Rates, oil, sub-prime hit equities
By R. Mark Rogers, Senior Economist, Econoday
June 22, 2007

Last week saw a net decline in most interest rates. Nonetheless, a thin week for economic indicators let the markets have lots of time to mull over the recent uptrend in interest rates with the result that equities have been pushed lower. Oil prices continued upward to also weigh on most equity sectors. Sub-prime woes resurfaced as Bear Stearns engaged in a $3.2 billion bailout of two of its hedge funds.

Recap of US Markets

OIL PRICES

Crude spot oil prices continued to rise last week – even from the prior week’s elevated levels. The biggest movement in prices were on Monday, Wednesday, and Friday. Crude spot oil prices for West Texas Intermediate rose $1.09 per barrel to $69.09 per barrel on Monday due to a rise in attacks by militants on Nigerian oil facilities. This was the first time spot prices closed over $69 per barrel since last September. Spot prices fell $0.91 per barrel on Wednesday due to a large jump in U.S. crude oil inventories. U.S. refiners continue to have capacity problems as refinery activity declined in the latest week reported. Refineries ran at 87.6 percent capacity in the latest week, compared to 89.6 percent the prior week. On Friday, prices spiked back up by $0.59 per barrel due to threats by striking union workers in Nigeria to continue their strike. Curiously, U.S. stockpiles of crude are at their highest in nine years. The high crude stocks bolster arguments by OPEC members that crude production does not need to be increased. Increased crude production would not alleviate current refining constraints in the U.S.

The spot price per barrel for West Texas Intermediate was up for the week by $0.95 per barrel to close at $68.95 per barrel.

STOCKS

Equities took a downturn last week with higher interest rates and higher oil prices cutting into traders’ views on returns on equities. Monday, however, started the week with markets focusing mainly on higher oil prices and profit taking from gains the prior week. Equities generally slipped, primarily due to the profit taking. Monday’s modest dip was led by the transportation sector which felt the pressure of higher oil prices. Tuesday saw a dip in interest rates which boosted stocks modestly. A dip in housing starts was reported in the morning and supported the slippage in interest rates for the day and in turn boosted equities. Stocks dropped sharply on Wednesday with the Dow down almost 150 points. Good news on crude oil stocks and a drop in oil prices supported equities early Wednesday as did Home Depot’s announcement of a buyback and Morgan Stanley’s spectacular earnings report. But interest rate worries led to a sharp change in psychology during the day as buying interest withered and all major sectors declined by close. Talk of two Bear Stearns' hedge funds nearly going under due to sub-prime related losses also pushed the markets down. Bear Stearns was forced to pump $3.2 billion into saving the funds. Thursday saw a rebound in most equity indexes with the tech sector leading the way. A drop in oil prices and a sharp rise in the Philly Fed manufacturing index boosted equities. The Conference Board’s index of leading indicators posted a 0.3 percent rise for May and also provided ild support for equities on Thursday. Weekly jobless claims were up but were still seen as in a healthy range. Stocks were hit hard on Friday with the Dow dropping just over 185 points. A number of factors were responsible – concern over the possibility of additional hedge funds succumbing to sub-prime fallout and continued interest rate worries. Also, some investors were sitting on the sidelines, waiting for the scheduled rebalancing of some Russell indexes with some firms being removed and others being added. Private equity firm Blackstone debuted on the New York Stock Exchange Friday at a substantial premium over what underwriters paid for the stock the day before, but excitement over Blackstone could not turn the overall market positive.

Last week, all major indexes were down significantly: the Dow, down 2.0 percent; the S&P 500, down 2.0 percent; the Nasdaq, down 1.4 percent; and the Russell 2000, down 1.6 percent.

Year-to-date, the Dow is up 7.2 percent; the S&P 500, up 5.9 percent; the Nasdaq, up 7.2 percent; and the Russell 2000 is up 6.0 percent.

BONDS

The yield curve was down except on the ends with the 3-month T-bill up and the long bond unchanged.  Rates were flat to down incrementally on Monday. Rates were under mild downward pressure from a drop in the National Association of Home Builders’ index to its worst level since February 1991. Rates fell moderately on Tuesday in response to a decline in housing permits – the first reported decline out of the latest four months. Rates rose on Wednesday despite a drop in oil prices. A rate hike by Sweden's central bank and hawkish minutes from the Bank of England led traders in the U.S. to boost Treasury rates. Interest rates were mixed on Thursday with long rates up and short rates flat to down slightly. Worries over further fallout from sub-prime hedge funds and a rate increase by the Taiwan Central Bank pushed up long rates while flight to quality appears to have nudged short rates down. Rates dipped in Friday except for the 3-month T-bill which edged up. The decline in rates was due to some easing in concern over additional hedge fund losses related to sub-prime lending.

