn too fast and may get out of control. Too little,
and the wheels may freeze up and cease operation. Neither
is a desirable result. What does this have to do with us,
the kings and queens of the short-end of the yield curve?
Long Term
Capital of Greenwich, Connecticut is a hedge fund who just
a few months ago was quite large. In fact, the bond super
daddy's and Nobel Laureates on staff theorized that leveraging
their large capital base would be a good thing…to the
tune of 100 to 1. At the cliff's edge they controlled over
one trillion dollars worth of securities betting
on spread conversion. As you already know, the trade went
away from them and the exceptional level of leverage sapped
all of their capital almost overnight.
The unwinding
of this trade along with other hedge fund trades is important
to us because it exacerbates the new gloomy consensus outlook
for the economy, which includes lower corporate profits, near
panic conditions overseas and looming troubles in South America.
The result is significantly reduced Treasury yields due to
the demand for a safe haven and ever widening credit spreads.
As investors,
we have seen the impact of this as the yields on our favorite
parts of the curve sink to levels unimaginable just a couple
of months ago. The current yield levels are not supported
by the fundamentals of the economy, unless you think that
current events will trigger an outright recession of the domestic
economy in 1999.
So, to
get a better understanding of the fundamentals let's look
at the current domestic picture.
The
Consumer Sector
Most would agree that the U.S. economy is still performing
at a very high level of efficiency. We are still producing
great levels of output as measured by GDP and job growth without
any signs of inflation as measured by the traditional measures
or by commodity prices.
With the
turmoil surrounding the U.S., many are looking for cracks
in the foundation and indeed we are beginning to see "things"
topping off. This has a ripple effect because the real reduced
demand overseas leads to a perceived reduced demand at home,
which leads to a reduction in corporate profits forecast.
This in turn leads to a revaluation of the equity market lower,
which impacts the wealth of you and me. We then begin to question
if we really need that big screen television and we don't
buy. So perception becomes reality and recession is truly
a state of mind.
Retail
sales, the great barometer of consumer activity, has shown
a slight comeback after falling by 0.56% in July. However,
a larger influence in recent gains has come from vehicle purchases,
which have perked back up after the GM strike. There is a
high level of dealer incentives being offered now which is
responsible for a lot of the rebound.
Another
factor arguing for a slow down in future retail activity has
been the significant slow down in addition of consumer credit
and the topping off of the consumer debt burden. The debt
burden, measured as interest as a percentage of disposable
personal income, has peaked at 11.4% and leveled off. A review
of consumer credit indicates that the debt burden seems poised
to fall from current levels.
This indicates
that the consumer is not in a position to extend credit further.
Couple that with a reduction in wealth from financial market
turmoil and you can see why some economists are increasing
significantly the probability of recession in 1999.
Existing
home sales is another good barometer of retail activity. While
the index is up significantly in 1999, the last several months
have witnessed a leveling off of this activity. As homes are
sold increases in retail activity results as households purchase
durable goods to fill their new home.
After
months of record job growth the trend in job formation has
made a discernible turn downward. After averaging 300,000
new jobs a month in 1997, job growth has fallen from these
high levels. In September, there were 69,000 new jobs produced,
well below the average.
For the
first time in seven years the job growth rate in temporary
firms has fallen below that of overall job growth. This signifies
a significant slow down in overall prospects.
With the
slow down in job growth the psychologically important unemployment
rate has edged up slightly over the last quarter. The absolute
level of the unemployment rate is still at what usually is
alarming low levels. After reaching a low of 4.3% in April
of this year, the rate has inched up to 4.6% reported in its
last release in September. This is the area that is causing
the FOMC some heartburn. There is tremendous pressure by the
market on the Fed to create liquidity and ease overnight rates.
The Fed does not have to look much further than the current
job picture to become alarmed about creating inflation.
As the
equity market has turned significantly downward and impacted
the wealth of consumers, consumer confidence has waned. Couple
this with a slowing job market and there is another factor
that could push the national psyche into a recession state
of mind.
Many have
said that the most important factor to watch going forward
is consumer confidence. After setting an all-time high in
June, the index has moved steadily downward culminating in
a significant drop off in its latest release in September
to a level of 126.
