Goldilocks is back - boosting equities, trimming long rates
By R. Mark Rogers, Senior Economist, Econoday
May 4, 2007

Last week was mixed in terms of economic data but clearly netted on the side of moderation. Inflation numbers from the productivity and personal income reports put the markets in a good mood early in the week. The markets very much liked how the week ended with modest payroll gains and easing wage inflation.  The Dow continued to set record closes and the S&P 500 recovered past the 1,500 mark.

Recap of US Markets

OIL PRICES

Oil prices ended last week down sharply, more than reversing the prior week’s increase. Spot prices for West Texas intermediate declined on Monday due to a lessening in tensions over the Iranian nuclear program. Prices slid the rest of the week. Prices fell on Tuesday in anticipation of a rise in supplies to be reported on Wednesday. The big movement was a $1.31 drop on Wednesday due to a government report on higher crude inventories. Distillates were down but due to lower operating rates at refineries which have been pushed down by lower demand. Soft U.S. economic data on Friday – the jobs report – and a belief by traders that gasoline prices have peaked helped push prices down further on Friday.

The spot price per barrel for West Texas Intermediate dropped for the week by $4.53 per barrel to close at $61.93 per barrel.

STOCKS

Equities stumbled out of the gate on Monday but blue chips and techs ended the week with generally solid gains while the small caps languished. On Monday the tech sector was hit by soft earnings and market misgivings over a deal by Yahoo! to buy interest in an on-line ad exchange. Even though the personal income report on Monday had strong income numbers, equities focused on the soft spending number and headed down. End of month profit taking and program trading also pulled stocks down. Also of note, Delta Airlines emerged from bankruptcy on the last day of April. A healthy ISM manufacturing index boosted stocks on Tuesday. Standing out, however, was a surge in the price for Dow Jones & Co. following news of a takeover bid from News Corp. Wednesday posted the best gains for the week with the small caps and techs leading the day. M&A activity provided key support as did a sharp drop in oil prices. On Thursday, the S&P 500 passed the 1,500 mark for the first time in over six years. On Friday, the moderate employment report set a positive tone. But the real push came from M&A activity and rumors – especially regarding Microsoft’s possible purchase of Yahoo! and Reuters confirming a takeover offer.

By some measures, the Dow is on the longest bull run in 80 years, closing last Friday up in 23 of the last 26 sessions – the most since mid-1927 when the Dow closed up in 24 of 27 sessions. As the Dow ended the week at a record high, the S&P 500 ended the week just 22.96 points shy of its all-time high close of 1,527.46 set in March 2000.

Last week, the Dow was up 1.1 percent; the S&P 500, up 0.8 percent; the Nasdaq, up 0.6 percent; and the Russell 2000, up, 0.4 percent.

For April, the Wilshire was up 3.8 percent; the Dow, up 5.7 percent; the S&P 500, up 4.3 percent; the Nasdaq, up 4.3 percent; and the Russell 2000, up, 1.7 percent. April was the best month for the Dow since October 2003; for the Nasdaq since October 2004; and for the S&P500 since November 2004.

Year-to-date, the Dow is up 6.4 percent; the S&P 500, up 6.2 percent; the Nasdaq, up 6.5 percent; and the Russell 2000 is up 5.7 percent.

BONDS

The yield curve edged down on the ends – especially on the far end – while notes were little changed. Starting the week, bond traders took Monday’s personal income report to indicate a soft economy (a March dip in real PCEs) and lower inflation (flat core PCE price index for March) and rates fell notably. Also, the volatile Chicago purchasing managers’ index fell, helping to nudge rates down. On Tuesday, an unexpected rise in the ISM manufacturing index helped rates firm a bit – but not too much as the index still was only modestly positive. A dip in pending home sales also partially offset the upbeat ISM report. Rates were flat on Wednesday with little notable news to move rates. However, on Thursday, a drop in initial jobless claims more than offset very favorable unit labor costs released at the same time on Thursday. Still, the unit labor cost numbers did add to more favorable inflation views heading into Friday’s employment report. A very sluggish payroll number, softer wages, and a small rise in the unemployment rate pushed rates down on the long end – especially for the 30-year bond.

