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ALM First Financial Advisors
Fourth Quarter 2005 Economic Outlook
Prepared
by: Cullen Coxe and Mike Manley
October 14, 2005
TOPICS
COVERED
Third
Quarter Review
In a quarter that delivered two big hurricanes and skyrocketing fuel prices, Treasury yields were slightly higher. Despite the disaster of the hurricanes, the Fed proceeded raising the Fed Funds rate to 3.75%. In doing so, the Fed explicitly took a long-term view focusing on inflation and inflation expectations rather than responding excessively to near-term disruption.
As July and August arrived, so did stronger reports in a variety of categories including personal income and spending, manufacturing, payroll growth, hourly wages, and industrial production. As the summer unfolded, worries about softening GDP growth were replaced by concerns that a stronger economy—with its resultant increase in demand for raw materials and labor—would bring a higher level of inflation in the months ahead.
In the equity markets, we've seen an up-and-down pattern continue. This tug-of-war is understandable given the fact that there's been no shortage of positive and negative developments this year. On the plus side, there have been strong gains in the U.S. economy and significant strides on the earnings front. On the negative side, we've seen oil prices move into uncharted territory and the Federal Reserve shows no inclination to call a halt to its tightening efforts. Global events remain worrisome, although fortunately, the market's focus continues to be largely on the domestic front. In the quarter just ended, the Dow Jones Industrial Average rose 2.90%, to 10,568.
The Standard & Poor's 500-stock index was up slightly for the quarter, rising 3.2%, to 1,228, while the Nasdaq advanced 4.6% to 2,151.
Meanwhile, the Treasury yields rose during the third quarter following the so-called "soft patch" in the second quarter. The 10-year yield rose 41 basis points to close at 4.33%. The 2-year increased 54 basis points to 4.17%.
Other reasons for the rise in yields include stronger than expected economic news, rising oil prices, and inflation concerns. The price of gold reached a 17 year high of $472 an ounce.
Monetary Policy
The FOMC raised the funds rate target by 0.50% during the third quarter to 3.75%, as expected, and maintained both the "measured" and "accommodative" language.
The Fed did reference the effects of the hurricanes on the economy. The committee stated, "While these unfortunate developments have increased uncertainty about near-term economic performance, they do not pose a more persistent threat." The statement also said higher energy and other costs have the potential to add to inflation pressures.
Following the impact of hurricane Katrina many economists thought the Fed might stop raising rates after the September meeting at 3.75%. However, with the release of the statement it is now clear the Fed will most probably raise rates at the final two meetings of the year to 4.25%.
The Bond Market vs. The Fed
There continues to be certain disconnect between the bond market and the Fed. Even as the Fed continues to raise rates and implies it will continue to do so, longer-term Treasury rates have only slightly increased.
The Fed keeps indicating it's worried about inflation and that it's going to keep raising rates at a measured pace to combat it; as a result short-term yields continue to increase. However, the yield on the 10-year Treasury note remains primarily in a narrow trading range between 4.0%-4.4% caused by supply and demand factors depressing long rates, rather than economic fundamentals.
A major concern as we enter the fourth quarter will be the continued flattening or an inverted yield curve. This is a situation where short-term rates are actually higher than long-term rates.
In the past, an inversion of the yield curve has often resulted from an overly restrictive monetary policy. This has sometimes led to a recession, but not necessarily so. In this case, the demand from buy and hold investors and foreign accounts are the main reasons longer-term rates have not risen in concert with short-term rates.
In September, the Fed released a paper arguing that foreign buying in general may have kept 10-year Treasury yields 150 basis points below levels that would prevail without a foreign bid. The demand for U.S. debt coming out of China coincides with the country's growth and currency policy. China's foreign currency reserves rose $207 billion last year and are on track to rise by $260 billion this year. That money largely gets reinvested in U.S. debt. In fact, for China the appeal of U.S. debt likely depends less on concerns about the Fed, inflation, or budget deficits, and more on a steady need to invest cash.
Fed officials have recently been commenting on their inflation concerns. San Francisco Fed President Janet Yellen ended a speech with the assertion that "one option that is clearly not on the table is allowing an unacceptable rise in inflation." Thomas Hoenig, Kansas City Fed President, said that inflation is "higher than it was, and enough to get your attention." These remarks clearly state the case of continued rate hikes into 2006 and with continued demand of longer-term Treasuries an inverted yield curve is a distinct possibility.
This leaves the yield curve caught between China and the Fed, with the Fed determined to fight both real and expected inflation by controlling short- term rates, and demand from China and other foreign investors keeping longer-term rates below historical expectations.
Economic Indicators
For the last three months economic news has been somewhat positive, although the most recent hurricanes have created some uncertainty about the reliability of near term data. The steep increase in oil, gasoline and natural gas prices is expected to persist through early next year, and could subtract a full percentage point from growth over the third quarter.
Real second quarter GDP was unrevised at 3.3%, however nominal GDP growth was upwardly revised to 6.0% from 5.8%. The revision was a product of a modest change in the quarterly inflation rate as measured by the GDP deflator to 2.6% from 2.5%. Real third quarter GDP is currently estimated at 3.4% according to consensus. This is in contrast to the earlier outlook in August which was looking for third quarter GDP of 4.2%. Once again the hurricane is responsible for most of the downward revisions.
