By R. Mark Rogers, Senior Economist, Econoday

April 6, 2007

Last week the equity markets got their confidence back from lower oil prices and a pick up in pending home sales. Meanwhile, a strong jobs report pushed interest rates up further.

Recap of US Markets

OIL PRICES

Oil prices followed the news of progress on the fate of the 15 British sailors and marines seized by Iran in late March. Favorable comments by the Iranian president led to a notable drop in price on Tuesday with further slippage on Wednesday on the announcement of the British personnel’s imminent release. Inventories, however, were mixed last week. Gasoline stocks were down significantly – outweighing the impact of a rise in crude oil inventories. Net for the week, spot prices for West Texas Intermediate declined $1.59 per barrel to close at $64.28 per barrel. Still, last week’s close was $13.98 above the low for 2007 set in mid-January.

STOCKS

Equities rebounded nicely during last week’s shortened week. On Monday, a weak ISM figure on manufacturing unsettled the markets somewhat but merger and acquisition activity offset those concerns to lift the markets. Key deals involved real estate investor Sam Zell’s buyout of the Chicago Tribune and KKR’s purchase of First Data. On Tuesday, a sharp drop in oil prices (in reaction to Iran and the UK announcing their expectation that diplomacy would resolve the release of 15 British captives) and an unexpected rise in the National Association of Realtors’ pending home sales index gave the markets a surge of optimism and sharply boosted equities broadly. Wednesday saw the release of a weak ISM non-manufacturing report, leaving equities mixed and little changed except for some positive movement in the tech sector. An upgrade of Microsoft by Citigroup was the key reason for gains in the tech sector. Thursday saw broad gains in the equity markets as a few investors went bargain hunting before the start of a three-day weekend for equities. Several stocks were notable including DaimlerChrysler on news of a buyout offer for Chrysler and Johnson & Johnson on the company winning a federal lawsuit against Boston Scientific. Equity markets were closed Friday in observance of Good Friday.

Last week, the Dow was up 1.7 percent; the S&P 500, up 1.6 percent; the Nasdaq, up 2.1 percent; and the Russell 2000, up, 1.6 percent.

Year-to-date, the Dow is up 0.8 percent; the S&P500, up 1.8 percent; the Nasdaq, up 2.3 percent; and the Russell 2000 is up 3.3 percent.

BONDS

Interest rates last week were pushed up by a reversal of flight to safety and a strong employment report. On Monday, the weak ISM manufacturing index, combined with a jump in the ISM price index, left rates little changed. However, on Tuesday a rise in pending home sales bumped rates up despite a sharp drop in oil prices. A reversal of flight to safety pulled out some of the support for U.S. bonds with this effect continuing somewhat during the remainder of the week. Wednesday’s release of a flat ISM non-manufacturing report nudged rates down slightly. Jobless claims rose only moderately on Thursday and helped the markets focus on Friday’s jobs report. Rates backed up slightly on Thursday as the bond markets began to worry about a somewhat strong employment report being expected. Friday’s strong jobs report pushed rates up notably except on the short end.

Net for the week the Treasury yield curve is up except for the 3-month T-bill. Yields were up as follows: 2-year, up 14 basis points; 3-year, up 13 basis points; 5-year, up 11 basis points; the 10-year bond, up 9 basis points; and the 30-year bond, up 8 basis points. The 3-month T-bill was unchanged net.

Over the last four weeks, the longer maturities have been trending up, with the March jobs report adding to that trend.

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.

The Economy

Last week, economic data were primarily limited to the jobs report and the two ISM reports. The jobs report showed a resilient labor market while the ISM reports showed softness in manufacturing.

March jobs report surprises on the upside; wages moderate slightly

The labor market showed surprising resilience in March as nonfarm payroll employment rose by 180,000, following a revised 113,000 gain in February and a 162,000 increase in January. Gains in January and February were revised up by 16,000 in each month.

Within the payroll survey, strength was in construction and in the service-providing industries. Goods-producing industries were mixed in March as construction rebounded 56,000, following a 61,000 drop the month before. Manufacturing continued to decline with decreases of 16,000 and 11,000 in March and February, respectively. Natural resources & mining edged up 3,000 in the latest month.  Overall service-providing industries rose by 137,000 in March, following a 180,000 boost in February. Gains were led by retail trade, up 36,000; health care, up 30,000; and government, up 23,000.

One notable issue of debate in the March report was the impact of construction employment. The swing in construction employment (large jump from a large decline) is the biggest difference in the strength of the March report compared to the February report. That is, how much of the difference in the two reports was weather related' The swing in construction employment likely was related to moving from unseasonably cold weather in February to unseasonably warm weather in March. So, the strength in construction is likely temporary and should partially ease concerns about a too tight labor market.

On the inflation front, average hourly earnings slowed to a 0.3 percent increase in March from a 0.4 percent increase in February. The March increase was led by wage gains in natural resources & mining, construction, manufacturing, wholesale trade, and in information. Average hourly earnings are up 4.0 percent on a year-on-year basis in March, compared to up 4.1 percent in February. While wages moderated in March, the Fed will likely continue to focus on the fact that year-on-year rates are still at 4 percent. Fed officials have in recent weeks made a point that trends are slow to take hold and that one should not rely on just one month’s data.

While some argue that the employment report is not as strong as payroll gains at face value, the household survey actually suggests that the report is even stronger than indicated by payroll gains. From the household survey, the civilian unemployment rate edged down to 4.4 percent from 4.5 percent in February.

