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ALM
First Financial Advisors
Economic Overview
Fourth Quarter 1998
TOPICS
COVERED
Introduction
When I was going to college the library would play the theme
music from the television show "Hawaii Five-O" at
closing time. I always thought that they should have changed
the music to the rock group U2's song "I Just Can't Find
What I'm Looking For". Now, many years removed from college
life, I have found another group that could utilize this song-Economists.
For most
of last year one group of economists has been looking for
signs of increasing inflation while others were looking for
signs of an imminent slowdown in economic activity. I am sure
that if we wait long enough one of these two groups is going
to be correct, but right now neither inflation nor recession
appears to be on the horizon.
Our overview
this quarter will discuss the factors that seem to be keeping
both an increase in inflation and a slowdown in economic activity
at bay. We will then discuss what could go wrong, and finally
provide our forecast for the current quarter. But first, a
quick look at what happened last quarter is in order.
Last
Quarter
By the end of 1998 the capital markets turmoil caused by the
reports of crises throughout the world had essentially subsided.
As a result, Treasury yields-especially the two-year note-have
recovered. We did not believe that the two-year Treasury yield
could remain at the lows of early October and as the crisis
worries eased the yield climbed back to 4.75% at year-end.
The Federal Reserve cut the Fed Funds rate three times during
the 4th Quarter of 1998, bringing the target down to 4.75%.
The Fed took these steps as a preemptive measure against what
could have resulted from the Asian crisis and the chaos in
the financial markets. The minutes of the Fed's last FOMC
meeting indicated that they had reached the end of this round
of easings by listing their current bias as neutral.
Where
is the slowdown?
The U.S. economy continues to show surprising strength. The
fourth-quarter growth in GDP is expected to be 3.50 - 4.00%,
with momentum continuing strong into the first part of 1999.
Earlier consensus expectations that growth would slow sharply
remain just a forecast. The year over year GDP growth has
remained in the 3.50-4.00% range for three years well above
the normal trend growth of around 2.00-2.50%.
Another
indicator of the surprising economic strength is the recently
released employment data. Job growth totaled 2.9 million in
1998, down from 3.4 million in 1997 but still strong. The
year-end unemployment rate stood at a 28-year low of 4.30%.
A record 64.2% of the population are currently employed.
There
seem to be three reasons that the economy has been able to
continue growing above trend and creating new jobs at such
a healthy rate. First and most importantly, consumer spending
remains strong. Second, the drag caused by troubles abroad
appears to be lessening. Third, the chaos in the financial
markets has subsided.
Almost
all signs point to continued strength in consumer spending.
The previously mentioned job creation and low unemployment
rate coupled with solid income growth have combined to help
consumers, you and I, feel comfortable about our employment
situations.
 Lower
commodity prices have also helped by increasing real incomes.
The price of gasoline at the local gas station is an excellent
example of this. Prices are lower than they have been for
years. My local station in the Dallas suburbs is selling unleaded
regular for 80.9 cents per gallon. I must admit that when
I go to fill up I do feel a little wealthier.
Retail
sales continue to post strong gains. All but one month in
1998 showed increases from the prior year. Although the retail
sales figure is usually very volatile and only reports on
goods and not services, it can still be a good indicator of
consumer behavior. With the consistently positive results
of 1998 it seems safe to assume that the consumer is not shying
away from new purchases.
 The
housing market is also pushing consumer spending. Low mortgage
rates, and rising incomes sent home sales to a record in 1998.
New home sales set an all-time record and home ownership is
also at a record high.
Not only does the purchase of new homes impact the economy,
but existing home sales are also important. There is a multiplier
effect that takes place with the purchase of a home as the
demand for housing related durables, like furniture and appliances,
are tied to housing market activity.
One other
interesting statistic is the first time homebuyer home affordability
index. When the index measures 100, a family earning the median
income has exactly the amount needed to purchase a median-priced
resale home, using conventional financing and a 20% down payment.
A reading greater than 100 indicates the family has more than
enough money needed to purchase the home.
As can
be seen from the following chart the last few years have been
very conducive to purchasing a home. This is of course, fueled
by low mortgage rates and solid incomes. One large factor
that is impacting the consumer is the robust stock market.
