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ALM First Financial Advisors
Fourth Quarter 2007 Economic Outlook
Prepared by: Lisa K. McDaniel, CFA
October 9, 2007
TOPICS COVERED
PLEASE NOTE:
We are changing our outlook on the Fed meeting in December. In the Economic Outlook for November 2007, we said we did not expect another Fed easing until the first quarter of 2008. We are changing that forecast as we believe recent market conditions and the language in the FOMC minutes from October make it highly probable that the Fed will ease another 25 bps at its next meeting on December 11. The FOMC minutes painted a pretty clear picture of short-term economic weakness. This coupled with continued pressure on the financial sector and the downward trend in interest rates has caused the futures market to more than fully price in a December rate cut.
Third Quarter Review
The third quarter began with signs of trouble in the subprime-mortgage market as borrowers with questionable credit histories began to default on their loans and bonds backed by these mortgages lost value. Investors suddenly stopped buying bonds backed by these loans, sending credit markets into a tailspin.
Although the stock market ended with respectable gains, there was plenty of turbulence along the way, including a dive in August when credit woes drove major indexes more than nine percent off records set in July. At the same time oil prices hit a record high and the dollar hit a low against the Euro.
The Dow Jones Industrial Average recovered to end the quarter up 487 points, or 3.6 percent, at 13,895, ahead 11.5 percent year-to-date. The Federal Reserve helped in September with a half-percentage point cut in its target short-term interest rate, sending the Dow to its best month since May and the best September since 1997. The blue-chip index ended the quarter 0.7 percent below its record close of 14,000 set on July 19, 2007.
The Nasdaq Composite Index, with its heavy weighting in technology, outpaced other major indexes in the third quarter, rising 3.8 percent, or 98 points, to 2,701, up 12 percent this year. Among sectors within the S&P, energy was up 8.7 percent in the third quarter, industrials rose 5.2 percent and basic materials were up 4.2 percent.
As for the bond market, Treasuries completed their best quarterly return in five years after the sudden surge in corporate borrowing costs sent bonds tied to subprime mortgages tumbling, spurring demand for the relative safety of government debt. Government securities returned 3.8 percent since the end of June.
The benchmark 10-year Treasury note ended the quarter at 4.58 percent as the yield curve steepened, up from 4.47 percent the day before the Fed move. It was lower than 5.03 percent at the end of the second quarter as investors kept prices high in their quest for safe investments.
Higher Treasury yields at the start of the quarter sent mortgage rates higher, contributing to defaults, especially on riskier subprime loans. Bonds backed by home loans took a beating, with their values dropping sharply in July and August, signaling that the era of easy money is over, at least for now. Although credit hasn't disappeared from the financial system, it comes at a stiffer price than it did a few months ago.
Between July 2006 and June 2007, the spread between Fed funds and three-month LIBOR averaged 11 basis points (bps). The spread peaked in September at 83 bps and ended the quarter near 45 bps.
The decline in junk bond (bonds with ratings below investment grade) issuance in the third quarter was dramatic. According to Thomson Financial, U.S. companies issued just over $9 billion in junk bonds in the quarter, the worst on record. That is down from $56.5 billion in the second quarter, the second best on record after $57.5 billion in the fourth quarter of 2006.
Pain in the short-term commercial-paper market eventually eased and the junk-bond market showed tentative signs of life. But the credit crunch isn't over; analysts and investors say it is likely to continue the rest of this year and into 2008.
Monetary Policy
After being on hold for over a year, the FOMC got busy in the third quarter. Although there were no rate changes at the August meeting, the minutes later revealed that Federal Reserve officials recognized that downside risks to economic growth had increased. At the time of the meeting, policymakers still judged that the greatest risk to the outlook was the possibility that inflation would fail to moderate as anticipated. Nonetheless, the minutes contained language regarding the downside growth risks posed by the housing downturn and the possible tightening in broader financial conditions.
In mid-August, the Federal Reserve took the unusual action of cutting the discount rate by 50 bps in an action that was termed “temporary change(s)...to promote the restoration of orderly conditions in financial markets... designed to provide depositories with greater assurance about the cost and availability of funding.” In addition to cutting the rate, the Fed also broadened the terms and collateral that would be accepted at the discount window.
Finally, in a move that was more aggressive than expected, the FOMC cut the Fed funds rate at its September meeting by 50 bps to 4.75 percent in a unanimous vote. In addition, the Committee approved an additional 50 bps cut in the discount rate, taking it down to 5.25 percent.