Net for the week the Treasury yield curve is down on the ends. Yields were as follows: 3-month T-bill, down 5 basis points; 2-year T-note, up 1 basis point; 3-year, no change; 5-year, down 3 basis points; the 10-year bond, down 5 basis points; and the 30-year bond, down 7 basis points.

Except for the 3-month T-bill, which has been trending downward, rates have traded in a narrow range over the last few weeks.

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

The economy continues on a modest uptrend with sectors mixed but with some signs that inflation may be easing.

Employment and wage growth ease

The April jobs report indicated that economic growth may be slowing along with wage gains. Importantly, employment growth is slowing but not declining. Nonfarm payroll employment rose by 88,000 in April, following a revised 177,000 gain in March and a 90,000 increase in February. April’s payroll gain was the lowest since November 2004’s rise of 65,000. Also, payroll increases for March and February had a combined downward revision of 26,000.

Nonfarm payroll employment on a year-on-year basis was unchanged at up 1.4 percent in April from March.

Within the payroll survey, strength was in the service-providing industries as good-producing employment declined. Construction fell 11,000 after a 50,000 partial rebound in March. Manufacturing decreased 19,000, following an 18,000 drop in March. Natural resources & mining edged up 2,000 in April, following a 4,000 rise the month before. Overall service-providing industries rose a moderate 116,000 in April, following a 141,000 gain in March. Gains were led by government, up 25,000, and by professional and business services, up 24,000. Weakness was in retail trade which fell 26,000.

Not only was the moderation in payroll employment good news for a Goldilocks economy, but wage growth eased to a less inflationary pace. Average hourly earnings moderated to a 0.2 percent rise in April, following a 0.3 percent boost in March. Average hourly earnings slipped to up 3.7 percent on a year-on-year basis in April from up 4.0 percent in March. This is the lowest year-on-year rate for average hourly earnings since a 3.6 percent pace in March 2006.

The household survey showed signs of an incremental loosening in labor market tightness. The civilian unemployment rate edged up to 4.5 percent from 4.4 percent in March. The employment-population ratio declined to 63.0 percent from 63.3 percent in March. And the labor force participation rate edged down to 66.0 percent in April from 66.2 percent the month before. We probably, however, still need to see a little more loosening in the labor markets to get core inflation established within the Fed’s implied target zone.

Personal income report mixed but healthy overall

Personal income growth in March was quite healthy with a 0.7 percent gain which also matched the increase in February. The important wages & salaries component rose 0.7 percent, following a 0.5 percent advance in February. Wages and salaries make up about two-thirds of personal income. However, we are likely to see softer growth in April, based on softer employment and wage gains and a dip in the average workweek.

Personal income on a year-on-year basis rose to up 5.7 percent from up 5.5 percent in February. On the same basis, the wages and salaries component firmed to up 4.6 percent year-on-year in March from up 4.5 percent in February.

Personal consumption expenditures increased 0.3 percent, following a 0.7 percent rise in February. A negative in this report is that much of the gain in consumer spending was price related - especially for nondurables which includes gasoline sales. Chained dollar ("real") PCEs actually slipped 0.2 percent in March, following strong gains in prior months. Real PCEs rose 0.4 percent each month from November through January and then rose 0.3 percent in February. Given the strong gains in the prior months, the March dip is not disconcerting unless April is down, too.

The big news from the personal income report actually was the inflation data. The overall PCE deflator was still high at 0.4 percent in March, the same as in the prior month. March was boosted by higher oil prices as expected. More importantly, the core PCE price index (excluding food and energy) eased to no change (rounded down), following a 0.3 percent rise in February. The consensus had forecast a 0.1 percent rise in the core PCE price index. The unrounded percent change for the core PCE price index was 0.04931 percent, compared to 0.32774 percent in February.

On a year-on-year basis, the overall PCE deflator was up 2.4 percent in March, compared to up 2.3 percent in February. On a year-on-year basis, the core PCE deflator slipped to up 2.1 percent from up 2.4 percent in February - the core PCE price index seems headed toward the Fed’s target zone.

