Summertime is known for dramatic and often violent swings in the weather. A perfect morning is often followed by a muggy afternoon and then ferocious thunderstorms. The same thing often happens in the financial markets, with trading thinned out by vacations and volatility driven by rumors and aggressive chatter from analysts and commentators.
While it would be an overstatement to say the economic news took a backseat to policymakers this week, the economic news played a supporting role at best. The week began with news of a plan to safeguard the viability and liquidity positions of Fannie Mae and Freddie Mac. Later a ban on naked short selling of stocks of primary dealers and the GSEs was enacted.
As luck would have it, Fed Chairman Ben Bernanke was already slated to speak before both houses of Congress to deliver the Fed's semi-annual economic update. Treasury Secretary Paulson visited Congress to brief them on the Treasury's Fannie Mae and Freddie Mac rescue package. Even the president got into the action, with a press conference on the economy.
So Much News in so Little Time Makes for a Volatile Week
After plunging earlier in the week, stocks bounced back in the middle of the week, helped out by a sharp pullback in oil prices. Oil closed below $130 a barrel on Thursday, down from its recent high of $145.25, hit 14 days ago. The drop likely reflects increases in U.S. oil and gas inventories, increased chatter about curbing some types of futures trading, removal of the executive order prohibiting offshore drilling, milder weather, and even a hint of some thawing in relations with Iran. Wow, you might want to read that sentence a couple of times!
The break in oil prices below $130 a barrel is significant and if prices stay below that level or move even lower, that should reduce some of the downside risks to the overall economy. Oil prices above $130 a barrel and gasoline above $4 a gallon appear to be just about the breaking point for the U.S. economy. Airlines are scaling back their flight schedules and households are reducing their everyday travel and scaling back vacation plans. The latest break in oil prices has sent oil and wholesale gasoline prices down 10.6 percent and 10.9 percent, respectively, over the past two weeks.
Declines in energy prices are coming just in time. With the economic stimulus coming to an end this month, some break in gasoline prices will be necessary for the economy to avoid a recession during the second half of the year.
Recent economic reports show the economy operating at a pace that is still at least modestly in positive territory. Retail sales rose 0.1 percent in June and sales excluding the volatile motor vehicles sector rose 0.8 percent. Despite the headline gains, sales were generally weaker than expected. Spending at gasoline stations surged 4.6 percent in June, reflecting the huge run-up in prices. After subtracting spending at gasoline stations, retail sales declined 0.5 percent in June. Nearly all the decline was at stores that sell big-ticket discretionary items, like furniture, electronics, and household appliances. Spending at grocery stores also increased in June, climbing 0.6 percent. The spike in food and energy costs means that much of the economic stimulus was either siphoned away at the gas pump or eaten up at the grocery store.
Inflation is clearly at problematic levels. The Consumer Price Index rose 0.7 percent in June and prices excluding food and energy items rose 0.3 percent. The headline CPI is now up 5.0 percent year-to-year and the core CPI has increased 2.4 percent. Inflation is even more problematic at the wholesale level, where energy and import prices play a much larger role. The overall PPI is now up a whopping 9.2 percent and the core is up 3.0 percent.
U.S. Outlook
Leading Economic Indicators • Monday
Barely staying out of recessionary territory, the Leading Economic Indicators index (LEI) continues to suggest that economic prospects remain dim as the economy tries to work out the serious credit and housing market issues.
After posting 0.1 percent increases in April and May, the LEI is expected to record a modest -0.1 percent decline in June. The largest negative contributors should be stock prices, initial claims and the real money supply. The yield curve and vendor deliveries appear to be the only positive contributors to the total index.
Previous: 0.1% Wachovia: -0.1% Consensus: -0.1%
Durable Goods Orders • Friday
Following a downwardly revised -1.0 percent decline, durable goods orders remained unchanged in May as solid contributions from transportation equipment, computers & electronic products and electrical equipment offset declines in machinery and primary metals orders. On a year-over-year basis, durable goods orders have now posted declines over the past three months.