The Fed said in its statement that the easing “is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”
Following the Federal Reserve’s decision to cut the Fed funds rate, stock prices rose, the yield curve steepened, bond spreads tightened slightly, the dollar weakened, and oil prices rose.
This decision by the FOMC to deliver an aggressive 50 bps ease underscored the dramatic shift in its assessment of risk in recent weeks. The Committee departed from its usual balance of risk judgment and therefore didn’t provide too much guidance about the likely outcome of the October meeting. Yet the Committee's focus on financial developments in the final paragraph is a signal that further easing like this initial move may not necessarily be data dependent but could be triggered by additional signs that financial conditions are tightening.
Although financial markets welcomed the news, the issue of moral hazard has also been raised. This is the idea that a bail-out by the Fed will promote excessive risk taking in financial markets. Some are saying the Fed threw inflation caution to the wind by cutting the funds rate target in a preemptive attempt to head off potential economic weakness arising out of the current difficulties in the credit markets.
No doubt Fed officials are sensitive to criticism of bailing out borrowers and investors who made risky bets. As Chairman Bernanke himself said at the Kansas City Fed’s Jackson Hole Conference last month, “It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions.” However he went on to say, “Developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.”
Currency
Recent financial market volatility has taken its toll on the dollar. Turmoil in global markets briefly interrupted the dollar’s decline this summer, but the trend picked up with a vengeance after the interest-rate cuts in mid-September. This shift left the dollar substantially weakened going into the last months of the year, and investors say it could fall further.
At the start of July, the U.S. currency weakened in response to mounting concerns about turmoil in the credit markets. When those worries spread and deepened, sending stock markets around the world lower, investors sought the safety of U.S. Treasury bonds. The dollar staged a rally that lasted into the middle of August.
The resilience proved short-lived. Even as stocks started to recover, concerns about a slowing U.S. economy were cemented by an unexpectedly large half-percentage-point cut in the Federal Reserve's target short-term interest rate. That sent the dollar sliding against a host of currencies, because lower interest rates make dollars comparatively less attractive to hold. By mid-September, the currency reached nearly $1.40 to the Euro (€1), compared with $1.35 in June.
The dollar’s weakness is a double-edged sword for the U.S. economy. It makes exports cheaper, which in turn helps diminish the trade deficit. It also pumps up U.S. companies’ overseas earnings, which are worth more when translated into dollars.
A weaker dollar hurts consumers by raising the price of imported goods, yet it also helps the economy stave off a deeper slowdown, by making U.S. exports more competitive and influencing more foreigners to visit the U.S. Indeed, visits by foreign tourists to U.S. theme parks and other attractions are up, which means more bookings for hotels, restaurants and rental cars.
On the other hand, there are big downsides to a weaker dollar. For one thing, it makes foreign travel pricier for Americans. It also pushes up the price of commodities, many of which are denominated in dollars, as the producers of those materials raise prices to offset their loss of buying power. That, in turn, could trigger more inflation.
A feeble dollar also raises the risk that foreign investors will be less inclined to buy large amounts of U.S. Treasury securities that finance the country's deficit. In a worst-case scenario, Treasury prices would fall and yields rise, sending other interest rates higher and stifling economic expansion.
A rapidly falling dollar would raise the price of imports, which would in turn fuel inflation. Yet as long as the dollar’s decline is gradual, most economists see it as a modest plus overall.
Economic Indicators
Recent indicators point to a softer though still expanding U.S. economy. GDP growth for the second quarter came in at 3.8 percent after only 0.6 percent growth in the first quarter. The sharp rebound in second quarter growth reflected a big positive from net exports, a strong gain in investment spending (11.0 percent) led by a surge in business construction (26.2 percent), a smaller decline in residential investment (-11.8 percent), and a rebound in government spending (4.1 percent), all of which offset a sluggish gain in consumption (1.4 percent) that was impacted by the spring surge in gasoline prices.
Non-farm payroll employment was initially reported to have fallen by 4,000 in August, the first drop since August 2003. Revisions to the prior two months were downward, by 81,000, in a report that showed labor market conditions much weaker than consensus expectations. The data showed marked declines in manufacturing payrolls, following very modest declines over the previous few months.
