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This past week there was not much economic data but a second tier indicator took center stage and had a significant impact on the markets. A surprisingly weak ISM non-manufacturing survey raised the decibel level for recession chatter. This and comments from Fed officials led equities to give up gains made the prior week. Economic data are pointing to a flat first quarter and Fed officials expect a sluggish first half before the economy improves. But thus far, Fed officials are forecasting that the economy will miss being in recession.
Last week stocks got back into correction mode, falling for the fifth week out of six for the year. Equities got off to a poor start on Monday as financials pulled the markets down after downgrades by analysts for American Express, Wells Fargo, and Wachovia. A slightly lower-than-expected factory orders number also nudged equities down. The big hit took place on Tuesday as the previously-believed-to-be-healthy ISM non-manufacturing business activity index dropped sharply to its lowest level since the 2001 recession. But Richmond Fed President Jeffrey Lacker rattled the markets with his comments that there could be a mild recession but that there still might not be a need to cut rates further – especially since he sees inflation risks rising. On Wednesday, Philly Fed President Charles Plosser worried the markets with his comments that the FOMC needs to be vigilant about possibly rising inflation. A report from Macy’s that its sales fell sharply in January also weighed on stocks on Wednesday. Equities ended a three-day losing streak on Thursday largely on bottom fishing by many investors. But the week ended on a negative note with most indexes down for the day – with techs being the exception for the day. Financials led equities down over fears of further losses seen as likely and due to the credit market problems. Techs were heavily supported by Amazon’s announcement of a $1 billion buyback of company stock.
Last week, major indexes were down: the Dow, down 4.4 percent; the S&P 500, down 4.6 percent; the Nasdaq, down 4.5 percent; and the Russell 2000, down 4.3 percent.
Since year end, major equity indexes down significantly. Major indexes are down as follows: the Dow, down 8.2 percent; the S&P 500, down 9.3 percent; the Nasdaq, down 13.1 percent; and the Russell 2000, down 8.8 percent.
Treasury yields were mixed this past week with the long bond yield up slightly while some shorter maturities had rates that eased slightly. While yields changed only moderately over the week, there were some notable swings during the week. Yields fell on Tuesday primarily due to the weak ISM non-manufacturing report. The 2-year and 5-year note yields were particularly soft, falling 13 basis points each for the day, indicating that the markets were expecting the Fed to be lowering the fed funds rate in the near term. Rates jumped on Thursday after an afternoon auction for 30-year Treasuries showed disappointing demand. Comments by Dallas Fed President Richard Fisher warning about inflation risks also weighed on long bond prices. Treasury rates fell on Friday, however, both on recession concerns and over fears of climbing default risks in private debt. Overall, long yields were up slightly for the week, primarily over heightened inflation worries. Shorter maturities yields were lower (except for the 3-month bill) due to flight to safety and over weak economic data.
Treasury yields were mixed in direction last week follows: 3-month T-bill, up 14 basis points, the 2-year note; down 14 basis points; the 5-year note, down 7 basis points; the 10-year bond, up 5 basis points; and the 30-year bond, up 11 basis points.
In recent weeks, the 3-month T-bill has headed lower on expectations of further rate cuts by the Fed. But inflation fears are nudging up yields on both the 10-year and 30-year T-bonds.
Oil prices netted the week up on supply issues and despite concern over a softer U.S. economy. Violence in Nigeria and Turkish military action in Kurdish northern Iraq bumped up the spot price for West Texas Intermediate at the start of last week. But on Tuesday and Wednesday, recession fears were the focus. Tuesday’s sharp decline in the ISM non-manufacturing index weighed on oil prices as did Wednesday’s unexpected surge in oil inventories. Progress on the fiscal stimulus package nudged prices back up on Thursday. But most of the week’s gain was on the last day of the week with a $3.66 per barrel surge for the day to $91.77 per barrel. Behind the price jump were a reduction in exports from Nigeria, lowered projections for output from the North Sea in March, and fears that OPEC will be cutting production at its upcoming March 5 meeting.
