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ALM First Financial
Advisors
Fourth Quarter 2001 Economic Overview
Prepared
by: J. Steven Orr, CFA
October 5, 2001
TOPICS
COVERED
Third
Quarter Review
The
3rd Quarter of 2001 will be remembered only for September
11th. From an economic perspective it marked the beginning
of this recession.
The quarter
was not a happy one for businesses or shareholders. Layoff
announcements hit records and companies released earnings
warnings by the pound. The final reading for Gross Domestic
Product in the third quarter will be around -1.0%.
Just about
the only statistics that did not drop over the quarter were
the mortgage refinance index and inflation indices. The refinance
index rose because of declining interest rates.
Stocks,
as the anticipation mechanism for future earnings, took it
on the chin. After loosing just over 10% last year, the S&P
500 Index has returned a -21.1% through the end of the third
quarter. The index lost 15 of the 21% in the third quarter
alone.
With only
one quarter left it is safe to say we are in a bear market.
There is a case to be made that we have been in a global bear
market for some time. The European markets are off 40% from
their peaks, and the Nikkei is down around 70% from its peak.
At home, the NASDAQ, home of the tech flyers, is off 70% from
its peak last year.
Fiscal
Policy
Congress took up the bulk of the third quarter fretting over
the dwindling budget surplus and fictitious Social Security
"lockbox." In fact the Federal government continued to run
a surplus in the current budget because tax receipts exceeded
spending. The fact that the receipts were coming in from the
FICA tax is no justification for the political hot air expended
by the Democrats. The tax rebate cut into about a third of
the surplus. More importantly, the surplus was below government
forecasts because the economy was faltering.
All this
has been ignored since 9/11, and the talk now is only how
much spending will increase. Congress is happiest when it
can spend, and it will be a race to see which side of Congress
will "rebuild" with the bigger stimulus package. Spending
in the home district is always the best reelection ploy, and
look for a number of pet projects included in the defense
authorization.
Monetary
Policy
The quarter
saw the Fed continue its easing program with a bias toward
continuing the cuts. Indeed, the Fed statement released from
the summer Jackson Hole meeting stated that the Fed "would
continue to ease until the first signs of increasing activity."
The Fed cut the Funds rate twice during the quarter: 25 basis
points in August and then 50 basis points on the first day
of equity trading after the terrorist attack. For the year
the Fed has cut eight times and dropped the rate 350 basis
points.
Since
the tragic events of September 11th the Fed has pumped huge
amounts of liquidity into the financial system using repurchase
agreements and lending from its SOMA account. The first weekend
after the attach the Fed lent over $80 billion versus a normal
weekend of about $4 billion.
The two
year Treasury rallied throughout the quarter, as market participants
bet both that the Fed was behind the economy and that there
was much more easing to come. The chart below can be read
either of two ways but only has one conclusion. First, the
two year is a good anticipator of Fed action. Second, Greenspan
listens to what the market wants. There is antidotal evidence
of the latter. The conclusion is the two-year area of the
curve is the last place to be when the Fed quits easing.
Economic
Indicators
A review
of the major indicators released during the quarter provides
little comfort.
The Consumer
Price Index slowed to an almost 2% annual rate as gasoline
and food price pressures moderated.
There
are several consumer confidence surveys; the two largest are
the University of Michigan and the Conference Board. Both
were sagging before 9/11 and are headed further south.
This is
an important measure because the consumer represents over
two-thirds of GDP. That is why we were urged to go to the
mall after the terrorist bombing.
Turning
to the home front, the MBA Refinancing index showed the effects
of lower rates on the mortgage industry. New and previously
owned home sales had been a bright spot but faltered as the
job situation worsened. Refinancing activity is very important
for our clients, because of the rising prepayments in their
portfolios. The refi index has more than doubled since May
and is higher by a factor of ten year over year.
Turning
to the cyclical sectors of our economy Industrial Production
continued to fall. The August reading marked eleven straight
months of lower activity. September's data will likely be
worse since many factories could not get deliveries in or
out for several days.
The automakers
had to idle plants and layoff workers because of the transportation
halt. Their just-in-time inventory methods rely on hourly
deliveries of parts from plants in Canada and the U.S.
Fourth
Quarter Outlook
The economy
was not well before the attack, and the last thing it needed
was a jolt to consumer confidence. September 11th at the least
kept people at home and their wallets closed. We look for
the fourth quarter to remain weak, with GDP growth coming
in at around -1.0%. There is reason for optimism. The effects
of fiscal and monetary stimulus should kick in and fuel a
recovery in the second half of 2002.
The monetary
stimulus of lower rates will be with us for a while. The Eurodollar
futures market has consistently predicted a "V" shaped recovery
throughout the summer. Markets are coming around to the idea
that the economy will need a longer recovery period. The Fed
will cut one more time this year and rates will likely bottom
in the first quarter of 2002.
The effective
Fed Funds rate is currently priced to a 2.08% rate in January.
This implies a likely target funds rate of 2.25% by the end
of this year.
The Treasury
curve is a bit different story. The two-year has traveled
a long way in this easing cycle, dropping over 215 basis points
this year. Going much below 2.50% over the next three months
appears difficult. We expect the yield curve to continue to
steepen over the next several months. The shape of the curve
is defined by the difference in yield between the two and
thirty year Treasury. At the end of the second quarter the
difference was 149 basis points, and at the end of the third
it was 258 basis points. One or two more cuts at the front
end and pressures on the long end of the curve could push
the curve out to 300 basis points. This is set against a ten
year average of 120 basis points. The pressures on the long
end include suspension of the Treasury buyback program, fears
of insurance company selling and inflation fears down the
road from the Fed eases.
A steep
curve allows leverage and borrowing participants to fund positions
in the short-term market and buy intermediate and long term
paper at a positive spread. This is called the "carry trade"
and has a large effect on demand and supply of short-term
securities.
On the
fiscal side, Congress appears to be moving toward President
Bush's spending proposals. New spending on defense items and
rebuilding New York will take months to filter through the
economy but could add as much as 1% to GDP. Normally we would
worry about letting Congress go on a spending spree. Excessive
spending generally drives up inflation fears, which in turn
pushes up long-term interest rates. We think the possibility
of inflation slim at best this time. This is because world
economies are weak and demand low. We look for CPI and PPI
to be stable over the next several months.
Summary
We
look for both the domestic and global economy to worsen in
the months ahead. Expect to hear higher unemployment and lower
sales forecasts as consumers keep their wallets closed. War
does change the dynamics of recovery however. The large fiscal
and monetary stimulus cannot be overlooked and should lead
to positive growth in gross domestic product by the third
quarter of 2002.
Click
here to view Summary Chart
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