U.S. Review
Approaching Stall Speed
This week's economic reports show economic activity stalling out in the first quarter. Home sales continued to weaken and factory orders fell sharply after rising solidly in the previous month. First-time claims for unemployment insurance also increased significantly and are now running at a level consistent with real GDP growth between zero and 1 percent. We continue to believe the U.S. will narrowly avoid a recession. Narrowly is the key word. Our forecast calls for real GDP to grow at just a 0.2 percent pace in the first quarter and for growth to pick up to a 0.8 pace in the second quarter. The risks are to the downside, even with this modest growth forecast.
Inventories are one key area of concern in the first quarter. The revised fourth quarter GDP data show inventories falling $10.1 billion. We know output of motor vehicles fell sharply in January, as the major manufacturers shut down assembly lines to work off excess inventories. The net result could be a much larger inventory drawdown. If that were to occur, first quarter real GDP would likely dip into negative territory.
Still No Recession But It Is A Very Close Call
January's personal income and consumer spending figures tend to support our case for a stall in economic growth and no net decline. Personal income rose 0.3 percent in January and consumer spending rose 0.4 percent. Inflation rose 0.4 percent too, however, which means that spending was unchanged after adjusting for inflation. This marks the second straight month that real personal consumption outlays were unchanged and the third time in the past four months. Spending is being constrained by higher food and energy prices, which are leaving consumers with less money to spend on other items.
The flat personal consumption numbers do not necessarily spell doom for the economy in the first quarter. If real outlays rise just 0.1 percent in February and March, spending will increase at a 0.8 percent pace in the first quarter. Such an outcome seems reasonably likely at this time.
Autos, Jobs and Housing
The cutbacks in auto production were clearly evident in February's Chicago Purchasing Managers' reports. The headline index fell seven points in February to 44.5, a level not seen since December 2001. Weakness was also present in the sub-indices as production dropped while new orders remained below the key 50 level for the second straight month. Today's report is consistent with the overall readings we have seen in other regional purchasing managers' surveys, notably the Philly and Empire reports. It appears we are likely to see another sub-50 reading in next week's national ISM manufacturing survey.
First time claims for unemployment insurance increased 19,000 the week ending February 23rd. As a result the four-week moving average, which helps take some of the volatility out of the weekly numbers, remained elevated at 360,500. Since the start of the year, the trend in initial claims has clearly been rising. While we expect non-farm employment to register a modest rebound in February, the outlook is one of a labor market that will continue to soften in the months ahead.
Mortgage applications have fallen sharply over the past two weeks, reflecting a slight up-tick in mortgage rates. Rates remain low, however, and will likely drop in light of the recent weak economic news. A recovery in housing in many depressed areas will take most of 2008 and even then the stability of construction will be accompanied by uncertainty on prices.
U.S. OutlookISM Manufacturing Index • MondayAfter posting its first sub-50 reading in eleven months, the Institute for Supply Management's manufacturing activity index rebounded to 50.7 in January from December's 48.4 reading. Now equally weighted between the five subcomponents, a surge in the production index drove the overall result in January.
Regional purchasing manager indices have fallen substantially in February and suggest we could see another sub-50 reading in the national index. The continued lift from strong export growth, however, will limit any downside change. U.S. exports growth is very strong given the weak dollar and solid global growth outside of the U.S.
Sluggish overall domestic demand is expected to weigh on factory production in the first half of the year. Supportive global economic activity, however, should help offset some of this weakness.
Previous: 50.7
Consensus: 48.5
Wachovia: 49.7
ISM Non-Manufacturing Index • WednesdayAll eyes will be squarely focused on the release of the newly calculated ISM non-manufacturing index for February. January's jaw-dropping reading of 44.6 (41.9 for the old index) surprised everyone and sparked fears of stagflation.
While we agree there appears to be moderation of business activity in the service sector, we have not found the supporting evidence from other indicators that would support a drop of this magnitude. We expect to see a moderate bounce back in headline index in February to 48.1.
Economic data so far this quarter suggest little, if any, growth in real GDP. Second quarter growth should bounce back but we will likely not see any significant change until the third quarter when checks from the fiscal stimulus package arrive in taxpayers' mailboxes. Don't expect consumers to suddenly get fiscal religion – those checks will more than likely be spent.
