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ALM First Financial Advisors
Fourth Quarter 2006 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
October 12, 2006
TOPICS
COVERED
Third Quarter Review
Major U.S. stock indicators all flirted with or hit lows for the year in mid-July, leaving them little changed for 2006 up to that point. However, once Federal Reserve policy makers decided in early August to pause in their two-year-plus campaign of raising interest rates, all that changed, and the stock market staged a rally with bigger gains and more drama than investors had experienced in a long time.
The Dow Jones Industrial Average ended the quarter just shy of a record-breaking close, at 43.91 points below the peak reached in January 2000. More specifically, the index rose 528.85 points in the quarter to end at 11,679.07, leaving the average up 9 percent for the year and up 8.8 percent from its July low. The average advanced 4.7 percent in the quarter, its best performance in a July-September period in 11 years and the fifth consecutive quarterly increase.
Other factors that aided the stock surge included low Treasury yields and a pullback in the prices of crude oil and other commodities, which kept inflation fears in check.
The Standard & Poor's 500-stock index followed suit, rallying 65.65 points, or 5.2 percent, to end at 1,335.85, leaving it up 7 percent for the year. It still is 191.61 points from its record close of March 2000. At its summer low, the index showed losses for 2006, but it has rallied 8 percent since.
The Nasdaq Composite Index also turned around, rallying 86.34 points in the quarter to 2,258.43, up 1.8 percent from its July low, up 4 percent in the quarter and up 2.4 percent this year. Still, it needs to more than double to reach its record of more than six years ago.
The bond market also defied expectations in the third quarter. In June, the prospects for bonds appeared gloomy as inflation was still a big worry and many investors were uncertain about the change of command at the Fed.
However, the bond market produced a dynamic rally that sent prices higher and yields lower. The yield on the 10-year Treasury note, which reached a four-year high of 5.25 percent near the end of June, ended the quarter at 4.64 percent, the largest quarterly decline since the second quarter of 2005.
Throughout the Fed.s latest tightening cycle, the long end of the yield curve has stayed stubbornly low. The Fed raised the funds target by 425 basis points (bps) over the last two years, while the yield on 10-year notes rose only 23 bps. The move in long rates pales by comparison to every other episode of tightening by the FOMC since the Volcker era.
What is different this time? For one thing, inflows from foreign private investors and central banks have helped keep long rates low. Another factor is that volatility in U.S. interest rates has drifted lower since the mid-1980s, and lower volatility may explain a key part of the lower reward embedded in long-term U.S. rates. Nominal rates pay investors both a .real. yield and a mix of compensation for inflation and interest rate risk. It.s that compensation for interest rate risk that has declined in recent years.
Monetary Policy
The minutes of the August 8th FOMC meeting, at which the Fed voted to maintain its federal funds rate target at 5.25 percent (with one member officially voting to dissent) suggested an even-handed debate in which the FOMC seemed relatively split between concerns about uncomfortably high inflation and potential forthcoming economic weakness. The minutes reflected significant uncertainty about the economic outlook, particularly the spillover impact of declining housing activity on consumer spending. Inflation concerns were sufficiently pronounced to suggest that a handful of members preferred to hike rates but did not dissent, suggesting that further rate hikes may lie ahead.
At the September 20th FOMC meeting, the committee held the fed funds rate steady at 5.25 percent for a second consecutive month. Richmond Fed President Lacker dissented again, stating a preference for a 25 bps rate hike at this meeting, but the rest of the committee seemed more comfortable holding the rate steady than in the August meeting. Recent evidence that third quarter GDP growth is likely to show further deceleration, combined with relatively favorable core inflation readings and declining market-based measures of inflation expectations, eased the decision to hold rates unchanged.
While it made minor adjustments to its statement, the FOMC left its basic message unchanged, still leaving the door open to additional firming. On growth, the Fed said that "The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market." On inflation, the Fed repeated that "Readings on core inflation have been elevated," and noted that "the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures."
However, the Fed stated again that "inflation pressures seem likely to moderate over time, reflecting reduced momentum from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand."