And household employment resumed its stronger-than-payroll pace as household employment surged 335,000 in March, following a modest 38,000 decline in February. The labor force rose by 195,000 in March, while the number of unemployed fell 141,000. It is easy to argue that the economy is stronger than suggested by payroll growth. More jobs are being created by the self-employed than in the past.

A number of measures of labor market tightness continue to suggest little slack in the labor markets. The employment-population ratio rose to 63.3 percent from 63.2 percent in February. The employment-population ratio was unchanged at 66.2 percent in March.

Overall, last week’s employment report reflects a healthy labor market with a small improvement in wage inflation.  Despite the moderation in wages, the strong payroll numbers will likely push bond rates up. Come Monday, equities are likely to be chomping at the bit to head up due to the jobs report’s signal that the economy is not too weak.

ISM reports show soft economy but firming prices

According to the Institute For Supply Management, manufacturing was flat in March as its composite manufacturing index declined to 50.9 from 52.3 in February. The breakeven point is 50 and represents zero growth in this diffusion index. New orders and backlogs also declined in the manufacturing index.

The ISM non-manufacturing index also fell -- to 52.4 in March from 54.3 in February. Both surveys, however, showed declines in the inventory indexes --indicating that producers are bringing inventories in line and they will not weigh on production.

On the inflation front, both surveys showed a boost in price indexes. In the manufacturing survey, prices paid jumped to 65.5 in March from 59.0 in February. Many of the commodities reported up in price were energy related and no commodities were reported in short supply. In the non-manufacturing survey, prices paid surged to 63.3 from February's 53.8. Many commodities reported up in price also were energy related. The short supply list is small – mainly construction related. Price increases generally do not appear to be related to any shortages.

The bottom line

The economy is mixed with the labor market providing a strong foundation for the consumer sector but manufacturing is currently soft. Last week’s data likely leave the Fed on hold but you can count on a further push by the Fed for inflation targeting since the tight labor market will make it difficult to bring inflation down further without a nudge in expectations. A number of Fed officials – including Chairman Bernanke – believe inflation targeting would make it easier to bring inflation expectations down.

Looking Ahead: Week of April 9 through April 13

Looking ahead, the first big item this week on the economy will be Wednesday afternoon’s release of the minutes for the March 20-21 FOMC meeting. Fed watchers will be picking apart the minutes for any new information on the Fed’s policy stance. Additionally, we get an update on inflation with import prices and producer prices for March. We also see whether exports continue to support manufacturing with Friday’s report on international trade.

Wednesday

The U.S. Treasury monthly budget report showed a budget deficit in February of $120.0 billion vs. a budget deficit in February 2006 of $119.2 billion. Fiscal year-to-date the budget deficit, reflecting strong tax receipts, is down a very sharp 26 percent. The month of March typically shows a moderate deficit for the month. Over the past 10 years, the average deficit for the month of March has been $49.6 billion. March 2006 posted a deficit of $85.3 billion.

Treasury Statement Consensus Forecast for March 07: -$89.0 billion
Range: -$100.0 billion to -$75.0 billion.

Thursday

Initial jobless claims rose 11,000 to 321,000 for the week ending March 31. Nonetheless, the four-week average slipped 1,500 to 315,750 -- a level that is consistent with solid payroll growth.

Jobless Claims Consensus Forecast for 4/7/07: 320,000
Range: 295,000 to 332,000

Import prices rose 0.2 percent in February but slipped 0.1 percent excluding petroleum. Import prices need to remain soft to help bring core CPI inflation down, but we have seen a large swing in oil prices due to the Iranian seizure of British sailors and marines in March.

Import prices Consensus Forecast for March 07: +0.9 percent
Range: +0.3 to +1.4 percent

Friday

The U.S. international trade gap narrowed to $59.1 billion in January from December's $61.5 billion. Exports posted a 1.1 percent increase, while imports declined 0.5 percent. The decline in imports was primarily due to a sharp drop in oil prices from December to January. In contrast, oil prices were up significantly in February and we will likely see a worsening in imports and in the deficit. However, markets should also focus on whether the uptrend in exports continues and provides support for U.S. manufacturing.

International trade balance Consensus Forecast for February 07: -$60.3 billion
Range: -$62.5 billion to -$58.5 billion

The producer price index rebounded a sharp 1.3 percent in February, following a 0.6 percent drop the prior month. And the core rate firmed to a 0.4 percent boost in February, following a 0.2 percent increase in January. Much of the jump in the overall PPI was due to a large boost in energy (especially oil-related) but also due to higher food prices. For March, the impact of oil prices is uncertain. During March, oil prices swung sharply, declining during most of the month but then spiking the last week and a half. Most likely, the impact will be to pull the energy component down, given the greater portion of the month with declining oil prices. The core rate in February was led by a large increase in tobacco prices and also a significant boost in light truck prices. Neither is likely to be repeated in March.

PPI Consensus Forecast for March 07: +0.7 percent
Range: +0.5 to +1.0 percent

PPI ex food & energy Consensus Forecast for March 07: +0.2 percent
Range: +0.1 to +0.3 percent

The University of Michigan’s Consumer sentiment index slipped to 88.4 in March from February's 91.3. Consumer sentiment has been declining while gasoline prices have been rising. Nonetheless, inflation expectations were unchanged in March at 3.0 percent. Several Fed officials have been talking up the importance of inflation expectations and on the need to bring them down to get actual inflation down.

Consumer sentiment Consensus Forecast for preliminary April 07: 87.5
Range: 87.0 to 90.0