Dow sets record among mixed economic and inflation numbers
By R. Mark Rogers, Senior Economist, Econoday
May 18, 2007

Last week saw the Dow set an all time high and the S&P 500 edge closer to its record high. Economic data were mixed but netted on the positive side. Higher oil prices helped nudge up rates on notes and bonds.

Recap of US Markets

OIL PRICES

Oil prices were up significantly over last week. Movement early in the week led prices upward modestly due to supply disruptions in Nigeria and due to comments by Saudi Arabian officials indicating they would support keeping OPEC supply curbs in place at least through June. Wednesday, however, saw a dip in prices with inventory data coming in higher than expected. The big movement last week was on Thursday with a $2.31 surge in the spot price for West Texas Intermediate. News of maintenance problems with Murphy Oil’s Louisiana refinery led to supply concerns as other refiners have been having similar problems. Traders see U.S. refiners having difficulty keeping up with demand despite currently high prices.

The spot price per barrel for West Texas Intermediate was up for the week by $2.57 per barrel to close at $64.94 per barrel.

STOCKS

Equities were mixed last week with the blue chips posting notable gains while techs and small caps declined. The Dow ended the week at an all time high. The S&P 500 ended higher and just shy of its record close of 1527.46 set on March 24, 2000. Merger and acquisition news was a key focus on Monday – especially with the announcement that majority holdings of the Chrysler division of DaimlerChrysler would be sold to a private equity firm at a sharp discount to Daimler’s purchase price. Techs and financials were particularly weak. Yahoo! helped pull down techs while financials were downgraded by some analysts and a report by the Fed that banks had tightened lending standards for home loans weighed on financials. Also, investors tended to move to the sidelines, waiting for Tuesday’s CPI report. However, a favorable CPI report only managed to help the Dow as others indexes declined – notably small caps and techs. Pulling down the Nasdaq were Amgen, Dell, Apple and Yahoo! Amgen’s stock has been hurt on concerns over its anemia drugs. Overall for equities, investors were nervous awaiting Wednesday’s housing starts report. Wednesday was broadly positive for all major indexes. On the economic front, the housing starts report showed starts in April edging up but permits fell notably and were the key focus. However, industrial production was reported as quite healthy for April, boosting investor confidence. Fund managers helped boost key stocks as one hedge fund manager announced an $800 million stake in Citigroup while another announced additional ownership in Johnson & Johnson and also WellPoint. Stocks were down on Thursday as oil prices surged and economic data were mixed. Initial claims were reported down and the Philly Fed manufacturing index edged up but the index of leading indicators dropped. On Friday, equities got an unexpected boost from a small gain in the consumer sentiment index.

Last week, the Dow and S&P 500 were up 1.7 percent and 1.1 percent, respectively. The Nasdaq and Russell 2000 both were down 0.1 percent and 0.7 percent, respectively.

Year-to-date, the Dow is up 8.8 percent; the S&P 500, up 7.4 percent; the Nasdaq, up 5.9 percent; and the Russell 2000 is up 4.6 percent.

BONDS

The yield curve rose last week except on the near end. There was no economic news on Monday to move rates but traders nudged rates up on the bet that the CPI on Tuesday would surprise on the high side. On Tuesday, the core CPI came in with a respectable 0.2 percent rise as expected and rates showed little change for the day. On Wednesday, a decline in housing permits and a rise in industrial production essentially were offsetting, leaving rates mostly flat. Thursday saw a bump up in rates, largely due to a surge in oil prices. Rates also jumped on Friday as a major mortgage servicer rebalanced portfolios and some hedge funds moved funds from bonds to equities.

Net for the week the Treasury yield curve is up except for the 3-month T-bill. Yields were up as follows: 2-year T-note, up 11 basis points; 3-year, up 13 basis points; 5-year, up 15 basis points; the 10-year bond, up 12 basis points; and the 30-year bond, up 11 basis points. The 3-month T-bill was down 3 basis points.

Rates on notes and bonds have broken out of their recent and narrow trading range, heading upward as the economy has improved and oil prices have boosted overall inflation. 

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

With the latest CPI report, inflation has eased but is being reluctant to fall into the Fed’s implied target zone of 1 to 2 percent yearly inflation. Housing numbers are mixed but are pointing down more than up. However, manufacturing is looking stronger than expected.

Core consumer prices remain soft but still hover at the top of Fed’s implied target

Higher energy prices boosted the overall CPI in April but the core rate remained moderate. The overall consumer price index in April increased 0.4 percent, following a 0.6 percent jump in March. While the core CPI firmed slightly to a 0.2 percent increase in April, following a 0.1 percent rise in March, the April gain was moderate. This is taking into account the fact that the unrounded change in the core CPI was 0.17729 percent in April, following a 0.06120 percent increase in March.

The markets focused on the moderate core figure. Helping keep the core rate modest was a 0.2 percent rise in the owners’ equivalent rent subcomponent of housing – which had risen 0.3 percent the month before. Also, several components actually declined – apparel, new & used motor vehicles, public transportation (largely airline fares), and tobacco products.  On the upside, medical care costs jumped 0.4 percent in April, following a 0.1 percent rise in March.

However, outside-the-core components remain problematic. Energy prices pushed up the overall CPI as expected while food price inflation firmed.  Energy prices increased 2.4 percent, following a 5.9 percent surge in March. Food price inflation remained strong in April with a 0.4 percent boost, following a 0.3 percent increase in March.

Year-on-year, the overall CPI edged down to up 2.6 percent in April, increasing from up 2.8 percent in March. The core rate slipped to up 2.4 percent on a year-on-year basis, compared to up 2.5 percent in March. 