Before the storms, the labor market looked to be on stable footing as evidenced by the job growth over July and August. The July increase in jobs was 277,000, while the August increase was 211,000. Both of these figures benefited from upward revisions over the last couple of months. In fact payrolls have been upwardly revised the last four months dating back to May. However September's payroll figure came in at a negative 35,000. This was due to the impact of the hurricanes on the reading. According the Labor department payroll growth would have reached 200,000 if not for the storms. That would put quarterly payroll growth at an average of 229,000 jobs per month. The unemployment rate finished at 5.1% up from 4.9% in August. The increase in September's rate was due to an increase in the labor force, not any structural changes in employment.
Over the remainder of the year it will likely be difficult to gauge real job growth due to the lingering impact of the storms. Monitoring revisions will become more important and will be most likely to produce volatility.
One sign contradictory to the overall positive economic environment lately has been consumer confidence. U.S. consumer confidence had the largest one month drop in 15 years. The consumer confidence index dropped to 86.6 from 105.5 in August. The index had produced readings above 100 in seven of the past eight months dating back to last year. A sustained weakening in confidence could spill over into reduction in consumption as well as a cooling in investment spending. There are signs that confidence is starting to rebound, however sustained higher energy prices will have a dampening effect.
Overall retail sales were weaker than expected for August, falling 2.1% on a 12.0% plunge in auto sales, while sales excluding autos posted a solid 1.0% increase. Auto sales account for around 25% of the total sales figures. Given the extreme level of incentives offered by the auto makers earlier in the quarter, a decline was expected. Overall retail sales have grown at an annualized rate of 6.1% over the last three months despite the sharp decline in August. Sales excluding autos are up 10.3% on the same basis.
Durable goods orders were significantly stronger than expected in August, rising 3.3%. The rise in orders was broad based as every major category posted gains. Excluding transportation, durable goods orders rose 4.2%. The sharp rise in orders in August follows a weak report in July. Taken together, durable goods orders are still running a solid 7.9% ahead of year-ago levels. Excluding the transportation category, orders have risen 7.5% over the last year and are up 17.1% at annual rate over the last three months.
The ISM manufacturing index was much stronger than expected in September, rising to 59.4 from 53.6 in August. This is the highest level on this index since August 2004. The most recent report also suggests that inflation pressures increased in September as the prices paid index jumped to 78.0 in September from 62.5 in August.
The ISM non-manufacturing index was weaker than expected, falling to 53.3 in September from 65.0 in August. Pushed higher by rising energy prices, the prices paid index jumped in September, to 81.4 from 67.1 in August. This represents the highest level on prices paid in the eight-year history of this survey.
Core CPI (which excludes food and energy) was lower than expected in August, rising only 0.1% in the month and holding steady at an annual inflation rate of 2.1% year-over-year. Meanwhile higher energy prices continue to push the headline inflation rate significantly higher. For the second consecutive month, the overall CPI rose 0.5% which pushed the 12-month inflation rate up to 3.6% (the fastest rate since May 2001). The three month annualized inflation rate of 1.4% in August exactly matches the three-month inflation rate in August 2004. The 12-month inflation rate has held fairly steady between 2.0% and 2.2% since last year. Energy prices still haven't trickled down into the core reading of the figure.
Core PPI prices were lower than expected in August, remaining unchanged for the month. The year-over-year core PPI inflation rate eased to 2.4% in August from 2.8% in July. Headline PPI prices rose 0.6% in August, pushed higher by a 3.7% increase in energy prices. The year-over-year overall PPI inflation rate rose to 5.1% in August (the highest since December 1990) from 4.6% in July.
Core personal consumption expenditures (PCE) were higher than expected, rising 0.2% in August. This raised the 12-month core PCE inflation rate to 2.0% from 1.9%. Overall PCE rose 0.5% in August, also higher than expected, and are up 3.0% over the last 12 months. As the Fed makes more noise about inflation expect the focus on this figure to increase in the coming months.
If you can believe this, oil finished the third quarter up "only" 15%, closing the quarter at 69.41, only $0.50 cents from the high. Since quarter end prices have fallen back below $65. The commodity that might have the biggest impact on inflation concerns could be natural gas, which soared 87% during the quarter. The winter months could push that price even higher as more people rely on natural gas to heat their homes.
Gold prices hit a 17 year high during the quarter of $475/oz (which they have since surpassed). Gold is often thought of as the ultimate inflation hedge, and is sometimes a useful tool in gauging inflation expectations.
Third Quarter Outlook
It is still early as far as gauging the exact magnitude of the impact of the hurricanes. However, at this point, the effects of the hurricanes, while devastating for the region, are expected to have only a temporary impact on national economic growth; a moderately negative impact on third quarter GDP, with a rebound in the fourth quarter and first quarter 2006 GDP growth.
The impact of the hurricanes on the economic data will persist for a while and it will take some time to disentangle the weather related effects from underlying trends. However, we expect the focus will remain on inflation and project higher yields in the 4th quarter.
The steep increase in oil, gasoline, and natural gas prices as we head into winter months is a concern. While this may reduce the consumer's disposable income and restrict growth, it will not keep the Fed from raising rates.
The market is pricing in an 82% probability of a 4.25% fed funds by year-end. Also, the fed fund futures are now implying a 52% probability of a 4.50% fed funds on January 31, 2006. Fed policy makers, backed by evidence the economy was strong before the storm, say the effect may be short-lived and that inflation may pose a greater risk than a slowdown.
It is our view the Fed will be more focused on the threat of increased inflation due to higher energy prices and price pressures than the potential for slower growth. We expect a 4.25% fed funds target rate by year end.
Summary
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