Last week we saw new signs of recession with the highlight – or lowlight – being the February jobs report which included an unexpected drop in payroll employment. Stocks continued to fall under the weight of recession fears and under continuing revelations of further likely losses in the financial sector due to subprime problems.

Recap of US Markets

STOCKS

Equities were under heavy downward pressure last week due to more signs of recession and more subprime losses by financials. Stocks were mixed on Monday as investors soaked in news of record oil prices and a soft ISM manufacturing report. Financials tugged downward on equities on Tuesday as analysts cut earnings forecasts for Citigroup and indicated that the company would need additional injections of investment to offset growing losses. Markets were a little unsettled by Fed Chairman Bernanke’s remarks that the subprime problem still has a ways to go before being solved and that mortgage lenders should consider forgiving some principle for delinquent subprime loans that were delinquent. The point was that many subprime loan balances now exceed home values due to a decline in home prices and refinancing will only be practical if the balances are no more than home values. Nonetheless, the key factor weighing on stocks Tuesday was concern about Citigroup and other financial firms likely incurring further subprime losses.

Equities got a mild bump up on Wednesday from a better-than-expected ISM non-manufacturing survey. Higher oil prices also lifted many energy stocks. Wednesday’s gains were posted despite negative news about bond insurer Ambac Financial. The biggest movement of the week was on Thursday when all major indexes dropped significantly due to more bad news in the financial sector. Merrill Lynch announced it would stop issuing subprime mortgages and plans to sell its mortgage unit. Thornburg Mortgage raised bankruptcy fears as it was unable to meet a sizeable margin call and grew deeper in default. S&P cut its credit rating on Washington Mutual.  And retailers generally posted sluggish sales numbers. Stocks fell further but at a lesser pace on Friday on news of a 63,000 drop in payroll jobs in February which further raised fears of recession.

Last week, major indexes were down as follows: the Dow, down 3.0 percent; the S&P 500, down 2.8 percent; the Nasdaq, down 2.6 percent; and the Russell 2000, down 3.8 percent.

Since year-end, major indexes are down as follows: the Dow, down 10.3 percent; the S&P 500, down 11.9 percent; the Nasdaq, down 16.6 percent; and the Russell 2000, down 13.8 percent.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

BONDS

Treasury yields were mixed last week with yields on the near end falling while those on the far end firmed. Expectations of further rate cuts by the Fed pulled short rates down while inflation concerns bumped rates up at the far end. Rising oil prices and a declining dollar also helped nudge long rates up.

Early in the week, rates (except for the 3-month T-bill) drifted upward on higher oil prices, on news in the Fed’s Beige Book of stronger commodity prices, and on elevated prices paid indexes in the ISM manufacturing and non-manufacturing reports. Rates did ease somewhat on Thursday on flight to quality on negative news from a number of financials, notably Thornburg Mortgage.

Treasury yields were mixed last week as follows: 3-month T-bill, down 40 basis points, the 2-year note; down 12 basis points; the 5-year note, down 6 basis points; the 10-year bond, up 3 basis points; and the 30-year bond, up 14 basis points.

Expectations of further sharp cuts by the Fed in interest rates have pulled down short-term yields while inflation concerns are keeping the long end firm.

OIL PRICES

Oil prices set record highs in four of the five trading days last week. Upward pressure was from new lows in the dollar against key currencies such as the euro, investors moving into oil as an inflation hedge, saber rattling in South America from leftist governments of Ecuador and Venezuela against Colombia, and on an unexpected drop in U.S. crude inventories. Despite new record highs, prices were tempered by OPEC’s decision to maintain production levels rather than cut levels due to fears of a U.S. recession which would cut demand for crude oil. An intraday high for West Texas Intermediate of over $106 per barrel was set this past Friday.

The spot price for West Texas Intermediate surged $3.68 per barrel net for the week to settle at a new record close of $105.52 per barrel.

The Economy

Last week ended with the February jobs report raising the odds that the economy is already in recession. Economic weakness appears to be spreading beyond just housing and manufacturing.