Productivity better than expected while labor costs ease

Productivity and labor costs for the first quarter came in better than expected. First quarter productivity came in at an annualized 1.7 percent, down from the fourth quarter pace of 2.1 percent. Productivity came in notably above the market consensus projection for a 0.5 percent annualized increase. Year-on-year, productivity dropped to up 1.3 percent in the first quarter from up 3.4 percent the prior quarter.

But the big news in the productivity report was the sharp deceleration in unit labor costs. Unit labor costs decelerated to an annualized 0.6 percent increase, following a 6.2 percent spike in the fourth quarter. High unit labor costs have been a key concern for the Fed. Year-on-year, unit labor costs are down to up 1.3 percent, compared to up 3.4 percent in the fourth quarter.

ISM reports show modest improvement

Sluggish regional reports on manufacturing have been a cause of concern over whether manufacturing is slowing too much. The April reports from The Institute For Supply Management came in somewhat positive and boosted market confidence on manufacturing and non-manufacturing. The ISM's manufacturing index jumped 3.8 points to 54.7 in April for its best reading in nearly a year. New orders firmed even more than the composite as did backlogs.

The Institute For Supply Management's non-manufacturing index also showed strength in April, rebounding to 56.0 from a multi-year low of 52.4 in March. New orders rose marginally while backlogs were flat.

ISM price indexes were mixed. The manufacturing prices paid index jumped 7.5 points to 73.0, primarily reflecting higher energy prices. However, there were no notable commodities in short supply, indicating little price pressure moving forward – at least outside of energy. The non-manufacturing price index was little changed but still high at 63.5 – also mostly energy related.

Construction stays on dual track

Not unexpectedly, the March construction report showed residential outlays still on a downtrend while nonresidential and public construction remained upbeat. Construction spending edged up in March as outlays rose 0.2 percent, following a 1.5 percent gain in February.

On a year-on-year basis, overall construction outlays slipped to down 2.0 percent in March from down 1.2 percent in February.

Private residential construction fell 1.0 percent in March, following a 1.8 percent rebound in February. Private residential construction is down 14.4 percent on a year-on-year basis, compared to down 13.3 percent in February.

Private nonresidential outlays posted a healthy 2.4 percent increase in March following a gain of 3.0 percent in February. Private nonresidential outlays are up 16.5 percent in March on a year-on-year basis, compared to up 16.6 percent in February.

Nonresidential strength was broad-based with no major subcomponents being negative.

Essentially, nonresidential and public construction are offsetting the decline in residential construction. If the decline in residential construction even decelerates (less of a decline), then we could see notable improvement in construction overall.

The bottom line

The economy is showing signs of slowing but not declining overall. The consumer sector appears to be moderating but not weakening too much. The tightness in labor markets loosened marginally. This is in the right direction but there is still a ways to go. On the inflation front, the combination of a flat core PCE deflator, a sharp deceleration in unit labor cost growth, and slower wage inflation were all favorable toward a Goldilocks economy. The combination of moderate growth and lower inflation should be good for both equities and bonds. However, one should expect the monthly data to tip slightly in either direction. Remember, over the last several months, views on the economy have swung between “too hot” and “too cold,” yet on average it indeed is just about right.

Looking Ahead: Week of May 7 through May 11

Highlights will be reading the tea leaves for interest rates in the wording of the FOMC statement on Wednesday, getting another inflation reading on Friday at the producer level, and seeing how well retail sales are holding up after the sluggish employment report.

Monday

Consumer credit rose a moderate $3.0 billion in February, down from a $6.6 billion gain in January and at a sub-trend 1.5 percent annual rate. More moderate consumer spending in March suggests continued modest growth in credit.

Consumer credit Consensus Forecast for March 07: +$4.0 billion
Range: $3.3 billion to +$6.5 billion

Wednesday

The FOMC announcement for the May 9 FOMC policy meeting is expected to leave the fed funds rate unchanged at 5-1/4 percent. Markets will be watching for any subtle changes in the wording on the FOMC’s current anti-inflation bias.

