Four for the Future
This week we saw four economic indicators that helped define our economic future. First, the nation's trade deficit narrowed more than expected during June, falling to $56.8 billion. Broad-based strength in exports contributed to the gain with particular strength in capital goods ex-autos, industrial supplies and aircraft. The improvement was even greater after adjusting for inflation. In real terms, the trade gap fell $43.2 billion compared to $60 billion during 2006. On the import side, non-petroleum imports fell reflecting weakness in domestic demand.
Improvement in the trade deficit means second quarter real GDP will come in much stronger than earlier estimated. Our current forecast, which calls for a 3.0 percent rise in second quarter GDP, assumes a contribution of 3.2 percent from trade.
Retail Sales: Fading Stimulus
Second, over the last three months retail sales, ex-auto and gasoline, have slowed to a 3.5 percent pace compared to over eight percent in 2006. Consumers continue to pull back on big ticket discretionary items such as furniture and autos.
On net, retail sales suggests that 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. Moreover, there appears to be little forward momentum for consumer spending for the second half of this year (this view is reinforced by the other two indicators released this week and covered below). Our outlook is for consumer spending to decline for the second half of this year. Real household income growth remains weak. Confidence is low. Credit is limited. The consumer remains under pressure. See our related special commentary: Consumers Are Feeling Blue.
Jobless Claims: Weak Labor Market Persists
Weekly jobless claims declined just 10,000 in the latest week and the four week moving average came in at 440,000 which is much higher than is consistent with any forecast of job gains. Certainly the claims are biased upward due to the new federal extension of benefits but the extent of the rise in claims still appears excessive relative to what would be consistent with any turnaround in the job market.
We retain our outlook for continued job losses in the second half of this year. Job losses are a blow to household income growth as well as consumer sentiment. As a result, we retain our outlook for a drop in consumer spending for the second half of this year.
Consumer Prices: Temporary Peak? How Much Decline Ahead?
Recent oil price declines were seen as helping the consumer, reducing the downside risks to the overall economy and helping financial asset prices. Not so with the latest consumer price data. Inflation is clearly at problematic levels. The Consumer Price Index rose 0.8 percent in July, while headline CPI is now up 5.6 percent year-to-year. Meanwhile, core CPI, excluding food and energy items, rose 0.3 percent and is up 2.5 percent year over year. Persistent inflation is a hit to real household incomes.
Slower economic growth has not led to lower inflation as many analysts had expected. Moreover, the extent of any decline in inflation may still leave the pace of inflation above that consistent with current financial asset prices. One odd observation in the data is that food at home is now more expensive than food away from home. The price of chicken on the grill is going up faster than chicken at our favorite fast-food place. If this keeps up, it could become cheaper to go out to eat than to fix dinner at home.
U.S. Outlook
Producer Price Index • Tuesday
As much as producers would like to pass along the recent higher wholesale prices to consumers, that definitely happening remains in question. Domestic demand is weak and the outlook is even weaker. That's not your typical recipe for higher consumer prices. While upward price pressure will persist, the outlook for consumer prices will be determined greatly by the direction commodity prices head from here.
Specifically looking at July, we believe headline PPI will rise a modest 0.2 percent as seasonal factors should limit any increase with gasoline prices. Food prices, however, should continue to its upward climb. Lower motor vehicle prices, especially from SUVs, should help limit the increase in core PPI to 0.2 percent, in line with the past two months.
Previous: 1.8% Wachovia: 0.2% Consensus: 0.5%
Housing Starts • Wednesday
Recent changes to the building codes in New York City caused developers to jumpstart multi-family projects before the tougher building requirements took effect. As such, total housing starts jumped 9.1 percent to an annualized pace of 1.066 million units in June from 977K in May. Single-family starts fell 5.3 percent to an annualized rate of 647K, marking its lowest level since January 1991.
Even though it appears the decent of housing starts has slowed and may even prove to be the cycle bottom, tough underwriting standards (as evidenced by the July Senior Officer Loan Survey) and higher mortgage rates will continue to pressure the housing market for some time. We still believe it will take another year before we see a positive contribution to overall economic growth from the residential construction sector.
