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ALM
First Financial Advisors
Economic Overview
Fourth Quarter 1999
TOPICS
COVERED
Introduction
As I start to write this overview I, as anyone else would
do, think about the task at hand. It is indeed, a difficult
task. I think of the probabilities of being wrong on this
or that and then I think of the comments that will surely
come from clients that are now my friends.
So, to
analyze this difficult task consider the significant events
that have already occurred in this 10-day old year/decade/century/millennium
(I know…it is really not the new millennium but everyone
else is making this mistake so I will graciously use it for
affect).
- Y2-Chaos
proved to be a gigantic exaggeration.
- The
equities markets sold off tremendously only to rebound sharply.
- Chairman
Greenspan was reappointed to another four-year term.
Y2K:
Leading into the turn-of-the-century a number of Y2K related
theories were whipsawing the bond market. First was the hoarding
of cash balances by financial institutions to fund deposit
withdrawals. This is really what is affecting the market today.
Most participants have witnessed the Federal Reserve Bank's
balance sheet expand significantly in the 4th Quarter. The
Fed will need to extract some of this balance sheet growth
in the coming months.
The second
theory was the expected GDP strength for the second half of
1999 that was generated by inventory build-up, technology
expenditures and the consumer investment into staples to survive
the loss of utilities.
Of course
never a light flickered except in those few instances where
some daredevil squirrel tried to disprove the laws of physics,
chemistry and electricity with one misplaced paw.
Bond market
participants were suddenly confronted with the fact that nothing
happened after Y2K. So, how best to analyze the long-term
effects of Y2K preparation? The answer is unknown and causes
a degree of uncertainty that is priced into market interest
rates.
Equity
Market Action: The first several days witnessed a tremendous
sell off in stocks, particularly technology stocks. The Nasdaq
shed over 100 points in a day (which is a tremendous amount)
and was looking for more. Indeed, Barron's first issue
of the New Year spoke confidently that a major correction
was now under way. Of course, the first trading day after
Barron's hit the newsstand saw stocks rebound sharply.
Now, why is this important for us bond market participants?
The theory is, which in this case is reality, when stocks
sell off stock buyers need to put their money somewhere so,
they look at the bond market. All of this activity certainly
affects market interest rates.
Reappointment
of the Chairman: Alan Greenspan's term was not due to
expire until the end of June. So, why would Clinton reappoint
him now? Most Presidents wait until the bitter end so they
can exert whatever pressure, small or large, they can over
the Central Bank. However, everyone agrees that for Clinton
to salvage what small amount of good reputation he has left
he needs to have Al Gore elected to the White House.
In the
current environment Chairman Greenspan has a reputation that
is almost beyond reproach with the financial markets. Uncertainty
over his reappointment introduces uncertainty to the capital
markets, which increase risk premiums in required rates of
return. This could cause economic problems right about the
time the meat of the 2000 election cycle is underway. So,
why not take the uncertainty out now? Apparently that question
was answered by the White House …or by the Gore 2000
Campaign.
Given
the events of this young 2000, lets review what has happened
in these few short days in the bond market.
- The
6-month consensus forecast for market interest rates by
the blue-chip economist group was busted on the first day
of trading.
- The
Two-Year Note yield has moved from 6.04% at the end of the
year to 6.46% today. That is a 7% move of its total yield
value in 10 calendar days.
So, where
do yields go from here? We think not much higher. The market
has already built in at least a couple of tightenings. The
next FOMC meeting is scheduled for February 1st and 2nd. Most
are expecting a 25 basis point move. I think that there is
a distinct probability of a 50 basis point move by the Fed.
If this were to occur I think that this would calm things
down a bit.
To get
a better feel for what the FOMC will be looking at, let's
review the economic indicators from the 4th Quarter.
4th
Quarter 1999
The Two-year Treasury note yield continued its strong move
up as the FOMC hiked the Federal Funds target by another 25
basis points on November 16th. This made the total move by
the FOMC for 1999 75-basis points.
Economic
strength was very evident throughout the quarter as the 3rd
Quarter GDP registered a whopping 5.7% annualized growth.