The policy paragraph was identical to that released on August 8th as the Fed repeated, "Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."
Economic Indicators
The Federal Reserve.s Beige Book, a summary of anecdotal economic developments in the System.s twelve Districts, indicated that economic growth activity continued to expand over the mid-July to August period, though with five Districts reporting deceleration. Manufacturers were reporting little ability to pass higher energy prices into final goods prices. Labor markets were described as steady since the last report.
Growth and core inflation in the second quarter were slightly lower than previously reported. The Commerce Department.s final estimate for second quarter real GDP growth was an annualized 2.6 percent, below the preliminary estimate of 2.9 percent released in August. The four-quarter growth rate of real GDP is 3.5 percent, while growth in the first half of the year averaged 4.1 percent.
The downward revision to real GDP was mainly due to a downward revision to inventory investment and an upward revision to imports of services. Corporate profits were revised lower.
Non-farm productivity was 2.5 percent higher in the second quarter than levels one year ago. This productivity growth rate was in line with the average growth rate of productivity over the last 12 years and almost a full percentage point above the productivity growth rate seen over the previous 20 year period which ended in 1994.
Nonfarm payrolls rose only 51,000 in September, but August employment was revised upward to 188,000 new jobs from the 128,000 originally reported. The average rate of payroll creation over the last three months was 121,000.
The report also showed job growth during the 12 months ended in March may have been about 45 percent higher than previously reported. In a preliminary estimate, the Labor Department said payrolls for the 12 months ended in March 2006 will be revised higher by 810,000, the biggest revision since the Labor Department started benchmarking numbers in 1991. This will boost the average rate of job creation from April 2005 to March 2006 by about 67,500 jobs per month (to 236,500 jobs per month from 169,000). The revision does not appear to be concentrated in any one industry or region.
So while the headline number was lower than expected, there was nothing weak about the September employment report. The labor market, judging by both measures of labor market utilization and wage increase, is at its tightest since the second quarter of 2001. The massive upward benchmark revision to payrolls changes the history of job creation significantly (and should lead to lower productivity growth and higher unit labor cost increases from second quarter 2005 to first quarter 2006).
The consumer price index (CPI) release for August came in close to expectations at 0.25 percent. Year-over-year headline CPI fell to 3.8 percent last month. Food prices rose 0.4 percent, above their year-over-year trend, while energy costs increased 0.3 percent with small rises in most energy components.
Meanwhile underlying core inflation reached its highest 12-month pace in over 10 years. Core CPI prices (excluding food and energy) rose 0.2 percent in both July and August. This increased the 12-month core inflation rate to 2.8 percent from 2.7 percent, tying November 2001 as the highest reading since February 1996.
The producer price index rose 0.1 percent in August, as a sharp gain in food and a small uptick in energy offset a 0.4 percent drop in the core. Declines in car prices (-2.6 percent) and trucks (-3.4 percent) subtracted 0.4 percentage points from core PPI prices. The year-over-year change in core PPI prices slowed to 0.9 percent in August from 1.3 percent in July.
The ISM index of manufacturing activity fell in August, but was in line with expectations and only slightly below July's reading of 54.7. In September, the ISM manufacturing index declined for a second consecutive month, falling 1.6 percentage points to 52.9. The September reading of 52.9 is the lowest reading since the 51.8 posting in May 2005. Whereas only nine industries reported growth in August, 12 industries reported growth in September.
After three months of slowing, growth in non-manufacturing business activity picked up in August. The ISM non-manufacturing index was stronger than expected, rising to 57.0 from 54.8 in July. Eleven sectors reported increased business activity, three reported decreased activity, and four indicated unchanged activity compared to July.
Non-manufacturing activity decelerated sharply in September, registering its slowest growth pace since April 2003, but appeared set to rebound in October. Orders growth picked up, and employment, order backlogs and export orders all improved. While business caution increased in late-summer, lower energy prices now appear to be supporting a pickup.
