U.S. Review
Still Stuck In The Mud
There were only a handful of major economic reports released this past week and none marked any significant change from recent trends. Most notably the data on the housing sector remain weak, with builder sentiment at record lows and housing starts and building permits continuing to decline. Also, inflation clearly remains problematic. Industrial production remains weak, as manufacturers remain cautious in the wake of a struggling U.S. economy.Homebuilding still has a way to go before it will find a bottom. Builder sentiment fell back to its all-time low in June, as builders reported a slight dip in buyer traffic. The lack of improvement in buyer traffic likely reflects tightening credit conditions and generally weakening economic conditions. Affordability has improved tremendously but lower prices will not turn the market around by themselves.
With buyer traffic weak and credit extremely tight, builders are cutting back. Housing starts fell 3.3 percent to 975,000 units in May and building permits declined 1.3 percent to 969,000 units.
A Rough Road Ahead Of Us
We are continuously asked when do we believe the housing market will hit bottom? There is no single answer to that question. There are several components to the housing market, including sales, new construction, prices and foreclosures. We expect sales to bottom out late this summer but do not look for any significant improvement for about a year. New home construction will likely decline right through the end of this year and should bottom out either late this year or early next year. Housing prices will likely hit bottom in the first quarter of 2009, which is also when we believe foreclosures will top out.The inflation data have received a great deal of attention recently, with some analysts suggesting that inflation presents a greater threat to the economy than the credit crisis. We do not believe the Federal Reserve will hike rates in order to combat inflation. Money growth has not been excessive in the U.S. and a quarter-point or half-point hike would do little to solve the flooding problems in the Midwest or increase petroleum production. We do believe the Fed will raise interest rates once the credit crisis subsides, but that still appears to be several months off and puts the first hike somewhere into 2009.
Industrial production came in slightly weaker than expected in May, with overall output falling 0.2 percent. Unseasonably mild weather caused utility output to slide 1.8 percent, as consumers did not have to run their air conditioners as much as they usually do. Utility output likely bounced back in June, as much of the East Coast endured a heat wave during the first part of the month. Output in the factory sector was unchanged in May, as motor vehicle output rebounded slightly and production of most other goods was flat or down slightly. May's drop in industrial production brings the year-to-year change to - 0.1 percent, marking the first negative year-to-year change since June 2003.
With industrial production stalling, capacity utilization is declining. The overall capacity utilization rate fell 0.2 percentage points in May to 77.4 and is now back to levels that in the past have been consistent with moderating industrial prices.
As weak as recent economic reports have been, the economic data remain roughly consistent with an economy growing at around a 1 percent annual rate. First time claims for unemployment insurance fell by 5,000 in the latest week to 381,000. Continuing claims staged an even larger drop falling by 76,000. In a full blown recession, weekly first-time claims would be in excess of 400,000 and continuing claims would be in an undisputed uptrend.
U.S. Outlook
Consumer Confidence • Tuesday
Since last month's report, we have continued to receive economic data that would suggest further deterioration in consumers' psyche. First and foremost, the headline shock of the jump in the unemployment rate of a half of a percentage point to 5.5 percent likely impacted consumers' perception of a struggling job market. Second, gasoline prices, on average, have broken the $4.00 per gallon measure in June and appear likely to continue to climb higher during the remainder of the summer driving season. Factor in higher prices at the grocery store, declining home prices and a struggling stock market and we have a consumer whose confidence has been shaken to the core.After registering a 15-1/2 year low on the headline confidence index in May, we expect consumer confidence will continue to drift lower in the coming months.
Previous: 57.2 Wachovia: 54.0 Consensus: 57.0
FOMC Meeting • Wednesday
Dealing with a sluggish economy and a financial market still in a fragile state, the Fed is expected to hold its federal funds target rate steady at the July 25th FOMC meeting at 2.00 percent.Rising inflation concerns, however, have started rumors that Fed tightening could begin as early as August. We feel that outcome is not likely given weak economic growth and the declining trend of many core inflation measures. While the core PCE deflator, the Fed's favored measure of inflation, remains slightly above the Fed's preferred range at 2.1 percent, core CPI has declined consistently since the start of the year. Fed officials have come out vigorously voicing their concerns of rising inflation expectations. However, unless the inflation outlook deteriorates more than the Fed expects in the coming months, we anticipate the Fed will remain on hold through the remainder of the year to give the financial markets and the economy more time to heal.