The spot price for West Texas Intermediate rose $2.81 per barrel net for the week to settle at $91.77 per barrel, $7.85 below the record high of $99.62 set January 2nd.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
This past week the markets were rattled not only by Fedspeak but by an indicator that usually does not get much attention – the ISM non-manufacturing index.
Markets fear that weakness in the economy is spreading. Housing has been in recession for some time and manufacturing has shown signs of turning negative. What was supposed to keep the economy out of recession was the service sector. But last week’s non-manufacturing ISM cast doubt on strength in this sector as well. While the ISM non-manufacturing survey does cover more than just services, the sector still makes up the great bulk of the survey and in January both services and construction industries declined. The ISM's non-manufacturing business activity index plunged to 41.9 in January from 54.4 in December. This is the most extreme move on record and the lowest reading since the 2001 recession.
Weakness was widespread within the report with the notable exception of exports. New orders plunged to 43.5 in January from 53.9 the month before -- again the lowest reading since the recession. Backlogs fell 3 points to 46.0 in more bad news. Employment also fell through the floor, down nearly 8 points to 43.9, the lowest reading since the very beginning of the expansion and one certain to deepen concern over the jobs market. Export orders however are still above water, up 2 points to 52.0 and reflecting strong global demand and the competitive advantage of a weak currency.
By industry, weakness was broad-based. Of 17 industry categories, only three were positive. And inflation pressures are still a problem. Prices remained elevated at 70.7 compared to 71.5 in December.
While one month does not make a trend, the January non-manufacturing index suggests that the economy shrank during the month of January.
Factory orders jumped 2.3 percent in December, following a 1.7 percent gain the prior month. For the latest month, strength was in durables which posted a 5.0 percent surge while nondurables orders declined 0.4 percent.
The latest numbers suggest that some strength remains in manufacturing. However, with signs of slowing in the economy, one will need to watch to see if cancellations pick up.
Productivity and labor costs in the fourth quarter came off the very good third quarter results. However, the numbers do not represent a worsening in inflation pressures but merely quarterly volatility in output and hours worked. Fourth quarter productivity decelerated to an annualized 1.8 percent increase, following a 6.0 percent surge in the third quarter. Unit labor costs rebounded 2.1 percent annualized in the fourth quarter, following a 1.9 percent decline in the third quarter.
While the fourth quarter numbers largely reflect a sharp deceleration in output (lowering productivity and raising unit labor costs), there is one notable change in the data that points to further slowing in the economy. Hours worked slipped an annualized 0.5 percent in the final quarter of 2007, following a 0.7 percent dip the prior quarter. Businesses are trimming work hours in the face of slowing demand and this could lead to further economic weakness.
Year-on-year, productivity was up 2.6 percent in the fourth quarter, unchanged from the previous quarter. Year-on-year, unit labor costs in the fourth quarter came in at up 1.0 percent, down from up 3.0 percent in the third quarter. The slowing mainly reflected the quarterly declines in the second and third quarters of 2007. Year-on-year, compensation in the fourth quarter was up 3.7 percent, compared to up 5.7 percent in the third quarter.
We had quite a number of Fed officials on the speaking circuit last week and there was some divergence about the direction of policy. However, they all seemed to agree that recent problems in the financial markets are going to take some time to correct. And that the first half of the year is going to be very weak.
Richmond Federal Reserve Bank President Jeffrey Lacker continued to argue last week that even though the economy might be headed for a mild recession that inflation concerns suggest that no further rate cuts are appropriate. "As I said, my sense is that the most likely path is sluggish growth in the near term. But I can also see the possibility of a mild recession, similar to the last two we have experienced -- in other words, shallow and with a slow recovery. What I don't expect is a more severe recession, like those we saw in 1982 or 1974. Keep in mind that monetary policy has moved aggressively in recent months, and that inflation-adjusted interest rates are now very low by historical standards."
"In my view, the prominence of downside risks means that further easing ultimately may be warranted. My expectation that growth is likely to be sluggish this year figured prominently in my thinking about policy last month, however, so if incoming data is not weaker than expected over the next several months, it's not clear further rate cuts would be warranted." So, implicitly according to Lacker’s view, unless growth is unexpectedly weak, a mild recession might be OK to get inflation down.