Previous: 1066K Wachovia: 930K Consensus: 960K
Leading Economic Indicators • Thursday
With component data reported so far, it appears the Leading Economic Indicators Index will decline for the third consecutive month in July. Negative contributions from initial unemployment claims and the S&P 500 stock index should more than offset positive contributions from the yield curve and consumer expectations as measured by the University of Michigan's consumer sentiment index.
The coincident index, which measures current economic activity, continues to remain in a tight range around levels that suggest the overall economy is just barely staying out of recession territory.
Previous: -0.1% Wachovia: -0.3% Consensus: -0.2%
Global Review
British Pound Takes A Plunge
As shown in the graph at the left, the British pound has plunged to a 2-year low. Not only has sterling weakened versus the U.S. dollar over the past two weeks, but it has lost ground against most other major currencies as well. What has taken the luster off of sterling?
In short, it is the realization that the British economy is weakening at a marked clip, which has altered expectations for Bank of England monetary policy going forward. As shown in the top chart on page 4, respective PMIs for the manufacturing, service and construction sectors have declined to multi-year lows. The first two PMIs currently stand near levels that were reached in late 2001. Although the British economy continued to expand in 2001 and 2002, the year-over-year growth rate got as low as 1.6 percent in the first quarter of 2002. Note that the U.K. economy grew 1.6 percent in the second quarter of this year relative to the same period in 2007. In our view, real GDP growth will slow even further, and perhaps turn negative, in the quarters ahead.
The construction PMI in the United Kingdom has essentially collapsed, which is consistent with the apparent weakness in the housing market. Indeed, orders for new housing are currently down about 20 percent relative to the same period last year. In addition, U.K. home prices are now declining on a year-over-year basis (see middle chart). A widely followed index of house prices remains more than three times higher than it was in the mid-1990s, but further declines in house prices, at least in the near term, seem likely. Should house prices continue to fall, U.K. consumers, some of which are highly geared, may pare back spending further. In that regard, the year-over-year growth rate in real retail sales slipped to 2.2 percent in June, the slowest rate in more than two years.
With highly geared consumers and declining house prices, the U.K. economy "looks and smells" very much like its counterpart in the United States. And, like the Federal Reserve, the Bank of England finds itself in an unenviable position. Clearly, recession is a very real possibility in Britain, which would argue for monetary easing as soon as possible. However, the Bank of England appears unwilling to cut rates, at least in the near term, because CPI inflation is well above the 2 percent rate that the Bank is mandated to achieve in "the medium term" (see bottom chart).
That said, the Bank hinted in its Quarterly Inflation report this week that rates could eventually be cut. Not only did the Bank acknowledge the balance of risks to its growth outlook are skewed to the downside, but it also projected that inflation will fall below the Bank's target in "the medium term." However, the Bank likely will refrain from cutting rates until inflation starts to unambiguously decline. In our view, the earliest the Bank could cut rates would be the end of this year.
Long-term interest rates in the United Kingdom have declined in anticipation of eventual easing. For example, the yield on the 2-year government bond has dropped about 100 basis points since mid-June, which has undermined support for the British pound. We look for sterling to depreciate further in the quarters ahead.
Global Outlook
Canadian Retail Sales • Wednesday
Consumer spending has been a primary driver of Canadian real GDP growth over the past few years. Although growth in retail spending remains positive, it has been slowing over the past few months due in part to the sharp rise in energy prices earlier this year. Solid labor market conditions have helped to support consumer spending, but the unexpected large decline in non-farm payrolls in July poses downside risks to consumer spending later this year.
Data on CPI inflation will be released on Thursday. The overall rate of inflation recently breached the top end of the Bank of Canada's 1 percent to 3 percent target range, and it is expected to rise even higher in July. However, the core CPI inflation rate, which stood at 1.5 percent in June, is expected to remain well within the target range, allowing the Bank to keep its policy rate unchanged at 3.00 percent for the foreseeable future.