Previous: 2.00% Wachovia: 2.00% Consensus: 2.00%
Existing Home Sales • Thursday
Existing home sales have shown tentative signs of a bottoming, even in hard hit areas like Fort Myers and West Palm Beach. Foreclosure sales in Florida, California and Arizona are helping boost the overall figures but are also fueling price declines. Sales of foreclosed homes provide tough competition for other sellers, causing inventories to rise. The increase in April almost entirely erased all of the improvement eked out over the previous six months. With builder inventory declining, we expect the resale market to gradually strengthen over the next 18 months. Higher fuel costs are also helping boost demand for homes located closer to key employment centers.While we are forecasting lower sales, the sharp jump we saw in the pending home sales index could present upside risk to the May resales report.
Previous: 4.89M Wachovia: 4.75M Consensus: 5.00M
Global Review
They Said What?
BoE Governor Writes a Letter
Data released this week showed that CPI inflation in the United Kingdom rose to 3.3 percent in May (see chart at left). Not only was the outturn the highest year-over-year rate of inflation since the early 1990s, when sterling's sharp depreciation in the wake of the currency crisis cause inflation to soar, but it also led Bank of England (BoE) Governor King to write an embarrassing letter. The Bank of England Act of 1998 gave the Monetary Policy Committee (MPC) an inflation target of 2 percent. If the target is missed by more than 1 percentage point, the Governor is required to write an open letter to the Chancellor of the Exchequer explaining why the target was missed and outlining the steps the MPC will take to ensure inflation returns to target. Within hours of the CPI inflation release, Governor King had published his letter to Chancellor Darling.The Governor explained the rise by "large and, until recently, unanticipated increases in the prices of food, fuel, gas and electricity." Indeed, the core rate of CPI inflation, which excludes food and energy prices, is only 1.5 percent at present. Therefore, the Governor is arguing that factors beyond the control of the MPC have caused CPI inflation to breech the Bank's target.
That said, this is no time for complacency in the fight against inflation. Although wage growth has been stable (see top chart), the Governor acknowledged that wages could shoot up if workers seek to offset reduced purchasing power caused by recent sharp increases in food and energy prices. Wage acceleration would surely lead to an increase in core inflation. With the potential for core inflation to move above 2 percent, the probability of a rate cut is very low. If there were any lingering doubts about the MPC's resolve to refrain from cutting rates further, they were put to rest this week by much stronger-than expected retail spending data. To wit, the volume of retail sales jumped 3.5 percent in May relative to the previous month. Moreover, it's hard to fathom a rate cut right after Governor King wrote a letter to the Chancellor.
Are higher rates in store? We do not believe so, at least not over the next few months. In his letter to the Chancellor, Governor King said that an attempt to bring the overall inflation rate back to target within the next 12 months, presumably via higher interest rates, would lead to "unnecessary volatility in output and employment." The sharp rise in retail sales in May notwithstanding, the U.K. economy is showing signs of slowing. Recent declines in house prices (see middle chart) could cause consumers to retrench, and higher rates would lead to further weakness in the economy. Inflation could eventually undershoot the MPC's target if the economy were to slip into recession.
Therefore, it seems the MPC will maintain its policy rate at 5.00 percent for the foreseeable future as it monitors developments. If oil prices stabilize, even at today's high levels, the overall CPI inflation rate will eventually return to the core rate of inflation. And with the economy showing signs of slowing, core inflation should remain contained. If, however, core inflation and/or wage inflation should move higher, the MPC likely would respond with higher rates.
Global Outlook
German Ifo Index• Monday
Investors pay close attention to the Ifo index of German business sentiment because it is fairly correlated with growth in German industrial production. The bad news is that the Ifo index has been falling in recent months, and another decline is expected in June. The good news, however, is that the index remains in territory that is consistent with positive growth. The bottom line is the German economy is slowing, but it does not appear to be slipping into recession.Preliminary data on German CPI inflation in June are slated for release at the end of next week. The current rate is 3.0 percent, and the consensus forecast anticipates a rise in June to 3.3 percent, which would match the cycle high.