Philadelphia Fed President Charles Plosser views also were somewhat hawkish. Plosser's comments hinted that he does not necessarily expect the Fed to cut rates further. First, he remains concerned about inflation pressures. "With inflation creeping up, we have to be particularly alert for rising inflation expectations. It is important that inflation expectations remain stable. If those expectations become unhinged, they could rapidly fuel inflation." He notes that the real fed funds rate is low -- near zero. "Taking expected inflation into account, the level of the federal funds rate in real terms -- what economists call the real rate of interest -- is now approaching zero.” He indicates that the next policy move will depend on incoming data, implying that no decision has yet been made to cut further.
Dallas Fed President Richard Fisher’s remarks this past week indicated that the Fed has a tough balancing act in determining the appropriate amount of easing in interest rates without refueling inflation. At the last FOMC meeting, Fisher dissented against the majority vote for a 50 basis point cut in the fed funds target rate. On recent policy, the Dallas Fed president came very close to blaming the Fed itself for current problems in the credit markets. "For the past few years, we have had a raucous party of economic growth fueled by an intoxicating brew of credit market practices that financed a housing boom of historic, and late in the cycle, hysteric proportions. With the benefit of perfect hindsight, some have argued that the Fed failed to take away the punchbowl as the subprime party spun out of control, leaving rates too low for too long and not using our regulatory powers to restrain excessive complacency in the pricing and monitoring of risk." These comments imply that he is currently worried about spiking the punchbowl too much.
Federal Reserve Bank of Atlanta President Dennis Lockhart gave a middle of the road view on policy and the economic outlook. His comments on policy were brief and general in scope. He said that recent interest rate cuts were taken "to avert a deep and protracted economic downturn." Lockhart's forecast calls for "weakness in the first half of 2008 followed by improvement in the second half, with inflation moderating from recent levels." But he did describe current inflation as "elevated and above my comfort zone."
San Francisco Federal Reserve Bank President Janet Yellen probably gave the most pessimistic view of the economy of Fed speakers last week. Though she believes economic growth will be very weak during the first half of the year -- the economy will avoid recession. While inflation is currently on the high side, she sees inflation easing to the 1-3/4 percent vicinity over the next few years. Yellen hinted more loudly than others that additional easing is needed. "However, economic prospects are unusually uncertain. And downside risks to economic growth remain. This implies that, going forward, the Committee must carefully monitor and assess the effects of ongoing financial and economic developments on the outlook and be prepared to act in a timely manner to address developments that alter the forecast or the risks to it."
From this past week’s round of Fedspeak, there is a consensus that the first half of 2008 is going to be very weak with at least one Fed official acknowledging the possibility of a mild recession. All indicate that they expect improvement during the second half of the year. While there is a range of leanings on likely rate cuts, all are still evaluating incoming data. All also seem to believe that correcting problems in the credit markets is going to take some time.
The economy indeed appears to be settling into a weak first half as many Fed officials have been forecasting for a few months. But it is not clear that Fed officials see the economy as weaker than they anticipated since the last FOMC meeting. Currently, the key to whether the economy is slowing too much is the strength of the labor market.
This coming week three key market moving indicators are released. Retail sales will give us an important reading on the consumer sector while the Federal Reserve Board’s industrial production report will provide an update on manufacturing. The international trade report will give us an indication as to whether exports are continuing to support manufacturing and the overall economy.
The U.S. Treasury monthly budget showed a slightly lower than expected surplus of $48.3 billion in December, up from a $42.0 billion surplus in the year-ago month but not enough to keep the fiscal year to date deficit from widening, now 31 percent deeper than a year ago. Special factors gave a boost to November's surplus as a corporate tax date increased receipts and a transfer payment date held down payments at the expense of November. The month of January typically shows a moderate surplus for the month. Over the past 10 years, the average surplus for the month of January has been $35.5 billion.
Treasury Statement Consensus Forecast for January 07: $21.0 billion surplus
Range: $15.0 billion surplus to $40.0 billion surplus.