Previous: 0.4% (month-over-month change) Consensus: 0.4%
Euro-zone PMIs • Thursday
Both the manufacturing and service sector PMIs in the Euro-zone slipped below "50" in the second quarter. Data released this week showed that real GDP in the Euro-zone fell at an annualized rate of 0.8 percent in the second quarter, the first quarter of contraction since area-wide GDP statistics began to be compiled in 1995. Although it probably is premature to claim that the Euro-zone has slipped into recession, growth clearly is quite weak at present. The "flash" PMI data for August will shed some light on how the Euro-zone economy is faring at present. "Hard" data on new orders in June are slated for release on Friday. Although the pace of growth is very weak at present, the ECB probably won't ease policy anytime soon due to concerns about inflation.
Previous (Man): 47.4 Consensus (Man): 47.0 Previous (Ser): 48.3 Consensus (Ser): 48.0
U.K. Retail Sales • Thursday
Consumer spending in Great Britain was quite strong earlier this year, but spending seems to have decelerated recently. Indeed, the volume of real retail sales has been broadly flat over the past few months. With unemployment starting to rise and consumer confidence plunging to the lowest level in decades, the outlook for consumer spending in the months ahead is not especially bright.
The second estimate of real GDP growth in the second quarter, which originally printed at 0.2 percent (not annualized), is slated for release on Friday. The release will be interesting because it will provide the first breakdown of second quarter GDP into its underlying demand components, which should give us some insights into the likely trajectory of U.K. GDP in the third quarter.
Previous: -3.9% (month-over-month change) Consensus: -0.2%
Point of View
Interest Rate Watch
Credit Spreads: Still Waiting for Godot
Over the last two months we have witnessed a narrowing of market expectations on the Federal funds rate through the rest of this year. In May, there were estimates for both a Fed increase and decrease in the funds rate over the second half of this year. Yet expectations for the benchmark funds rate have now settled in on no change.
But credit spreads have widened over the last two months. Whereas spreads had narrowed in the first four months of the year, the latest observations suggest that there is no direct path to a new equilibrium. Spreads on home equity, CMBS, high grade and high yield spreads have widened. Our sense is that the same below-trend economic growth that keeps the Fed on hold also suggests that downside risk remains for housing, commercial real estate and corporates. Moreover, investors appear very nervous on individual credit announcements. For example, in recent weeks we have heard about large write-downs on CDO portfolios. While issues with these portfolios were known, the reality of seeing the actual market pricing of these assets has increased investor sensitivity to risk. The Fed's Senior Loan Officer Survey suggests credit remains tight.
Our sense is that the worst of the credit crisis has passed and the peak in credit spreads occurred in March. But the workout will continue for quite some time—at least through the rest of this year. Overall economic growth remains below par. Employment declines will underline consumer weakness and thereby pressures on credit card, auto and housing. Home prices in the speculative markets continue to decline. Credit markets continue to search for the new equilibrium.
Topic of the Week
Tight Lending Conditions Will Linger
Earlier this week, the Federal Reserve released its July Senior Officer Loan Survey which showed elevated tightening continued in lending standards for all major loan components. As standards tightened, the net percentage of respondents indicating they were increasing their spreads of loan rates over the banks' cost of funds reached record levels.
Unfortunately it appears the difficult lending environment will stick around for a while, limiting potential economic growth. One of the special questions in this quarter's survey asked respondents how they expected credit standards on loans to households and businesses will change in the second half of 2008 and the first half of 2009. Senior loan officers' expectations across all loan products were clearly for continued tighter lending standards. About 55 percent of domestic banks said they expect tightening credit standards on Commercial & Industrial loans in the second half of 2008 with 45 percent expecting tightening standards in the first half of 2009. The outlook for commercial real estate loans looked worse with 72 percent and 52 percent expecting tightening lending conditions in the second half of 2008 and first half of 2009, respectively. Loans to households did not fare better with expectations for tightening lending conditions persistent in prime & nonprime mortgages, home equity lines and credit cards.
Not surprisingly, banks have become increasingly risk-adverse as they protect their precious capital positions. Given the expectations of sub-par growth in the coming quarters, it appears it is going to take another year or so before bank credit begins to become a significant factor towards overall economic growth.
Wachovia Corporation http://www.wachovia.com
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