February employment adds to recession argument

The big story last week was the continued decline in payroll jobs which hinted strongly that the economy is closer to recession. Payroll jobs have fallen for two consecutive months and January and December numbers both were revised down. Nonfarm payroll employment in February dropped another 63,000, following a revised decline of 22,000 in January and revised increase of 41,000 in December. February’s decrease in employment was the largest since a 212,000 fall in March 2003. While two months of job losses do not define a recession, the numbers certainly have raised fears that recession is already here. Additionally, not only was February weak, but the prior two months were revised down with a net revision of down 46,000.

The magnitude of February’s drop was not really dramatic – we just have not seen declines for almost five years. What does stand out about the latest report is that softness is widespread. Yes, payroll survey weakness was led by the goods-producing sectors. Manufacturing fell by 52,000 in February while construction jobs dropped 39,000. But importantly, the service-providing sector advanced but at a slowing pace, rising a very soft 26,000, following a 32,000 increase in January. Service sector strength was in government -- private sector service-providing jobs actually declined 12,000 in February. So, we are seeing a widening in softness in the economy.

While the labor market has softened a little, wage rates remain on the high side. Average hourly earnings advanced 0.3 percent in February, equaling January’s boost. On a year-on-year basis, average hourly earnings stood at somewhat elevated 3.7 percent pace – lower than the recent high 4.3 percent in December 2006 but way above the cyclical low of 1.6 percent in February 2004.

Turning to the household survey, the civilian unemployment rate actually dipped to 4.8 percent from 4.9 percent in January. Markets largely ignored the unemployment rate since the household survey is much smaller and is more volatile than the payroll survey.

The bottom line is that the latest jobs report indicates that sluggishness in the economy is spreading past the pro-cyclical components of housing and manufacturing and into services.

ISM manufacturing drops further into negative territory

Manufacturing appears to be weakening further while at the same time cost pressures are rising. The ISM manufacturing index fell a sizable 2.4 points to 48.3 in February – notably below the zero growth reading of 50. But new orders were not as negative, slipping only 4 tenths to 49.1 – a reading that just barely indicates month-to-month contraction. The big positive is that export orders came in at a still healthy 56.0.

The really bad news is that inflation measures remain elevated as the prices paid index came in at 75.5 in February. Much of the price pressure was energy related.

ISM non-manufacturing surprises on the upside

While the latest jobs report pointed to a slowing in the services sector, the lastest ISM non-manufacturing report suggests that the non-manufacturing sectors are not falling off a cliff and may be stabilizing somewhere near flat. The new composite headline index rebounded nearly 5 points to 49.3 with the business activity index, equivalent to a production index, actually edging over 50 to 50.8 vs. January's 41.9. New orders may be the report's most important index, showing a near breakeven 49.5, well up from 43.5. This is good news in that non-manufacturing may not yet be in recession and could keep the overall economy just barely out of recession. But the jury is still out on that. Nonetheless, costs remain elevated with prices paid down a slight 3 points to 67.9.

Construction weakness spreads

Through 2007 as housing plummeted, nonresidential and public construction kept overall construction in positive territory. But this no longer is the case as indicated by the January construction outlays report. Construction outlays continued their recent decline with a 1.7 percent fall, following a 1.3 percent drop in December. January's drop in construction spending was led by a 3.0 percent drop in private residential outlays. Public outlays and private nonresidential outlays also declined by 0.2 percent and 1.2 percent, respectively.

On a year-on-year basis, overall construction outlays were down 3.3 percent in January. The latest construction outlays numbers certainly will result in negative contributions to GDP for the first quarter.

Unit labor costs adding to the Fed’s dilemma

While soft and negative numbers for economic indicators are keeping the Fed focused on preventing recession, the most recent productivity numbers reminded the Fed that inflation pressures remain close at hand. Fourth quarter productivity was revised up marginally to an annualized 1.9 percent from the earlier estimate of 1.8 percent and compared to market expectations of 1.8 percent. But raising the specter of inflation coming from the labor sector was an upward revision to unit labor costs to an annualized 2.6 percent from the original estimate of 2.1 percent for the fourth quarter. While there is a cyclical component to the fourth quarter numbers (output swings such as the latest deceleration in output), the bump up in labor costs raises concern the Fed is easing too much and is fueling inflation down the road.  Fedspeak recently still emphasizes that the Fed is in recession fighting mode, but the latest unit labor cost numbers serve as a reminder that the Fed needs some help from a sluggish economy and soft labor market to keep inflation pressures down.