Retail sales rose 0.2 percent in August, as motor vehicle dealers. receipts posted a gain of 0.4 percent. Excluding autos, sales also rose 0.2 percent, but the July number was revised downward. August sales were restrained by a price related pullback at gas stations (-1.0 percent) that should be much larger next month.
The durable goods sector softened as orders of manufactured consumer goods declined and a softer transportation sector continued to unfold. Durable goods orders fell by 0.5 percent in August, after a revised 2.7 percent drop in July, marking the first back-to-back orders declines since March and April 2004. Non-transportation orders fell a sizable 2.0 percent, indicating a weakening of demand for manufactured consumer goods - the first decline since April and the largest reduction since last July.
In a sign of growing discomfort, the Conference Board.s measure of consumer confidence joined other sentiment measures in an unexpectedly weak performance in August. The Conference Board index fell to 99.6 in August (from 107.0 in July), the largest decline since the Katrina-related drop of last September. However, consumer confidence rebounded in September to 104.5, as threatening conditions in the Middle East receded and fuel prices plummeted. The August measure was revised upward to 100.2.
The solid rise in September erased more than half of the August decline, but the trend remained consistent with economic moderation. An improved outlook for income and lower inflation expectations indicate that the sharp drop in energy prices played a significant role in the September rebound. A stronger stock market and lower interest rates also supported consumer attitudes.
Separately, the University of Michigan reported a modest upward revision in its consumer sentiment index in late September to 85.4 from 84.4. Of interest in the report, consumers continued to rate the current period as a poor one for home buying. However, 34 percent referred to reductions in home prices. The net of those consumers reporting house prices "low" and favorable for buying conditions less "high" and unfavorable, has taken a dramatic swing toward favorable readings recently.
Consumer spending got off to a strong start in the third quarter. Nominal consumer spending rose 0.8 percent in July, while real consumer spending rose 0.5 percent, recording its strongest monthly gain of the year, supported by a faster pace of vehicle sales and healthy spending in the service sectors.
Real consumer spending then fell 0.1 percent in August, as a 1.3 percent drop in real durable spending was coupled with a 0.2 percent drop in nondurable spending and a mere 0.1 percent rise in real service spending.
Crude-oil futures prices hit an intraday record of $78.40 a barrel in July, as Israel rained bombs on southern Lebanon in response to the kidnapping of soldiers by the Islamic militant group Hezbollah. Although neither country is a major oil producer, there was concern that Hezbollah supporter Iran could become involved and cut crude-oil exports from the Persian Gulf. Forecasts of an active Atlantic hurricane season that could threaten production in the Gulf of Mexico also contributed to early price rises for crude oil and natural gas.
The early increases - which were based on potential, rather than actual, supply losses - deflated quickly as tensions eased in the Middle East and not a single storm that entered the Gulf of Mexico (so far) had a material impact on production. Oil finished the quarter down 15 percent at $62.91 a barrel, and unleaded gasoline settled at $1.55 a gallon, down 30 percent on the New York Mercantile Exchange.
Housing Market
The current U.S. housing slump continued in August but the rate of decline eased relative to recent months. Existing home sales fell by less than expected, down 0.5 percent to 6.30 million units in August from 6.33 million units in July. On a year-to-date basis, through August, total sales are off 6.5 percent from the record sales pace of 2005. Yet current sales are only 0.5 percent below the previous record-setting pace of 2004. Single-family sales are down 6.2 percent from the record sales pace of 2005, while current sales are 1.0 percent below the then record-setting pace of 2004.
Existing home prices soared in 2005, rising at a double-digit pace, reflecting a stunning, three-year rise in sales. The sharp price gain last year was the largest since the late 1970s.
However, the exuberance of the 2005 housing market had a downside. The extraordinary increase in existing home prices last year created a high hurdle for continued gains this year. Higher prices meant houses became much less affordable to typical households.
The rise in home prices, together with the percentage point jump in mortgage rates pushed down the housing affordability index to 102.9 in July, which was the lowest reading in 15 years. As a result, demand for houses buckled under its own weight. Resales fell 12 percent over the past year, and price gains tumbled. New home prices also fell in August, but declines in that volatile market are not as rare.