This momentum coupled with a fairly strong Christmas season
should bring in 4th Quarter GDP somewhere around 5.5%. Both
of these results are well outside the Fed's target range for
non-inflationary growth. In fact most economists speculate
the Fed would have certainly tightened at the December meeting
had it not been for the perceived Y2K problem.
Gold
and Oil Prices
After an explosive six months of sharply higher gold and oil
prices, things have stabilized for now. After a decade of
falling prices and record low levels, gold made a quick move
from the mid $200's per ounce to almost $300 per ounce. This
is significant because on an absolute price level it represents
a 20% move. It is important to many participants because gold
holds a place as an indicator of future inflation.
Along
this same line of thinking, the story on the price of oil
is even more alarming. Over a period of about 12 months the
price of a barrel of oil has doubled in price. Indeed, the
price of a barrel of oil has moved from a low of $11 per barrel
in November '98 to almost $26 per barrel today. But like gold,
the price action of oil has moderated and has settled into
a price range.
Consumers
Everyone is familiar with how the consumer drives the U.S.
economy and consumer spending requires a high level of consumer
confidence. By this standard alone the economy looks as if
it will continue its blistering pace for some time.
After
some natural peaks and valleys in the already high Consumer
Confidence Index hit its highest level of 141 in December
of 1999. With such high levels of consumer confidence an analyst
would expect to see spending remain strong.
Indeed,
you don't have to look very far to see increase in retails
sales, car sales and the increase in consumer credit.
A moderating
factor that should help contain the economic ebullience is
mortgage rates which have had a depressing effect on existing
home sales. These types of home sales hit a high of 5.6 million
units in the summer of 1999 and have fallen in lock step with
the increase in mortgage rates for the remainder of the year
to 5 million units in November.
Employment
and Wages
If the current members of FOMC were allowed to focus on only
one set of data, outside the actual inflation numbers, it
would be job growth data and the unemployment rate. The job
growth engine of the U.S. economy has been running at full
bore for many quarters. In fact, last month's new non-farm
jobs grew by another 315,000. The average per month number
for 1999 was 224,000 new jobs or 2.7 million new jobs on an
annualized basis.
The unemployment rate, which has really taken the driver seat
in market perception, was 14,000 unemployed people away from
setting a new low of 4% this past month.
Inflation
As mentioned above, the most important aspect of fixed-income
investing is the measurement of inflation. The three most
widely watched indicators of inflation are the consumer price
index (CPI), the produce price index (PPI) and the quarterly
employment cost index (ECI).
The inflation
story is what has some throwing away their Economics 101 texts.
In light of the fantastic economic growth of the U.S. economy
throughout the 1990's, old school economics suggests that
inflation should have reared its ugly head by now. But alas,
it has been conspicuously absent from our base inflation indicators.
CPI, after
showing a worrisome jump upwards has regained its negative
trend.
The exact
same story could be said for the employment cost index.
On the wholesale level, PPI never even wavered from its disinflation
profile.
The
Forecast
In summary, the economy has continued its steamy story that
has been experienced for most of the 1990's. If anything,
it has picked up some energy. So, based on the economic fundamentals
along with the non-event of Y2K we expect to see the Fed raise
the Fed Funds target by 75 basis points during 2000. Indeed,
I think it is very possible that the February meeting will
see a 50-basis point move.
 There
are, of course, a couple of things that could derail things.
First and foremost would be a stock market correction. As
mentioned above the equity market has been volatile of late.
Volatility does add a negative component to the market and
could signal the end of the upward trend. A significant retrenchment
of equity prices would certainly be felt on Main Street much
more today than it did in 1987.
On a longer-term
perspective another event that could alter the market rate
landscape is the continued exit of the largest borrower in
the history of mankind, the United States Government, from
the capital markets. This event takes away the great absorber
of capital and makes the competition for investments that
much more intense for the marginal investment dollar.
Outside the stock market correction event, our forecast for
the Two-Year note yield for the 1st Quarter of 2000 calls
for a high of 6.75% to a low of 6.25%
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