Previous: 44.6
Consensus: 48.0
Wachovia: 48.1
Employment Report • FridayFalling for the first time since August 2003, nonfarm payrolls declined by 17K in January as only the retail, health, education and leisure sectors added workers. For the year, payrolls rose by 1.137 million marking the slowest annual increase since 2003. The unemployment rate slipped a tenth of a percentage point to 4.9 percent.
Initial unemployment claims, one of the best leading indicators of employment, continues to trend higher. The four-week moving average has jumped to 360.5K, a level not seen since October 2005. Our model has February employment growth at +48K and the unemployment rate at 4.9 percent.
Employment growth is slowing. But firings have not increased in most industries. We expect employment growth to continue to weaken in the first half of the year which should lift the unemployment rate towards 5.5 percent.
Previous: -17K
Consensus: 40K
Wachovia: 48K
Global ReviewDollar Tumbles to All-Time LowsAs shown in the graph at the left, the euro rose to an all-time high versus the dollar this week. In addition, the U.S. dollar also fell to multi-year lows against the Australian dollar, the New Zealand dollar, and the Swiss franc. What's wrong with the greenback? Is more weakness yet to come?
Let's start with the first question. As noted above, the greenback declined broadly this week, suggesting that the root cause of the dollar's woes was something specific to the United States (see top chart on page 4). In that regard, U.S. economic data have generally been weaker than expected over the past week or so (e.g., Philly Fed, consumer confidence, and durable goods orders.) The weaker-than-expected U.S. data have increased the odds of recession, which have led investors to expect more Fed easing than they did a week or two ago. Indeed, the U.S. yield curve is currently priced for 100 basis points of additional Fed easing by summer. As U.S. interest rates have declined (e.g., the yield on the 2-year Treasury security has dropped more than 30 basis points since the middle of last week), the relative attractiveness of U.S. fixed income assets have deteriorated.
There are also some currency-specific factors at work as well. In terms of the euro, economic data in the Euro-zone generally have surprised to the upside over the past week or so. For example, the Ifo index of German business sentiment bounced up in February, which was contrary to the widespread expectation of a decline (see middle chart). In addition, the number of unemployed German workers fell more than expected in February, and anecdotal evidence suggests that retail spending in the Euro-zone strengthened in February.
In general, the overall pace of growth in the Euro-zone has slowed over the last quarter or two. However, recent data suggest that the Euro-zone economy has not fallen completely apart either. In addition, inflationary pressures in the Euro-zone have risen recently, which has the European Central Bank very nervous (see middle chart). Unless the economic outlook for the Euro-zone were to deteriorate rapidly, the ECB is likely to keep rates unchanged in the near term. As interest rate differentials between the Euro-zone and the United States have moved in the favor of the former, the euro has been given a lift.
Whither the dollar? Traders are fond of saying “the trend is your friend”, and the trend is obviously not in the greenback's favor at present. The dollars/euro exchange rate has broken through an important technical resistance level and currently is in terra incognita. The dollar could clearly continue to lose value in the near term versus most major currencies.
However, we continue to stick by our forecast that by the end of the year the dollar will be stronger versus most major currencies than it was at the beginning of the year. If, as we expect, the U.S. economy narrowly misses recession, then the Fed's easing cycle will come to an end by summer. At that point investors will start to speculate about the timing and the magnitude of the coming tightening cycle. As U.S. long-term interest rates rise, the relative attractiveness of U.S. assets will improve and the dollar should strengthen.
Global OutlookCanadian Real GDP • MondayThe Canadian economy hummed along through most of 2007, but many monthly indicators suggest that growth weakened noticeably in the fourth quarter. Indeed, the consensus forecast anticipates that the annualized growth rate slowed from 2.9 percent in the third quarter to only 1.0 percent in the fourth quarter.
The information contained in the GDP report will help to guide the Bank of Canada's policy meeting on Tuesday where another rate cut is widely expected. If the GDP data are soft enough, the Bank could conceivably cut rates by 50 basis points. A bright spot in the Canadian economy is the unemployment rate, which currently stands at 5.8 percent, the lowest rate in decades. The labor market report for February will be released on Friday. Too bad the Bank of Canada won't have the information when it makes its policy decision on Tuesday.