Net for the week the Treasury yield curve was down except for both ends. Yields were down as follows: 2-year T-note, down 10 basis points; 3-year, down 8 basis points; 5-year, down 6 basis points; and the 10-year bond, down 1 basis point. The 3-month T-bill rose 16 basis points while the 30-year bond was unchanged from the prior week.

Most interest rates dipped last week but remain near cyclical highs. The 3-month T-bill has basically made a U-turn, rising sharply for the week.

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 had only limited economic news. We got an update on housing in the housing starts report and the Philly Fed manufacturing survey provided insight into June manufacturing activity in the mid-Atlantic region.

Housing starts resume decline

Housing starts in May slipped 2.1 percent, following a revised 1.0 percent increase in April. May’s drop is the first after three consecutive gains, including a 6.0 percent boost in February and a 0.3 percent rise in March. In May, single-family starts declined 3.4 percent while multifamily starts posted a 3.1 percent increase. On a year-on-year basis, overall starts are down 24.2 percent in May.

The one minor story in the latest report is that the sharp drop in housing permits in April did not translate into huge weakness in starts in May. Permits in May rebounded, rising 3.0 percent, following April’s 7.1 percent drop. Housing permits stood at a 1.501 million unit annual pace, compared to 1.457 in April. All of the improvement, however, was in multifamily units. Single-family permits declined 1.8 percent while multifamily permits increased 16.5 percent. On a year-on-year basis, overall permits are down 21.7 percent in May.

Other housing indicators suggest that housing is still quite weak. The National Association of Home Builders’ housing market index fell back 2 points in June to 28 – the lowest level since early 1991. The pending home sales index produced by the National Association of Realtors declined 3.2 in April – the latest reading – and is 10.2 percent lower than April 2006.

The weak housing sector will likely continue to be a negative factor on GDP for the rest of the year and will also dampen consumer spending as home equity growth has slowed or even declined in some localities.

Philly Fed manufacturing survey shows improvement

The Philadelphia Fed's manufacturing survey has followed the lead of other manufacturing surveys, jumping to 18.0 in June from a modest 4.2 in May. The June reading is a significant improvement compared with near flat readings in prior months. New orders really picked up, rising to 18.3 in June from 8.7 the prior month.

The Philly Fed gain followed a similar boost in the New York Fed’s Empire State manufacturing survey which showed a jump to 25.75 in June from 8.03 in May. Other manufacturing indicators are showing similar strength – including a 0.8 percent increase in durables orders after a 5.1 percent surge the prior month. Manufacturing output was a little soft in May with a 0.1 percent gain, but followed healthier increases of 0.2 percent in April and 0.6 percent in March. Overall, manufacturing indicators – including the latest surveys – are pointing toward moderate strength in manufacturing rather than excessively robust future gains.

The Philly Fed survey showed mixed results on the inflation front. Prices paid edged down but remained high with a reading of 29.7, compared to 32.3 in May. But pressure on the input side is still well contained as prices received showed only modest pressure at 5.1 versus 2.2 in May. Most of the pressure in prices paid appears to be energy related.

The bottom line

Last week had limited economic data. The housing starts data showed housing to be much as expected – still weak. Meanwhile, the Philly Fed manufacturing survey indicated that manufacturing is improving – suggesting that the economy is strengthening after a flat first quarter.

Looking Ahead: Week of June 25 through June 29

Next week brings in a heavy dose of economic data with new information on home sales and on the manufacturing sector. On Thursday, the Fed will release it FOMC statement. The week winds up focusing on the consumer sector with the personal income report.

Monday

Existing home sales fell 2.6 percent in April to an annual rate of 5.990 million that was below outside expectations. Sales are at a cycle low and are down 16.9 percent from the cycle peak of 7.210 million units set in September 2005. While employment has been moderately healthy, other factors are working against a pickup in sales for now. Mortgage rates have picked up substantially in recent months and lenders have tightened lending standards. While markets have low expectations for sales, supply will be a key focus since supply overhang is weighing on new construction. Supply jumped to 8.4 months in April from an already high 7.4 months in March.

Existing home sales Consensus Forecast for May 07: 5.99 million-unit rate
Range: 5.85 to 6.15 million-unit rate

Tuesday

The Conference Board's consumer confidence index jumped in May to 108.0 from 106.3 in April. Gains in May were evenly spread between expectations, at 89.2 vs. 88.2 in April, and the present situation, 136.1 in May vs. 133.5 the month before. More recently factors affecting consumer confidence have been mixed. Employment has been positive, stocks have been volatile, interest rates have risen, and oil prices have spiked.

Consumer confidence Consensus Forecast for June 07: 105.0
Range: 103.0 to 108.0

New home sales showed more strength in April than existing home sales, jumping 16 percent to an annual unit rate of 981,000. Improvement was centered in the South where sales jumped 28 percent. Importantly, supply fell to 6.5 months from 8.1 in March. Apparently, builders are waiting on a sustained improvement in supply before pushing new construction.

