|
ALM
First Financial Advisors
Economic Overview
Third Quarter 1999
TOPICS
COVERED
Introduction
In the old news department, the market is continuing its focus
on inflation worries. This quarter however, a glut of other
issues including Y2K, politics, foreign exchange, and the
Fed are combining to provide a very interesting three months
for investors. At times like this a well thought out, forward
looking strategy could garner significant returns.
I heard
a story this week that illustrates the value of planning ahead.
A young country boy was walking down the lane with only two
cents in his pocket. As he approached a local farmer, he noticed
a beautifully plump red tomato and offered the farmer his
two cents for the beauty. The farmer replied that tomatoes
like that are going for a nickel.
The boy
then asked about a much smaller and greener tomato further
up on the vine. The farmer agreed to sell that one to the
boy for two cents. Having brokered the deal, the boy began
walking away and said he would be back to pick up his tomato
in a couple of weeks.
Acting
early and planning ahead may very well be the best strategy
for investing in the fourth quarter. A myriad of potential
problems lurk near the end of the year. But first, a quick
review of last quarter is in order.
3rd
Quarter
The two-year Treasury note yield pushed the upper limits of
our projected trading band in mid August, but otherwise behaved
more or less as we expected.
As the
July and August economic reports began filtering through the
market, the Fed decided it needed to raise rates again in
order to slow future growth. This was one of the most widely
expected Fed moves in recent memory.
Y2K
As this tiresome topic is becoming less of an issue in computer
circles, its impact is still going to be felt in the financial
markets. In the primary markets, fixed income issuers are
expected to stay on the sidelines for the last 6 - 8 weeks
of the year. New originations look to be less and less as
we approach the end of the year.
This lack
of supply near the end of the year could force agency spreads
to tighten making bonds more expensive. There are already
some reports of limited supply in various sectors of the secondary
market.
Even the
Federal Reserve appears to be buying into the extended year-end
vacation. Fed-watchers are proposing the idea that the Fed
does not want to make any policy changes in the last two months
of the year in order to avoid adding more volatility to the
market.
Politics
In the federal government the year 2000 is already here -
sort of. October 1 is the first day of fiscal 2000 and once
again the government has had to enact a stopgap funding measure.
In the past 50 years, Congress has only twice passed all of
the appropriation bills needed to fully fund the government
by the October 1 deadline. This year, only 4 of the 13 bills
had been passed.
Pundits
agree that the President and Congress appear to be on a collision
course for at least six of the remaining appropriation bills.
The President's budget has pushed the upper limits of the
statutory caps that limit federal appropriations. The President's
plan puts his budget about $18 billion above the spending
caps. He has proposed to make up the difference by raising
revenues, reducing payments to Medicare provider, and making
accounting changes.
The Republican
Congress, on the other hand, vowed that it would balance the
budget excluding the surpluses generated by the Social Security
trust fund. The congress is trying to be as "creative"
as it can to avoid "spending the Social Security surplus."
The problem
facing the Congress is that they must put together bills that
the President will sign. The President's primary opposition
to the appropriation bills thus far is the lack of funding
for his top programs.
The President
is pushing an increase in the cigarette tax as a way to increase
revenues, cover his proposed spending, and avoid using the
Social Security surplus. The Congress, after receiving a veto
of its $792 billion tax cut plan is in no mood to enact a
tax increase in order to cover higher government spending.
The result
of the standoff is that the Treasury is able to continue building
the surplus and retire debt. Government is one place where
doing nothing may actually be a good thing.
Trade
Deficit and the Yen
It has been the U.S. policy, especially the policy of ex-Treasury
chief Robert Rubin that a strong dollar is good for the economy.
However, over the last few months the dollar has weakened
against the yen. This, combined with the widened trade gap,
is causing some concern about the possible impact on U.S.
interest rates.
The Japanese
yen pushed ahead in the 3rd quarter, gaining 13.2% versus
the U.S. dollar. The yen climbed from nearly 121 yen/dollar
to almost 106 yen/dollar over the last three months.
The trade
gap, or more accurately the current account, indicates whether
a country is a borrower from or a lender to the rest of the
world. The current account deficit for the U.S. has ballooned
from $52.4 billion in the second quarter of 1998 to $80.7
billion in the second quarter of 1999. The deficit means that
dollars are going overseas to pay for goods and services and
those dollars need to be enticed back to the U.S.
The usual
method of strengthening the dollar and luring dollars back
home is increased interest rates. Increased rates in the U.S.
provide incentives for people to invest in the U.S., thereby
increasing the demand for dollars and providing the needed
financing for the current account deficit. Therefore, both
the weaker dollar versus the yen and the increased current
account deficit put some upward pressure on U.S. interest
rates.
Gold
and Oil Prices
Over the last couple of weeks gold prices have increased nearly
13%. This has garnered a lot of attention from the press and
is due mainly to policy changes from the major European central
banks, ending their large-scale selling of gold. For the year
however, gold prices are only up 4.84%.
Gold prices
no longer look deflationary as they have thus far this year.