Previous: 2.9% (annualized)
Consensus: 1.0%
U.K. PMI's • Monday and WednesdayThe effects of previous monetary tightening, slower growth in most of the world's major economies, and fallout from credit market dislocations have led to slower growth in the U.K. economy. The purchasing managers' index for the manufacturing sector, which will be released on Monday, and the service sector, on the docket on Wednesday, will provide some clues about how the economy performed in February. Although we expect that the Bank of England will remain on hold on Thursday (see below), further slowing in growth, which we expect the PMIs to signal, should lead the Monetary Policy Committee to ease policy further in the months ahead.
Previous (Manufacturing): 50.6
Previous (Services): 52.5
Central Bank Policy Meetings • ThursdayNext week is a busy week for some of the world's major central banks. As noted above, the Bank of Canada meets on Tuesday. We look for the Bank to cut rates by 25 basis points. The focus then moves to Europe where the European Central Bank and the Bank of England meet on Thursday. In our view, there is a very low probability of a rate cut by the ECB on Thursday. Indeed, most ECB policymakers believe that the major risk facing the Euro-zone economy at present is inflation. The probability of a rate cut on Thursday by the Bank of England is a bit higher, but well below 50 percent. The Monetary Policy Committee has eased by 50 basis points since December (the most recent 25 basis point cut occurred on February 7), and recent inflation data seem make to make an aggressive pace of easing not very likely
Current ECB Policy Rate: 4.00% Wachovia Expectation: 4.00%
Current BoE Policy Rate: 5.25% Wachovia Expectation: 5.25%
Point of ViewInterest Rate WatchFed Easing Does Not Solve All the ProblemsInterest rates are the price of credit, not money. Inflation is the product of too much money. Lower interest rates can be associated with a decline in the availability of credit. Such are the lessons, learned anew, by another generation of financial engineers and masters of a smaller universe.
Interest Rates as the Price of Credit, Not MoneyFor the past five months the Federal Reserve has been lowering the funds rate, which is an administered rate set by the Fed, yet we have seen that free market rates on private sector instruments have actually risen relative to default risk-free Treasury rates. By lowering the funds rate and pursuing an innovative Term Auction Facility, the Fed has improved market liquidity as represented by declines in the TED as well as Libor/Fed funds spreads.
However, liquidity is not credit nor is it bank capital. Pricing credit is increasingly difficult in an environment when uncertainty, more than risk, is ever more present and bank capital is increasingly being hoarded. In this type of an environment, a quick return to sustained economic growth is likely to be more difficult than commonly asserted. A blip in third quarter GDP due to a fiscal stimulus package does not represent sustainable growth.
There should be little wonder that discrete changes in the federal funds rate do not generate instant economic stimulus when faced with wholesale declines in bank capital and credit downgrades as well as counterparty uncertainty. Discovering the new risk/reward equilibrium is a process not an instant revelation.
Topic of the WeekCould Subprime Tremors Shake Commercial Real Estate?The abrupt collapse of the subprime mortgage market and severe correction in home construction and home prices have raised concerns the same thing could happen to commercial real estate. While a correction is clearly underway, the underlying economics of commercial real estate are still fairly solid so we do not expect a sequel to the housing collapse.
Commercial real estate saw a more gradual build up of demand than residential. The high value of commercial properties along with rising property prices and more stringent growth management laws increased the barriers to entry into the business. Even with these barriers, plenty of liquidity still found its way into the industry, particularly through REITS and private equity firms. Most of these dollars, however, went into existing properties.
The unwinding of the real estate boom spurred slower economic growth, higher borrowing costs and tighter lending standards, which is making it much tougher to secure financing. With less demand, mortgage lenders pulled back considerably and investors have turned much more cautious shunning not only residential, but anything real estate related including commercial real estate. These factors will eventually affect commercial construction and fundamentals. While cap rates and vacancy rates have moderated, current market conditions will begin to put upward pressure on cap rates which will cut into leasing activity. More specifically, office and retail properties will feel more of the brunt due to slower employment and consumer spending.
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