Inventories of unsold houses have climbed appreciably in the last year. At present there are just under four million unsold homes on the market, excluding new construction. At the present absorption rate this is a 7.5 month supply. In July there was a 7.3 month supply and one year ago 2.8 million homes were available - a 4.7 month backlog.
New-home sales bounced back during August after three straight declines. Sales of homes increased by 4.1 percent to a 1.05 million annual rate, after falling in July, June and May. While Wall Street had expected another decline in August, the sales rate was only slightly above the 1.045 million-pace consensus of economists.
New-home prices in August were mixed. The average price decreased to $304,400, down from $314,200 in July - yet above the $295,000 reported in August 2005, according to the Commerce Department. The median rose to $237,000 from $236,200 in July; the price in August 2005, however, was higher, at $240,100.
Declining prices can make homeowners feel less wealthy and dampen their spending on goods and services, which is worrisome for the economy. On the other hand, falling prices can help the housing market by making homes more affordable and reducing the rising tide of unsold homes.
Housing construction in the U.S. fell to a three-year low in August. Housing starts fell 6 percent in August, and 19.8 percent over the past year. The data cements a double-digit drop in residential investment in the third quarter, following a significant net drag on growth over the past year. While the declines in starts will be seized on by some of evidence of forward-looking housing concerns, the sharp building declines in 2006 will help clear inventories in the next few quarters.
It is important to note the sharp drop in residential investment already reported over the past year has occurred as the U.S. economy has continued to grow. Retail sales, employment, even construction-related employment rose during the month of August. This continues to suggest that housing's decline will merely weaken an economy that had been growing above trend, while non-correlated industries continue to recover.
Fourth Quarter Outlook
There is clearly increased concern about downside economic risk at this point in the cycle. The markets are debating if the Fed has achieved a soft landing (where growth and inflation cool just enough to end Fed tightening) or whether we will face a recession. Below-trend economic growth is set to continue in the fourth quarter, but with lower energy prices and interest rates cushioning domestic demand, prospects for an economic soft-landing remain intact.
Overall, growth in manufacturing is decelerating, as activity related to auto production has taken a severe hit already, and some business related to homebuilding should continue to decline.
The decline in existing home prices, the first in more than a decade, reflects slack demand. But, like the new home market, the retrenchment in the resale market may be approaching its most intense point.
Evidence continues to mount that the U.S. economy will absorb a severe correction related to housing activity without contracting overall. In August, nominal construction outlays were stronger than expected and non-residential outlays rose 2.3 percent in August, overwhelming the housing declines.
Meanwhile, core consumer inflation edged higher again in August, helping to ensure that inflation concerns remain squarely on the Fed.s radar screen.
Bond markets are celebrating the decline in oil prices and a slight moderation in underlying inflationary pressures in the U.S. Sharply lower energy prices should push headline inflation lower in September.
However, the markets may be over-reacting. It is true lower oil prices can help to keep inflationary expectations in check. This makes it easier for the Fed to stay on hold despite some further rise in core inflation. More importantly, however, lower oil prices further mitigate the downside risks to growth. The U.S. bond market is currently predicting Fed rate cuts for next year. However, with lower oil prices, the residual risk that the Fed may be forced to shore up the economy next year with lower rates is diminishing.
Still, major questions linger for the markets in the fourth quarter. Even bulls don't expect the rally in stocks to continue at the same eye-popping rate of recent weeks, but they are hoping to ward off the worst-case scenarios that skeptics envision.
Based on current and forecast economic conditions, ALM First has revised its forecast for Fed Funds, removing another tightening in fourth quarter 2006, and adding a 25 basis point cut in second quarter 2007. The market is also priced for the Fed to remain on hold through the rest of the year and to ease as soon as early 2007. At this point the probability of another Fed tightening has dissipated according to futures contracts, after peaking at 78 percent earlier in August.
Summary
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