However, payrolls rebounded significantly in September, rising 110,000. Moreover, there were large revisions to the August and July reports. August's initially reported 4,000 decline is now reported as an 89,000 increase and July's 68,000 gain is now reported up 93,000. The source of almost all the upward revision was government employment as the anomalies in education employment around the end of the school year were corrected. The report served to reduce recession fears raised a month earlier, but still left evidence of a gradual cooling in the labor market. Average job growth since June has been around 90,000, versus a 12-month average of 136,000.
The Producer Price Index (PPI) fell 1.4 percent in August (after rising 0.6 percent in July), led by a sharp 13.8 percent drop in wholesale gasoline. The core PPI rose a slightly higher than expected 0.2 percent, following a 0.1 percent increase in July. Sharp increases in prescription drug prices, and small increases in autos and some capital goods prices boosted the core, but probably only for the month. On a year-over-year basis, the core PPI decelerated to a 2.2 percent pace from 2.4 percent in July.
Core consumer prices rose 0.2 percent in July. The year-over-year core Consumer Price Index (CPI) inflation rate held steady at 2.2 percent. Overall CPI prices increased 0.1 percent. Energy prices fell 1.0 percent and food prices increased 0.3 percent. The year-over-year overall CPI inflation rate eased to 2.4 percent in July from 2.7 percent in June.
The August inflation reports showed that declining gasoline prices restrained headline inflation, while core consumer inflation continued to decelerate gradually. The Consumer Price Index fell 0.1 percent in August on a large 3.2 percent drop in energy costs. Food prices rose a solid 0.4 percent. Excluding food and energy, the core CPI rose 0.2 percent, in line with consensus estimates. On a year-over-year basis, the CPI rose 2.0 percent, while the core CPI rose 2.1 percent.
The Institute for Supply Management reported that its gauges of manufacturing and services industries both indicated a continued, though slower, expansion in August. The ISM manufacturing reading of 52.0 in September was almost a full percentage point decline from August and four percent below the June peak.
The non-manufacturing index fell to 54.8 in September, down almost six percentage points since June. Both surveys showed slowing orders growth, indicating that business activity is likely to ease further in coming months.
The Conference Board's consumer confidence index fell more than expected in September to 99.8 from 105.6 in August and 111.9 in July. While slightly above consensus, the index reading was the lowest in 12 months. The Conference Board's survey readings remain above their long-term average levels, but the August report signaled softer readings on job creation and declining expectations of future conditions.
Despite all the palpable gloom, August was another solid month for U.S. consumers. Consumer spending rose 0.6 percent in August in both real and nominal terms. Consumer durable spending, primarily autos, was quite firm. Nominal consumer nondurable spending actually fell. Personal income rose 0.3 percent. Wage gains, as indicated by the employment report, edged up only 0.2 percent.
While consumer spending gains in September should be softer, the gains in July and August already show a 2.8 percent annualized rise above the second quarter average, which should help boost third-quarter GDP.
Retail sales rose 0.3 percent in August as auto-dealer receipts rose a strong 2.8 percent. Sales ex-autos trailed consensus expectations, falling 0.4 percent after an upwardly revised 0.7 percent gain in July.
Higher-than-normal temperatures in the eastern U.S. slowed purchases of fall apparel such as sweaters and hooded sweatshirts. The slump in home sales and increased fuel costs and interest rates prompted consumers to limit unnecessary spending on clothing, furniture and home goods. The report suggests that holiday sales may post the smallest gain since 2002 from the slowdown in consumer spending.
Durable goods orders rose 5.9 percent in July, following June's upwardly revised 1.9 percent rise. The overall result reflected a 35.7 percent increase in defense orders, which followed a 12.6 percent decline in June. Transportation orders were also strong, rising 10.8 percent after a 9.2 percent rise in the previous period.
However, August durable goods orders were weaker than expected, falling 4.9 percent on lower transportation orders for both aircraft and vehicles. Even excluding transportation, orders were weaker than expected, dropping 1.8 percent.
Oil prices are expected to average around $70 a barrel for the year, reflecting a global supply/demand imbalance that will last longer than previously thought. Despite a small increase in crude capacity, it is doubtful that OPEC will release enough crude oil into the market to ease the imbalance.
Housing Market
The housing market remains the biggest drag on the economy to date, and recent data indicate that it has yet to bottom out.
Existing home sales fell 4.3 percent in August to 5.5 million, the slowest rate since 2002. Single family home sales were down 3.8 percent in August, marking the sixth consecutive month in which single family home sales declined.
The inventory of unsold homes edged up 0.4 percent which represents a 10-month supply of homes on the market. The number of current home owners putting their homes on the market is outpacing the demand for housing.