A review
of these retail indicators shows what seems to be a leveling
off in economic activity and exhibits a heightened probability
of lower growth in 1999 and an increased possibility of negative
growth.
The
Wholesale Sector
The wholesale sector, being responsive to changes in consumer
behavior, is undoubtedly watching closely as these events
unfold. Production levels in the wholesale sector, as measured
by industrial production, after trending downward for many
months took a significant jump back into positive territory
in its latest release in August. In June and July industrial
production actually recorded negative growth as industries
worked out of an inventory build up that had taken place during
the first half of the year.
In August,
industrial production jumped up 1.7%. This would be significant
by itself but almost the entirety of the growth came from
the restart of GM after the strike.
 Businesses
across the country have been involved in the largest capital
investment program in history as factories and businesses
spent huge sums on technology. This investment is largely
credited for the tremendous increases in worker productivity,
which has lead to the tremendous job growth and low unemployment
experience over the past several years. To extrapolate further,
the significant increase in productivity is directly responsible
for keeping a lid on inflation.
However,
as can be seen in the capacity utilization index capacity
has been expanding to a point were utilization is down to
levels were future investment in technology and other capital
investments could slow significantly should the economy turn
lower. This would obviously further degrade economic activity.
The
Martket Environment
As you know, during the excellent economic activity of the
past few years we have monitored inflation closely. Inflation
is the boogey man of the fixed income markets because incipient
inflation, that which is unexpected, eats away at our future
contractual cash flows. In general everyone watches the inflation
indicators of manufacturers and producers as measured by PPI
and that at the consumer level through CPI.
As you
may recall PPI has been deflationary over the past year. In
fact, only three months have recorded an actual increase in
producer prices year-to-date in 1998. In August, the latest
release date, PPI actually fell by 0.40%.
CPI has
also been well behaved. The average monthly increase in consumer
prices year-to-date is 0.15%. In fact going back to January
1996 the monthly average increase in consumer prices is a
paltry 0.22%.
 At
ALM First, we like to focus on commodity prices as a precursor
to changes in the inflation indices. Specifically, crude oil
and gold. The story of oil and gold has been widely publicized
in the press and in our discussions. I am sure that everyone
is aware that the levels of prices exhibited here are very
low. However, there has been a slight move upward in both
oil and gold over the past month.
We will
be watching this closely going forward. It is our opinion
that the price of a barrel of oil has reached its low and
will move higher over the next year. We do not feel that it
will move to a point that will damage our short-term inflation
outlook.
So, with
the economy appearing to shift downward as indicated by our
review of the consumer and wholesale sectors, inflation not
rearing up as exhibited by our review of commodity prices
and the inflation indices and the U.S. Government in a budget
surplus you would expect yields on Treasuries to fall. The
question is how much?
In our
3rd Quarter review ALM First projected that short-term rates
would fall. In fact, we stated that currency problems related
to chaotic markets overseas could push the yield on the two-year
note down to 5%. At the time this was a relatively bold statement.
This
largely held true until the floodgates opened after the end
of July sending the yield on the two-year note down to 3.90%.
This is slightly (humor insert) less than our low projected
band of trading. On top of that credit spreads have jumped
through the roof holding spread product investments gains
somewhat limited to that of Treasuries and Agency bullet securities.
So
what has happened? It relates directly to the all of the
stories indicated above:
- Decreased
global economic activity
- Increased
probability of a downturn in the domestic economy
- Money
flows from scared equity investors into the Treasury safe
haven
- Money
flows from panicked foreign investment
- Hedge
fund trade unwinding
- Liquidity
problems exacerbated by a retraction of leverage as a result
of the factors related above
Where
does it go from here? The market anticipates an easing
of 75 basis points by the FOMC by year-end. This is measured
by viewing the rate implied by Eurodollar futures for maturity
in December 1998. The FOMC has two more meetings scheduled
for 1998 and we feel that indeed the Fed Funds rate will see
4.50% by year-end. The two-year note on the other hand anticipates
quite a bit more easing over the course of the next 12 months.
We do not feel that current yields of less than 4% is indicative
of where the two-year note should be purchased given today's
environment. We feel that the trading range will move slightly
higher over the next quarter.
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