Retail sales slowed sharply in December, following a strong holiday season start in November. Much of the weakness was in gasoline sales. Retail sales fell 0.4 percent, following a strong 1.0 percent gain in November. Excluding motor vehicles, sales also declined 0.4 percent, after a 1.7 percent jump in November. While many saw the December decline in sales as a sign of recession, that is a suspect conclusion given that the December dip came off such a strong November. The January numbers will give a better perspective on consumer health. The Fed will be watching to see if spending is slowing rather than outright declining.
Retail sales Consensus Forecast for January 07: -0.3 percent
Range: -0.9 to +0.3 percent
Retail sales excluding motor vehicles Consensus Forecast for January 07: +0.2 percent
Range: -0.5 to +0.5 percent
Business inventories rose 0.4 percent in November, well below a 1.6 percent rise in sales to drive the stock-to-sales ratio down 2 tenths to a record lean 1.24. Businesses in all sectors have been trying to keep a careful watch on inventories, making sure too much overhang does not develop. But a rise in inventories would spell trouble for businesses, indicating a slowing in demand. And the partial numbers for December indicate that may be happening. Wholesale inventories jumped 1.1 percent in December. Also factory inventories rose 0.8 percent in December.
Business inventories Consensus Forecast for December 07: +0.4 percent
Range: +0.2 to +0.7 percent
The U.S. international trade gap worsened in November to $63.1 billion from a $57.8 billion shortfall in October. The deterioration in the gap was due to an acceleration in import growth while exports gains slowed. Both petroleum and nonpetroleum imports jumped in the latest month. On the export side, the softening was mainly due to a drop in aircraft shipments. We are likely to see a reversal of both in the December data.
International trade balance Consensus Forecast for December 07: -$61.6 billion
Range: -$65.5 billion to -$59.1 billion
Initial jobless claims eased back 22,000 to a 356,000 level for the week ending February 2 after spiking 72,000 the week before. Though the latest decline is a big improvement from the shocking 378,000 level of the prior week, the current level is way above the 300,000 mark claims sank to at mid January. The initial claims series is a good leading indicator for the economy and markets will be watching to see whether the economy is merely slowing or turning negative.
Jobless Claims Consensus Forecast for 2/9/08: 343,000
Range: 330,000 to 392,000
The Empire State manufacturing index slowed to a reading of 9.0 in January from 9.8 the prior month. While January remained in positive territory, the new orders index suggests that the overall index may be weakening in coming months. The new orders index fell to 0.0 from 13.2 in December. Meanwhile, price news has not been favorable. Input costs rose to 40.2 in January from 35.0 in December while output prices increased to 18.3 versus 12.5 the prior month.
Empire State Manufacturing Survey Consensus Forecast for February 07: 5.75
Range: 2.87 to 11.00
Import prices were steady at no change in December but following a strong 3.3 percent jump in November. December’s softness was in petroleum prices which dipped 0.6 percent while nonpetroleum prices increased 0.3 percent. With oil prices coming off recent historical highs, we may see a similar pattern in January. The weaker dollar is keeping upward pressure on nonpetroleum prices as is strong demand overseas for commodities.
Import prices Consensus Forecast for January 07: +0.5 percent
Range: 0.0 to +0.9 percent
Industrial production was flat in December, following a 0.3 percent gain the prior month. The manufacturing sector is giving very mixed signals. Durables orders spiked in December but a number of manufacturing surveys have been less optimistic. The ISM manufacturing index has been stuck right at the break-even level for the last six months. The employment situation report suggests a soft January for manufacturing output -- aggregate hours in manufacturing were unchanged in January, following a 0.6 percent drop the month before.
Industrial production Consensus Forecast for January: +0.1 percent
Range: -0.1 to +0.5 percent
Capacity utilization Consensus Forecast for January 07: 81.4 percent
Range: 81.2 to 81.6 percent
The Reuters/University of Michigan's consumer sentiment index edged up in January to 78.4 from 75.5 in December. Consumer spirits have been holding up decently given the trouble in the jobs market, not to mention the depressed housing market and volatility in the financial markets. But further deterioration in equities and a rise in unemployment could be undermining confidence. However, inflation expectations held steady in January with the 12-month reading unchanged at 3.4 percent.
Consumer sentiment index Consensus Forecast for preliminary February 07: 77.0
Range: 70.0 to 80.6
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