In July, new home sales rebounded a modest 2.8 percent following a 4.0 percent decline in June. The reprieve was short-lived, however, as August new home sales plunged 8.3 percent to 795,000, while the previous three months were revised down a net 34,000.
Housing starts also declined in August by 2.6 percent, reaching a 12-year low. Housing permits plunged another 5.9 percent, bringing the total for the year to 17 percent.
Single family housing starts declined more than seven percent in both June and July, as supply is being cut dramatically.
Real single-family homebuilding was down 32 percent from its peak in the second quarter of 2007. But the steep decline barely matched the decline in home sales, and inventories of unsold new homes are holding near their recent highs. Builders are faced with elevated inventories of unsold homes, weakening home sales as the result of tighter credit standards, and prices that are now falling on a national average basis.
Total Home Sales in the U.S. 
Fourth Quarter Outlook
The third quarter appears to be ending on a softer note. The earliest signs from fundamental data suggest the Fed’s policy stance prior to September 18 was relatively tight for a decelerating economy, already carrying a heavy burden from contracting housing. The latest data reinforce the impression of an economy in which growth remains moderate and inflationary pressures are likely to continue to subside. A soft landing with a slow convergence to trend growth is probable, unless uncertainties among households and investors suddenly trigger a sharp consumption slowdown or the credit crunch spreads beyond the housing sector.
The fourth quarter may prove more challenging for consumers, as energy and food prices rebound. Forecasts are now less certain, as the economy digests the effects of an intensifying housing situation. However, crude oil and gasoline have parted ways recently in a way that might exaggerate concerns about final energy prices. In addition, winter heating costs are dominated by smoothed natural gas services prices, not heating oil.
Each tightening cycle thus far has ended with a financial crisis. In this light, the current subprime financial crisis is familiar territory. Some, but not all, crises have led to recession; others have led to a mid-cycle slowdown.
The last two times when there was major turmoil in financial markets, the Federal Reserve cut interest rates only to begin raising them again within a matter of months. Federal Reserve district bank presidents are already expressing skepticism about the need for further rate cuts, and some investors agree.
As it turned out, neither the October 1987 stock market crash nor the Russian debt default in August 1998, which caused bond markets to seize up around the world, depressed U.S. economic growth as was widely expected.
Nor was anyone talking about rate increases in the immediate aftermath of the 1987 stock crash when forecasters and Fed officials alike were worried that the loss of wealth would cause consumers to cut spending. The FOMC responded both to disorderly market conditions and widespread predictions of a recession by cutting rates in several small steps.
The last reduction in that cycle came in January 1988. Only two months later, with economic growth picking up rather than weakening, the committee reversed course and began raising rates again. It must be said however, that in neither instance was the economy coping with a severe housing contractions, so things may well turn out differently this time.
Risky asset markets rallied and money markets stabilized significantly in the wake of the Fed’s move. This easing in financial conditions has reduced some of the downside risks to other markets and growth. Yet investors should continue to expect steeper yield curves, elevated volatility, a weak dollar, and weakening earnings growth.
The improvement in the markets has only partially offset the financial restraint that occurred over the past few months in the wake of the jolt from rising subprime defaults. Beyond a rise in price, the availability of credit also remains restrictive. Mortgage lenders are still finding it difficult to issue paper in the non-agency market. Housing activity will almost certainly have a few more quarters of very steep contraction, and home prices are poised to decline further.
The housing slump shows few signs of easing; the stock of unsold homes was at a record in June, and monthly figures show that the median price of existing homes is still falling. Delinquencies on subprime mortgages will continue to rise; many of these loans had low introductory rates that reset at significantly higher levels after two or three years. Mortgages granted in 2005, at the height of the housing bubble, have only just begun to reset, suggesting that the delinquency rate of nearly 14 percent in the first quarter will move higher. This will sap consumer confidence and weigh on spending.
Despite fears that the housing crisis will kill consumer spending, there are no signs of that yet. It appears consumer spending is on track to advance around four percent for the third quarter.
The principal challenge facing the U.S. economy is not the dislocation in financial markets but the consequences of the housing fallout. Despite the recent financial market crisis, we expect a gradual recovery in consumer and business spending in 2008. There remain many positive signs, not least of which is the strong level of corporate profitability and robust corporate balance sheets, which gives some confidence that the non-financial sector can ride out the storm.
SUMMARY
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