Beige Book finds economy slowing but not in recession

The latest Beige Book clearly shows a slowing economy but the good news is that the report does not suggest pending recession – although the lack of such a description could be just spin by Fed  writers. 

Within the real economy, manufacturing is described as "sluggish or to have slowed" in many districts although export driven manufacturing is still healthy. Residential real estate remains weak while commercial real estate generally is slowing. Retail activity is "weak or softening" while services are slowing overall. Banks indicate that they have tightened credit standards. On the positive side, tourism is strong as are agriculture and energy sectors. Inflation news is mostly favorable from the labor sector but mixed on the upside elsewhere.

Outside of construction, the biggest weakness appears to be the labor sector as it is starting to be hard hit by the slowing in economic growth as there were reports of "increased prevalence of layoffs, reductions in work hours, or hiring freezes."

But the credit markets are the key focus of the Fed. Districts generally are reporting tighter credit standards, increases in mortgage delinquencies and foreclosures, and a decline in credit quality. With the Fed primarily focusing on bringing stability to credit markets, the Beige Book points to another sizeable rate cut by the Fed on March 18.

The bottom line

We have further evidence that the U.S. economy has started a mild contraction.  Whether the data will eventually meet the definition of recession is still in doubt as the stimulus from earlier Fed rate cuts is just now starting to kick in and we also will be getting a little nudge forward from the fiscal stimulus package in coming months. But for now, the Fed is still in recession fighting mode. The fed funds futures market has baked in a 100 percent probability that the Fed will be cutting its target rate by 75 basis points on March 18.

Looking Ahead: Week of March 10 through March 14

This coming week we get three very important market moving indicators: international trade, retail sales, and the CPI. These series will give us updates on whether exports are still supporting manufacturing, whether the consumer sector is doing its part to keep the economy out of recession, and whether the Fed is getting any relief from recently high inflation numbers.

Tuesday

The U.S. international trade gap has shown improvement despite a spike in oil prices, and the lower trade gap is providing some support for economic growth in the U.S. The nation's trade deficit narrowed sizably in December, to $58.8 billion from November's $63.1 billion. But the data largely reflect a softening in imports which declined 1.1 percent and reflected softening domestic demand especially for imported cars. Exports strengthened, rising 1.5 percent and reflected strong global demand for capital goods. For January, we may see higher oil prices reverse the trade gap somewhat but the underlying trend in a shrinking nonpetroleum gap should continue.

International trade balance Consensus Forecast for January 08: -$59.5 billion
Range: -$61.5 billion to -$57.7 billion

Wednesday

The U.S. Treasury monthly budget report is continuing to show a soft economy as revenues have been down compared to the prior year. Four months into the Treasury's fiscal year and the federal deficit is indeed on its way to a doubling, at a fiscal year-to-date deficit of $87.7 billion vs. $42.2 billion this time last year. Data for January, a surplus month, was  disappointing, showing a smaller than expected surplus of $17.8 billion. Tax receipts are down this year while outlays, led by defense, are on the rise. Looking ahead, the month of February typically shows a moderate deficit for the month. Over the past 10 years, the average deficit for the month of February has been $79.7 billion.

Treasury Statement Consensus Forecast for February 08: -$157 billion
Range: -$175 billion to -$120 billion.

Thursday

Retail sales are showing signs of softening and what these numbers do will have a major impact on whether the economy tilts into recession or not as the consumer sector does the heavy lifting in terms of contributing to economic growth. Retail sales rebounded in January but strength was primarily in motor vehicles and gasoline and with the latter boosted by price increases. Retail sales rose 0.3 percent in January, following a 0.4 percent drop in December. Excluding both motor vehicles and gasoline, retail sales were flat in January after declining 0.3 percent in December. More recently, a few retailers have reported positive sales numbers but most have reported disappointing sales, including for motor vehicles.