New home sales Consensus Forecast for May 07: 0.920 million-unit rate
Range: 0.850 million to 0.990 million-unit rate

Wednesday

Durable goods orders advanced 0.8 percent in April, following a 5.1 percent boost in March. While housing’s weakness has drawn out longer than many expected a few months ago, manufacturing seems to be gaining some strength and the durables report has been one such indicator suggesting this improvement. We also have seen more recent improvement in some of the regional manufacturing surveys such as Empire State and Philly Fed. But back to the durables report, markets will as usual sort out how much strength or weakness is in the transportation component which includes the very volatile aircraft component. Excluding transportation, new durables orders rose 1.9 percent, following a 1.6 percent advance in March. Markets expect a dip in May due to a decline in Boeing orders.

New orders for durable goods Consensus Forecast for May 07: -1.5 percent
Range: -3.8 percent to +1.2 percent

Thursday

Last month, GDP for first quarter real GDP was revised down to an annualized 0.6 percent from the initial estimate of 1.3 percent. The first quarter GDP price index was unrevised from the initial estimate of 4.0 percent and matched consensus expectations. The core PCE price index also was unrevised and came in at 2.2 percent. For the final revision to the first quarter (until annual revisions), markets are expecting a small upward revision. However, the flat first quarter is now old news as most are expecting second quarter growth in excess of 3 percent.

Real GDP Consensus Forecast for final Q1 07: +0.8 percent annual rate

Range: +0.5 to +1.0 percent annual rate

GDP price index Consensus Forecast for final Q1 07: +4.0 percent annual rate
Range: +4.0 to +4.0 percent annual rate

Initial jobless claims jumped surprisingly in the June 16 week, up 10,000 to 324,000 and the highest level in about two months. There were no special factors to explain away the increase.

Jobless Claims Consensus Forecast for 6/23/07: 319,000
Range: 305,000 to 327,000

FOMC announcement

The Federal Reserve has been on hold on monetary policy since the last 25 basis point increase on June 29, 2006. While core inflation numbers have been favorable recently, other factors are keeping inflation the primary concern for the Fed. Labor markets remain tight and food and energy inflation are threatening to spill into core inflation. And many economists expect second quarter GDP growth to exceed 3 percent. Essentially no one is expecting the Fed to cut rates at the end of the June 27-28 FOMC meeting but markets will be carefully reading the FOMC announcement for any changes in the Fed’s anti-inflation bias.

FOMC Consensus Forecast for 6/28/06 policy vote on fed funds target: unchanged at 5-1/4 percent

Range: 100 percent probability for no change based on fed funds futures

Friday

Personal income fell 0.1 percent in April, following a 0.8 percent jump the prior month. But April’s weakness was largely technical – reflecting the coming off of atypically strong months earlier. April income was pulled down by a 0.4 percent drop in wages & salaries income. April's wages & salaries component was coming off a first quarter surge in unusually large bonus payments and the exercise of stock options. Wages and salaries growth should resume tracking growth in employment, wages, and hours worked – which were healthy in May. Personal consumption expenditures increased a robust 0.5 percent in April, following a 0.4 percent rise in March. More recently, retail sales jumped 1.4 percent in May with gains broad-based. Excluding autos and gasoline, sales were up 1.0 percent in May. Markets also will be focusing on the core PCE deflator to see if it will track recent improvement in the core CPI. The core PCE price index rose a modest 0.1 percent in April, following no change in March. More recently, the core CPI rose 0.1 percent in May.

Personal income Consensus Forecast for May 07: +0.6 percent
Range: +0.4 to +0.9 percent

Personal consumption expenditures Consensus Forecast for May 07: +0.7 percent
Range: +0.5 to +1.0 percent

Core PCE price index Consensus Forecast for May 07: +0.1 percent
Range: +0.1 to +0.2 percent

The NAPM-Chicago purchasing managers’ index jumped to 61.7 in May from 52.9 in April. This report – which covers both manufacturing and non-manufacturing – is notoriously volatile due to a relatively small sample size. However, other regional manufacturing surveys have been showing a resurgence in strength and markets will be watching to see if this carries over to the Chicago survey.

NAPM-Chicago Consensus Forecast for June 07: 57.5
Range: 55.0 to 61.0

The University of Michigan’s Consumer sentiment index fell back in early June, to 83.7 from 88.3 in May. While there is no component on the issue, high gas prices likely were responsible for the dip. Additionally, 12-month inflation expectations rose two tenths to 3.5 percent – likely concern for the Fed. Officials within the Fed have been focusing on the importance of anchoring inflation expectations.

Consumer sentiment Consensus Forecast for final June 07: 84.0
Range: 82.5 to 85.0

Construction spending edged up 0.1 percent in April, following a 0.6 percent boost in March. While housing starts dipped 2.1 percent in May, the three prior gains in housing starts should still support construction outlays in the residential component – construction outlays reflect a lagged pattern of a number of months of starts.

Construction spending Consensus Forecast for May 07: +0.2 percent
Range: -0.3 to +2.0 percent