On a monthly basis, durable goods orders are volatile making forecasting this series very tricky. The consensus sees a small contraction while our model is suggesting a modest increase in June. Orders for the volatile domestic aircraft sector slipped again last month and should apply some downward pressure. Offsetting some of this weakness, however, should include a modest gain in vehicle production. While machinery orders should bounce back, tech orders probably declined after increasing in May.
Previous: 0.0% Wachovia: 0.5% Consensus: -0.2%
New Home Sales • Friday
New home sales have been declining for the past two and a half years, but the slide is beginning to show signs of moderating and may bottom out in the next few months. The new home market has worked off far more excess inventory (though there is still a long way to go) than the existing home market, as builders have been more willing to cut prices to the new equilibrium levels. If inventories continue to decline at the same pace as they have over the past year, the total number of new homes available for sale would return to its relatively low late 1990s level in about 18 months. Significant levels of nearly-new inventory still exist in the resale market, however.
In concert with the dismal homebuilder sentiment, we expect new home sales to decline 6.3 percent in June.
Previous: 512K Wachovia: 480K Consensus: 505K
Global Review
China Slows Somewhat in Q2
As shown in the graph at the left, the year-over-year rate of real GDP growth in China edged down from 10.6 percent in the first quarter to 10.1 percent in the second quarter. Although the outturn represents the slowest rate of growth in three years, it also marked the tenth quarter in which GDP growth has exceeded 10 percent.
So why did growth slow? China does not release a breakdown of real GDP growth into its underlying demand components, but monthly data offer some clues. As shown in the top chart on page 4, export growth has slowed recently while import growth has picked up. Yes, some of the pick-up in import growth reflects higher oil prices. However, data on real trade flows show that growth in the volume of exports has slowed somewhat recently. Slower growth in China's exports is consistent with slower economic growth in the rest of the world. Indeed, the value of exports to the United States, China's largest trading partner, rose 14 percent in 2007. In the first six months of 2008 they were up only 9 percent relative to the same period last year.
Outside of exports, most components of spending appear to be holding up well, which explains why overall GDP growth slowed only slightly in the second quarter. Monthly data on retail sales and consumer prices suggest that growth in real consumer spending may have strengthened in the second quarter, and fixed investment spending also appears to have remained very strong. Although China does not publish data on inventories, inventories may have declined in the second quarter due to the massive earthquake that destroyed production facilities in Sichuan province.
We expect Chinese real GDP growth will trend lower over the quarters ahead. Although rebuilding in the earthquake-devastated areas will be growth supportive, deceleration in exports will work in the opposite direction. In addition, the government recently reduced consumer subsidies on gasoline. As gasoline prices rise, growth in real consumer spending on non-petroleum products should cool off a bit. In our view, real GDP will grow in the 8 to 9 percent range next year - hardly a catastrophe.
As shown in the middle chart, the rate of CPI inflation fell to 7.1 percent in June as food prices retreated. If food prices stabilize or if they decline further, then the overall CPI inflation rate will fall back to the non-food inflation rate, which is much more benign, in the months ahead. Our forecast calls for the overall CPI inflation rate in China to fall back into the 3 to 4 percent range by the middle of next year.
Rising inflation earlier this year prompted the government to speed up the rate of renminbi appreciation (see bottom chart). Indeed, the renminbi strengthened vis-à-vis the dollar at an annualized rate of 13 percent in the first half of the year. Looking forward, however, we believe the rate of appreciation will slow in the second half of the year because the fundamentals are starting to change. Not only is economic growth slowing somewhat but CPI inflation is starting to decline. Therefore, the government does not have the same incentive to allow rapid currency appreciation as it did earlier this year.
Global Outlook
Canadian CPI Inflation • Wednesday
The overall rate of CPI inflation in Canada has remained very well behaved this year, unlike the experience of most other countries. If, however, the consensus forecast for June is realized, then Canada will start to catch up to its trading partners. Although the overall rate of CPI inflation could very well breach the top end of the Bank of Canada's 1 percent to 3 percent target range over the next few months, the core rate of inflation should remain within the range, which should keep the Bank of Canada on hold for the foreseeable future.
Retail sales data for May will be released on Tuesday. Consumer spending continues to grow, albeit at a slower rate than early this year. With the labor market remaining generally solid, growth in consumer spending should remain positive.