Retail sales Consensus Forecast for February 08: +0.2 percent
Range: -0.5 to +0.5 percent

Retail sales excluding motor vehicles Consensus Forecast for February 08: +0.2 percent
Range: -0.4 to +0.5 percent

Initial jobless claims have improved recently but continuing claims remain on the high side, suggesting that the labor sector is still leaning toward the soft side. Initial claims for the week ending March 1 improved a bit more than expected, to a 351,000 level that is a 24,000 decrease. The four-week average fell slightly to 351,000. However, continuing claims for the week ending February 23 rose 29,000 to 2.831 million -- the highest level in 2-1/2 years. Most recently, the claims numbers are pointing to a mild softening in employment rather than sharp declines. The February payroll numbers came in with a decline of 63,000 but that is actually moderate for an economic contraction. Markets will continue to give the claims numbers close attention during this potential turning point in the economy -- especially to see if the Fed’s interest rate cuts are starting to work.

Jobless Claims Consensus Forecast for 3/8/08: 358,000
Range: 352,000 to 364,000

Import prices are heating up due to not just higher oil prices but also to overall commodity prices and the lower dollar. Recent Fedspeak has the Fed hoping that a depreciating dollar will not notably impact U.S. inflation but recent import price data suggest otherwise. The import price index shot up 1.7 percent in January, pushing the year-on-year rate to 13.7 percent -- the largest increase in 25 years of data. Excluding oil the gain in January was 0.6 percent for a 3.6 percent year-on-year rate. The 3.6 percent rate is the highest since the mid-1990s and is clear evidence that the nation is importing inflation. With oil and other commodity prices continuing to surge, expect another nasty import price figure for March.

Import prices Consensus Forecast for March 08: +0.6 percent

Range: -0.5 to +1.4 percent

Business inventories can lead to adjustments in manufacturing or in imports if inventory levels rise faster than sales. The latest numbers in December pointed to the risk of inventory overhang with a 0.6 percent jump in December, following a 0.4 percent rise in November. Gains were seen at the retail level and especially at the manufacturing and wholesale levels.

Business inventories Consensus Forecast for January 08: +0.5 percent

Range: +0.1 to +0.8 percent

Friday

The consumer price index continues to give the Fed grief as a long-term problem that may be getting worse while the Fed fights a potential recession. More than anything else, the Fed would like to see some soft inflation numbers to help keep inflation expectations anchored and allow more aggressive interest rate cuts to boost economic growth. But consumer prices definitely heated up in January as the CPI rose an uncomfortable 0.4 percent for a second straight month, putting the year-on-year rate at 4.3 percent -- the highest level in 2-1/2 years. The core rate headed in the wrong direction, rising 1 tenth to 0.3 percent in January -- which brings the year-on-year rate for this reading to 2.5 percent and its highest level in a year.

CPI Consensus Forecast for February 08: +0.3 percent
Range: +0.1 to +0.3 percent

CPI ex food & energy Consensus Forecast for February 08: +0.2 percent
Range: +0.2 to +0.3 percent

The Reuter’s/University of Michigan’s Consumer sentiment index has been pointing to notable slippage in consumer confidence – a factor which may play a key role in deciding whether the economy slips into recession or not. And we are getting different signals from different reports on consumer confidence. The Reuters/University of Michigan reading slipped to 70.8 at the end of February from 78.4 in January. This drop is less severe than the rival measure from the Conference Board. A big positive in the report is a 1 tenth dip in one year inflation expectations, though at a still elevated 3.6 percent. The dip back does suggest that price increases currently underway at the pump are not scaring consumers, who perhaps and hopefully are patiently adapting themselves to the problem. But the latest run up in oil prices could lead consumers to revert back to worrying about gasoline prices and inflation overall.

Consumer sentiment Consensus Forecast for preliminary March 08: 69.5

Range: 65.0 to 71.5