Neither, however, does the large increase this month appear
to be an indicator of future inflation. The YTD change is
not very large and the supply and demand issues are unique
to the gold market alone.
Oil, on
the other hand, is worrisome for inflation. Crude oil prices
have nearly doubled since the beginning of the year. Crude
oil traded at $12.60 per barrel at the end of 1998 and is
now $24.54 per barrel.
The inflationary fear is that OPEC has regained its pricing
strength and will be able to maintain the current price or
even push prices higher. OPEC is famous for cheating on promises
to cut production but last month members promised to keep
supplies at the current level of approximately 23 million
barrels a day until April. That works out to a reduction of
just over four million barrels from the February 1998 levels.
With the peak demand season for oil approaching prices could
rise even higher.
Consumers
The confidence of the consumer in the economy is still strong.
There has been a dip lately, most likely in response to the
lackluster stock market over the last couple of months.
The continuation
of the consumer's optimism combined with their love of spending
is fueling an acceleration in borrowing. Many economists express
concern about the rising level of indebtedness and its potential
to spoil the economic expansion party. As the following graph
shows, consumer credit as a share of disposable income has
reached historical highs.
Although
the consumer credit statistic is worrisome, its impact has
yet to be felt in bankruptcies or default rates. Default rates,
which are the percentage of borrowers who are more than thirty
days late in their payments, have fallen from 3.6% in December
to 3.2% in June.
Apparently
the robust economy is allowing many consumers to live a little
beyond their means. With incomes rising, stock market wealth
remaining high, and job prospects continuing to be strong,
the consumer's almost flippant attitude towards debt is not
producing any serious repercussions. The real test will come
when the economy slows down, or heaven forbid contracts.
Manufacturing
The monthly survey of purchasing executives conducted by the
National Association of Purchasing Management provides a comprehensive
look at the manufacturing sector. Participants respond to
questions about production, orders, commodity prices and inventories
among other things.
A reading
of 50 is commonly thought of as the neutral response. A reading
above 50 implies an increase in manufacturing activity and
a reading below 50 indicates a decline.
Based
on a surge in new orders and production, the monthly manufacturing
index rose 3.6 points to 57.8 in September. This is the highest
reading since November '94. The strength is partially due
to increasing export orders as many foreign economies are
beginning to rebound.
One interesting
aspect of the survey was the fact that 38% of the respondents
said that they plan to increase inventories in preparation
for Y2K. Will this issue ever stop…? A sizable increase
in inventories in one quarter could have a significant impact
on GDP but this impact should be offset in the next quarter
as those inventories are reduced. This poses a difficult problem
for the Fed because it will have to decide what is just a
temporary increase in the economy and what is a more long-term
growth issue.
Employment
and Wages
One sign that the continued tight labor market is making itself
felt comes from the manufacturing sector. Both General Motors
and Daimler Chrysler agreed to fairly generous compensation
packages with the United Auto Workers over the last few weeks.
Organized labor is regaining some of its strength now that
the unemployment rate is at a 30 year low.
Only 4.2%
of Americans were unemployed as of August 31. This low rate
combined with anecdotal evidence of increasing wages like
the autoworkers contract does not appear to bode well for
inflation.
The employment
cost index has jumped recently but the real story appears
to be the impact of increased productivity.
The above chart shows the year over year changes in unit labor
costs for durable goods products. Unit labor costs are computed
by dividing hourly compensation by productivity, where productivity
is defined as compensation divided by output. This chart shows
that unit labor costs have been declining for several years
as productivity gains have outpaced compensation increases.
The
Forecast
In summary, although many of the above-mentioned issues point
to increasing inflation, the actual inflation measures have
yet to show significant increases. Consumer prices are increasing
at a rate of 2.30% per year and, if food and energy items
are excluded, the so-called core inflation rate is 1.90%.
Producer prices are also only increasing 2.30% per year as
of the latest measurement.
The Federal
Reserve's press release from the October FOMC meeting indicated
the committee's continued fear of rising inflation. In typical
Fed language, the committee issued an "asymmetrical directive
with a tightening bias." The Fed apparently feels that
the balance of risks facing the economy are for increased
inflation and that the most likely move in the future would
be to raise interest rates.
We believe
that the Fed will not follow through on its directive during
the fourth quarter of 1999 and that the target Fed Funds rate
will remain at 5.25%. Lower stock prices, uncertainty about
year-end issues (I am avoiding the term Y2K for the rest of
the year), and the failure of cost pressures to affect the
consumer should all combine to keep the Fed from changing
rates for the next three months.
Our projection
for Treasury rates over the rest of the year is a little less
straightforward. Based solely on economic issues, the yield
of the two-year Treasury should edge higher due to general
inflation fears and especially the Fed's fear of inflation.
However, that big "year-end issue" will most definitely
have an impact on the market.
Short-term
Treasury yields should drop as the demand for liquidity and
safety push up prices. Further out on the curve, investors
will be more interested in the threat of another Fed rate
increase - limiting demand. As a result, our projected trading
range for the two-year Treasury over the remainder of the
quarter is 5.60% - 5.90%.
|