As consumers watch the values of their stock and mutual fund
holdings increase they feel wealthier and are more likely
to spend. It is hard to determine the direct impact of this
factor but there is no doubt about its dramatic impact.
The S&P
500 index started the year at just over 961 and, after a scary
drop in August and September ended the year at 1226. This
comes to a 28% gain, more than enough to provide an extra
boost to consumer confidence.
Combining
all of the indicators thus far, low unemployment, increasing
real incomes, affordable housing, and a climbing stock market
it is fairly easy to understand why confident consumers are
continuing their spending.
Indications
are that the troubled Asian economies are stabilizing. In
addition, the dollar has weakened somewhat against the yen
recently. The combination of these two factors should help
U.S. exporters by making their products more affordable in
the Asian countries
The financial
market turmoil of the summer has stabilized. Credit spreads
have narrowed since the height of the crisis when investors
were asking to be compensated for all of the perceived risks
throughout the world. Especially hard hit were high yield
(junk bond) and emerging market issuers, who were essentially
cut off from the market. These borrowers can now raise funds
again, easing the concerns of an imminent credit crunch.
With all
signs pointing towards a continuation of consumer spending
and the lessening of the Asian and financial market turmoil,
The current economic expansion seems poised to continue throughout
the coming quarter and possibly well into 1999.
What
happened to inflation?
Although the Asian crisis has been unable to derail the growth
in the U.S. economy, it seems to have helped keep inflation
in check. The excess supply of goods in Asia combined with
a strong dollar is keeping downward pressure on U.S. prices.
 Asian
companies, unable to sell their goods at home, are forced
to export and accept lower prices. The strong dollar makes
these goods even less expensive for U.S. consumers. This foreign
competition has limited the ability of domestic companies
to raise prices. As a result, manufacturing is the one sector
of the U.S. economy that was hurt last year. Consequently,
there has been an increase in excess capacity both in the
U.S. and abroad.
Another
factor keeping inflation in check is the decline in commodity
prices. Most economists agree that commodity prices cannot
continue to decline at their 1998 pace, but a rebound seems
unlikely this year given the lingering weakness of the Asian
economies. As mentioned earlier, oil prices are down considerably.
Gold prices,
another commodity used to indicate inflation, are on the same
track. All of these factors have combined to keep consumer
inflation low as evidenced by the monthly CPI numbers.
The consensus
overall inflation rate is projected to be 2.50% for 1999.
What
could go wrong?
A million things could go wrong from Saddam Hussain to the
Y2K problem. The potential impact would be to either derail
the economic expansion or set the inflation spiral in motion.
The major
threat is a slowdown in consumer spending. One possibility,
a drop in the stock market would definitely hurt consumer
confidence. The Wall Street Journal reported recently that
the largest worry of foreign central banks is the bursting
of the U.S. stock market and a resulting slowdown in the economy.
Another
of the worries for consumer activity is the decreased savings
rate. The household savings rate has been hovering around
zero for quite some time. In macro terms, consumers are living
beyond their means. The danger is that the consumer will decide
to be prudent and slow down spending. This would slow the
economy and eventually cause the Fed to lower rates to spur
activity.
Another
flair-up of international economic problems could revive financial
market fears. If serious troubles begin to affect Latin America,
the U.S. economy may not be able to escape as unscathed as
it did from the Asian problems.
On the
other hand, if growth continues at its anticipated fourth
quarter rate well into 1999, inflation will become the biggest
worry. The Fed will then have to reverse course and raise
rates in an effort to slow the economy.
The
Forecast
The recent reports showing the continued strength of the economy
have in essence shut the door on Fed rate cuts in the near
future. The Fed will also be reticent to raise rates due to
the continuation of possible foreign problems and a perceived
bubble in the stock market-high-flying Internet stocks, for
example-that might be burst by a rate hike. There is a fear
that this could initiate a boom and bust cycle that no one
wants.
We believe
that the Fed Funds rate will remain at 4.75% throughout the
first quarter and probably for most of 1999. Mr. Greenspan
will most likely utilize his congressional testimony to, in
the words of one Bloomberg columnist, "Put the fear of
tightening back into the Treasury market".
We also
feel that the two-year Treasury rate has recovered to a sustainable
level. It should remain in a 4.40% to 4.75% trading band for
the coming quarter. As usual various economic announcements
will cause gyrations to these projected yields creating good
buying opportunities.
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