Previous: 2.2% (year-over-year) Consensus: 2.9%
German Ifo Index • Thursday
The Ifo index of German business sentiment is widely followed by investors because it has a high degree of correlation with German industrial production growth. If, as is expected, the index falls again in July, then IP growth probably slowed further this month. Although the German economy is not likely to slip into recession this year, real GDP growth likely will fall well below 2 percent.
Investors will also be interested in the Euro-zone manufacturing and service sector PMIs for July, which also print on Thursday. Both indices have slipped below "50" recently. Although the readings on the PMIs are not yet at recession-like levels, the indices are consistent with slow growth.
Previous: 101.3 Consensus: 100.0
U.K. Real GDP • Friday
Like the U.S. economy, growth in the United Kingdom has slowed over the past year. In many respects, the British economy looks and smells like the U.S. economy. Home prices in many parts of Great Britain rose significantly between 1997 and 2007, and some consumers are stretched financially. Although consumer spending has held up well over the past few months, which probably guarantees a positive GDP outturn in the second quarter, the recent weakening of the labor market suggests that growth in consumer spending probably will slow in the quarters ahead.
Some analysts believe the United Kingdom will slip into recession this year. Although we do not have a bona fide recession in our forecast, we project growth this year will be the slowest since 1992 when the U.K. economy was last in recession.
Previous: 0.3% (not annualized) Consensus: 0.2%
Point of View
Interest Rate Watch
Short-term Rates: Uncertainty Dictates Little Change
Short-term rates remain range-bound as the Federal Reserve balances the dual challenge of below-trend economic growth and above-target inflation. The domestic private economy is in recession as weak growth in real disposable income for consumers and lowered profits for non-financial companies dictate a lack of spending power. Meanwhile, inflation continues to exceed the top end of the Fed's perceived preference range for inflation. Add to all that the uncertainty of credit quality and you have a prescription for unchanged rates at the short end.
Long-Term Rates: Risk Dictates a Bigger Range of Outcomes
However, at the long end of the curve, rates are expected to drift upward as concerns on three fronts - inflation, the dollar, and greater Treasury financing needs - are likely to push benchmark Treasury rates above four percent in the months ahead. Inflation expectations have already moved upward while estimates of Treasury financing needs have likewise risen.
Credit Spreads: In Search of Normality
Credit spreads are not expected to narrow much more as event risk remains a concern for investors. Capital markets continue to search for a new risk/reward tradeoff. At present, the trend in the TED spread (three month futures contract for U.S. Treasuries less the three month Eurodollar futures contract) suggests the new equilibrium spread will remain higher than where it had been during the 2004-2006 period. Risk is being priced back into the fixed income market, but the market is still determining what the new normal equilibrium price will be.
Topic of the Week
Post-Olympic Slowdown in China?
The world is currently focused on China as it races to complete preparations for the 2008 Olympics. There has been speculation that once the Olympics are over the slowdown in infrastructure spending and other investments may cause growth to slow within the Chinese economy. While it is true that economic growth in China is expected to trend lower, concerns about the role of the Olympics are likely misplaced.
The majority of Olympic-related investment has been in Beijing, so any economic softening attributed to a post-Olympic slowdown in spending would be felt most there. However, Beijing only constitutes 3.7 percent of the Chinese economy. Any slowdown in the capital city would not have a significant effect on the overall Chinese economy.
There was similar concern about the 2004 Olympics held in Greece. Approximately 12 billion USD was invested to host the Olympics, and there were fears that the absence of that spending in the period following the Olympics, would hurt the Greek economy. In fact, after spending over 5 percent of its GDP on the Olympics, Greece still experienced over 3 percent percent GDP growth in each of the next two years.
China will invest at least 42 billion to host the Olympics, making this the most expensive Olympics in history. Yet, this investment is still only 1.3 percent of China's GDP and the majority of it is comprised of much needed improvements to infrastructure in Beijing. There may well be slowing in Chinese economic growth, but it will be driven by factors such as the global slowdown, high oil prices and declining exports, rather than a post-Olympics hangover.
Wachovia Corporation http://www.wachovia.com
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