Previous: 103.5 Consensus: 102.5
Euro-zone PMI's • Monday
The purchasing managers indices in the Euro-zone have been trending lower over the past year or so, and the consensus forecasts anticipate further slippage in June. That said, both the manufacturing and service sector PMI's remain above the demarcation line that separates expansion from contraction. French data on consumer spending and business confidence and Italian data on industrial orders will give investors further insights into the current state of the Euro-zone economy.Data on the M3 money supply in the Euro-zone print on Thursday. Although the growth rate in the M3 money supply is expected to edge lower it probably will remain in double digits, which likely seals the case for a ECB rate hike on July 3.
Current Manufacturing PMI: 50.5 Consensus: 50.3 Current Service PMI: 50.6 Consensus: 50.5
Japanese Unemployment Rate • Friday
Japanese real GDP grew at an annualized rate of 4.0 percent in the first quarter, but April data suggest the economy will be hard pressed to repeat that performance in the second quarter. Indeed, next week's barrage of May data, which print on Friday, could suggest growth in the second quarter may be slightly negative. Data on international trade, industrial production, and retail spending will help analysts sharpen their estimates of second quarter GDP growth.Data on the unemployment rate, which has edged up to 4.0 percent from 3.6 percent last summer, will offer some insights into the state of the labor market. Investors will also look to CPI inflation data for May for any signs of rising inflationary pressures that other Asian economies are currently experiencing.
Previous: 4.0% Consensus: 4.0%
Point of View
Nantucket Notes
Next week we are off for a presentation at Wachovia's annual equity conference. Our presentation focuses on economics, of course, so what is the message? This year will continue to be a year of working through the challenges without a perfect solution to slay the debt/housing dragon.Four fundamentals suggest continued pressure on the economy and financial markets. Our expectations for growth is that consumer and investment spending will remain below-trend as both income and profit growth remain under pressure. Confidence surveys suggest consumers will remain cautious in the months ahead. Second, recent inflation indicators suggest little progress towards lower inflation back within the Fed's perceived target range. There has been little relief regarding higher energy and food prices which has kept total inflation elevated. In the near term, we expect total inflation will likely remain elevated. Moreover, several measures of short and long-term inflation expectations have edged higher which is of utmost concern to the Fed.
Growth and inflation expectations suggest that the Fed will not provide any get out of jail card for financial markets. Given these expectations, we believe the Fed will want to leave rates unchanged for the rest of the year.
Meanwhile, long-term interest rates are likely to rise due to the already cited inflation problem as well as further weakness in the dollar and rising federal financing needs. Expectations of dollar weakness suggest that investors will require a higher interest rate premium for exchange rate risk. This risk is reemphasized by the rising estimates of federal deficits. We look forward to seeing you if you are headed to Nantucket next week.
Topic of the Week
Housing Woes Will Continue
Residential construction, home sales and housing prices all continued to tumble through the first half of 2008, while mortgage delinquency rates and foreclosures continued to increase. As has been the story for some time, the bulk of the problems are in California, Florida, Arizona and Nevada. According to the Mortgage Bankers Association (MBA), these four states accounted for 89 percent of the rise in foreclosures during the first quarter of this year.Amid all this destruction, there are a few encouraging points. Home sales are showing some tentative signs of bottoming out in some of the weakest markets, including West Palm Beach, Fort Myers and Orange County, California. The National Association of Realtors Pending Home Sales Index rose 5.2 points in April and anecdotal reports suggest that gains were greatest in markets where prices have fallen the most. Construction also shows some tentative signs of finding a bottom.
While some encouraging news has surfaced, prices continue to tumble. The 10-City Composite Case-Shiller Home Price Index plunged a record 15.3 percent in the year ended March 2008. Our home sales and residential construction forecast have been lowered slightly from where they were earlier this year. The new forecast reflects tightening credit conditions, increased foreclosures, and a more sluggish economy. That said, most of the reduction in home sales and new construction is behind us. Housing will become sequentially less of drag on overall economic growth as the year progresses.
For more on our housing outlook see our Housing Chartbook - June 2008.
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