In contrast, the food and energy components are headed up, not down. The food component stood at 3.7 percent in April on a year-on-year basis, compared to 3.3 percent in March and compared to a recent low of 1.8 percent in May 2006. Energy is not rising as fast as during 2005 and 2006, but it is clearly tugging upward on the core. Energy price inflation was up 2.4 percent year-on-year for April, compared to 5.9 percent in March and a recent low of minus 11.3 percent for October 2006.

Based on the April report, the core CPI on a three-month-ago annualized basis stood at a 1.9 percent pace. Taking into account economic studies on the “bias” of the CPI compared to the PCE price index, the true inflation figure is about a quarter percentage point lower – meaning core inflation is about 1.7 percent in April and just under the ceiling of the Fed’s target zone.  But the numbers have been volatile over the last few months and core inflation cannot yet be said to have “settled” in the target zone.

Drop in housing permits overshadows rise in starts

While housing starts in April rose for the third month in a row, the market focus ended up being on a drop in permits. Housing starts in April rose 2.5 percent, following a 0.3 percent increase the prior month. In April, single-family starts rose 1.6 percent while multifamily starts advanced 6.2 percent.

Regionally, starts in April were strongest in the Northeast with a 31.3 percent surge. Starts also advanced 7.8 percent in the West.  Starts in the Midwest and South declined, 14.2 percent and 0.1 percent, respectively. The jump in the Northeast reflects atypically better weather for early spring.

However, housing permits fell 8.9 percent to a 1.429 million unit pace in April from 1.569 million units in March. Markets saw the drop in permits as more reflecting the true strength in housing. Unusually warm and dry weather likely helped starts while permits may reflect continued sluggishness in housing. Bolstering this argument was the 31.3 percent jump in starts in the Northeast region – such a surge is unlikely unless atypical seasonal factors are providing the boost. Single-family permits dropped 6.0 percent while multifamily permits declined 16.4 percent. On a year-on-year basis, permits are down 28.1 percent in April.

Industrial production surprises on the upside

While housing remains soft, manufacturing seems to be improving. Industrial production jumped 0.7 percent during April, following a 0.3 percent decline the prior month. March’s weakness was due to a drop in utilities output. Overall capacity utilization rose 4 tenths in the latest month to a still moderate 81.6 percent.

Manufacturing output rose 0.5 percent in April after posting a 0.6 percent gain in the prior month. For the latest month, manufacturing’s gain was led by durables. Industries that stood out were motor vehicles, computers & electronics, and electrical equipment. Manufacturing capacity utilization edged higher to 80.2 percent from 80.0 percent in March.

The Fed would like to pull off a balancing act in the manufacturing sector of getting soft growth but avoiding outright declines. Thus far, the Fed seems to be pulling it off. Year-on-year rates for manufacturing output have been on the decline, at only 1.9 percent in April for the lowest rate in about 3-1/2 years. But manufacturing has not turned in any extended negative numbers as is the case during a recession. Manufacturing surveys also suggest that this sector is not worsening but perhaps firming slightly.

Empire State and Philly Fed surveys edge upward

Both the Empire State and Philly Fed manufacturing surveys showed improvement in May – indicating that the slide in manufacturing is over – at least for now. The Empire State index rose to 8.0 from. 3.8 in April. New orders also showed modest strength, at 8.0 vs. April's 3.9. The Philly Fed index improved to 4.2 in May from a nearly dead-flat 0.2 level in April. May's index for new orders was especially positive, at 8.7 vs. 2.8 in April.

The bottom line

The economy is mixed with housing still in the doldrums but manufacturing turning modestly positive. Core inflation is down but food and energy components may be creating inflationary pressures on the core. Equities seem to be on a moderate uptrend, consistent with modest economic growth overall. And interest rates do not appear to be headed down soon.

Looking Ahead: Week of May 21 through May 25

Heading into the Memorial Day weekend, the schedule of releases is very light – with key indicators for durables orders and for new and existing home sales.

Thursday

Initial jobless claims for the week ending May 12 declined by 5,000 to 293,000 – continuing to come in stronger than expected. Initial claims have declined for five consecutive weeks and are at the lowest level since the 287,000 mark for the week ending January 13, 2007. The cyclical low was 279,000 for the week ending January 14, 2006.  A tight labor market is one of the key concerns of the Fed for its inflation watch.

Jobless Claims Consensus Forecast for 5/19/07: 310,000
Range: 300,000 to 315,000

Durable goods orders rose 3.7 percent in March, led by machinery and transportation. Defense aircraft and construction machinery were notably strong for the month. Excluding transportation, durables orders were up 1.3 percent in March, following a 0.6 percent dip the month before.  Manufacturing has begun to strengthen with the last couple of industrial production reports, and another good durables report would be favorable for manufacturing.

New orders for durable goods Consensus Forecast for April 07: +1.2 percent
Range: -1.5 percent to +3.1 percent

New home sales edged up 2.6 percent in March to an 858,000 annualized pace. Importantly, supply fell back to 7.8 months from an extremely swollen 8.1 months in February. Nonetheless, sales are still soft and need to rise before residential construction activity can pick up. Sales are down 23.5 percent on a year-on-year basis.

New home sales Consensus Forecast for April 07: 0.860 million-unit rate
Range: 0.825 million to 0.900 million-unit rate

Friday

Existing home sales tanked in March, dropping 11.3 percent – the largest monthly drop since January 1989. The 6.120 million unit annualized pace was the lowest sales level since June 2003. Supply rose to 7.3 months from 6.8 months in February and 6.6 months in January.

Existing home sales Consensus Forecast for April 07: 6.20 million-unit rate
Range: 6.00 to 6.30 million-unit rate