FOMC Consensus Forecast for 5/9/07 policy vote on fed funds target: unchanged at 5-1/4 percent

Range: 98% percent probability for no change, based on fed funds futures May 3 close, versus 2% for -25 bps

Thursday

Initial jobless claims dropped 21,000 to a 305,000 level in the April 28 week that was well under expectations. There were no apparent special factors. Jobless claims now appear to be pointing to a little stronger job market than the April employment report which was based on data earlier in the month.

Jobless Claims Consensus Forecast for 5/5/07: 315,000
Range: 295,000 to 325,000

Import prices jumped 1.7 percent in March reflecting a 9.0 percent spike in petroleum prices, but were up only 0.3 percent excluding petroleum. Oil prices generally trended up in April so we will likely see a strong increase in overall import prices, but the non-petroleum component is likely to get more attention.

Import prices Consensus Forecast for April 07: +0.9 percent
Range: +0.6 to +2.0 percent

The U.S. international trade gap narrowed to $58.4 billion in February from $58.9 billion in January. Imports fell 1.7 percent reflecting a drop in the price of oil along with a sharp drop in volume. Exports also fell, down an unusually sharp 2.2 percent reflecting a month-to-month downturn in exports of capital goods as well as a dip in exports of consumer goods. Given the run up in oil prices during March, we should expect a worsening in the trade gap. However, exports of capital goods are affected by Boeing aircraft shipments and we could see a rebound in exports in that category.

International trade balance Consensus Forecast for March 07: -$60.1 billion
Range: -$62.0 billion to -$58.5 billion

The U.S. Treasury monthly budget report showed a slight improvement in the federal deficit in March from February – dipping to a deficit of $96.3 billion from a shortfall of $120.0 billion in February. However, the March deficit was notably higher than for March 2006 – which came in at $85.3 billion. The latest deficit was swollen by higher tax refunds and timing of miscellaneous outlays including foreign aid to Egypt and Israel. Nevertheless, the fiscal year-to-date deficit is well under this time last year, at $258.4 billion vs. $302.9 billion. But continued improvement is uncertain, given the slowing in U.S. economic growth. The month of April typically shows a sizeable surplus for the month. Over the past 10 years, the average surplus for the month of April has been $99.4 billion with the surplus for April 2006 up to $118.8 billion.

Treasury Statement Consensus Forecast for April 07: +$150.0 billion (surplus)
Range: +$100.0 billion to +$172.0 billion.

Friday

The producer price index jumped 1.0 percent in March due to a surge in oil prices. However, the core rate slowed to no change in March, following a 0.4 percent increase in February.  Keeping the core rate flat were a dip in capital equipment and a modest rise in consumer goods excluding food and energy.

PPI Consensus Forecast for April 07: +0.7 percent
Range: +0.4 to +1.2 percent

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

Retail Sales increased at a robust 0.7 percent in March, following a 0.5 percent rise in February. Even excluding both gas station and motor vehicles components, retail sales increased 0.4 percent in March, following a 0.3 percent rise the prior month. We will likely get some boost from price-related higher gasoline sales. Also in April, motor vehicle sales rebounded slightly and that should be a positive. However, the retail sales component for autos uses different source data than motor vehicles sales and they do not always track each other. On the down side, retail trade employment was notably lower in April – suggesting at least some weakness in some components of retail sales.

Retail sales Consensus Forecast for April 07: +0.4 percent
Range: 0.0 to +0.8 percent

Retail sales excluding motor vehicles Consensus Forecast for April 07: +0.4 percent
Range: -0.1 to +0.7 percent

Business inventories growth slowed to a 0.3 percent rise in February, and was just under a 0.4 percent rise in sales and kept the stock-to-sales ratio unchanged at 1.29. Most of the deceleration in inventory growth was due to a drop in auto dealer inventories.

Business inventories Consensus Forecast for March 07: +0.4 percent
Range: 0.0 to +0.4 percent