Subprime woes send equities plummeting
By R. Mark Rogers, Senior Economist, Econoday
July 27, 2007
Last week saw sharp declines in equities and in bond rates with subprime concerns being the primary factor behind both. Subprime concerns led to downgrading of many financial stocks with many traders and investors worrying about a credit crunch. Poor earnings also led to movement of money from equities into the safety of bonds. A favorable GDP report at the end of the week provided some support for the markets but could not keep the bears at bay.
Crude spot oil prices continued upward last week despite some sizeable dips along the way. Prices dipped about a buck each day on Monday and Tuesday due to comments by OPEC officials that oil prices are too high. Oil jumped almost two-and-a-half bucks per barrel on Wednesday as the government’s weekly inventory report said crude stocks fell 1.1 million barrels as U.S. refiners boosted capacity to catch up with demand. Prices continued upward on Thursday, largely over concern from Wednesday’s report of lower crude inventories. Friday saw a spike of just over $2 per barrel as a stronger-than-expected second quarter GDP report led traders to believe that demand for oil will be stronger than previously believed. Additionally, analysts cut their projections for non-OPEC oil output due to declines in production by Norway, Mexico, and others.
The spot price per barrel for West Texas Intermediate was up last the week by $1.45 per barrel to close at $77.02 per barrel. Spot prices are now equal to the peak close set in July 2006 at just over $77 per barrel.
Equities fell sharply last week with subprime concerns being the primary factor. Earnings were mixed but more disappointing than surprising on the upside. However, the week started on a positive note. Equities rebounded from the prior week’s selloff with help from merger activity plus a positive surprise on earnings from Dow component Merck. The Dow ended the day up almost 100 points. Stocks reversed course on Tuesday on disappointing earnings from Texas Instruments, DuPont, American Express, and Countrywide Financial. Countrywide unsettled the markets by cutting its full-year outlook and commenting on the dismal state of housing. Comments by a bond fund manager that subprime problems were spilling over to junk bonds further rattled the markets. Talk turned to the possibility of a liquidity crisis in the credit markets. The Dow was down about 230 points for the day. Stocks made a partial rebound on Wednesday thanks to upside news from Amazon.com and Boeing. But dismal existing home sales news dampened the rally.
Thursday saw all major indexes taking big hits due to concern over a worsening in housing and credit markets. The Dow fell a fraction under 441 points – surpassing the 416 point loss on February 27. The nation’s number two homebuilder, D.R. Horton, announced massive losses, further weighing on equities on Thursday. A weak report on new home sales added to the bearish mood. A couple of key positive announcements could not stop the bloodbath. Ford surprised nearly everyone by announcing a second quarter profit. Apple also beat estimates despite talk earlier in the week about possibly disappointing sales of iPhone. A number of homebuilders reported losses after Thursday’s close, setting a downside mood for Friday. The last day of the week got initial support from a very favorable second quarter GDP report which posted a higher-than-expected growth rate of 3.4 percent along with moderate inflation. But the bears took over by late morning. The spreading impact of subprime problems in the financial sector simply outweighed the positive news of the day.
Last week, all major indexes were down. But the small caps bore the brunt of last week’s sell off. As is typical for selloffs, the blue chips benefited somewhat from flight to safety – but only enough to ease the damage. Major indexes were down as follows: the Dow, down 4.2 percent; the S&P 500, down 4.9 percent; the Nasdaq, down 4.7 percent; and the Russell 2000, down 7.0 percent.
Despite all of the noise last week, the equity declines were not terribly different from than those for the week ending March 2 – which included the sharp selloff of Tuesday, February 27. Of course, a rally followed. However, credit concerns were not as prevalent after the earlier stock market correction as now.
Year-to-date last week, the Dow is up 6.4 percent; the S&P 500, up 2.9 percent; and the Nasdaq, up 6.1 percent. The Russell 2000 is back in negative territory, down 1.2 percent.
Interest rates fell sharply last week – primarily on flight to quality. The week started quietly with rates little changed to up marginally on Monday with little negative news and even the stock market being positive. Tuesday saw a mild dip in rates from flight to quality as equities fell. Rates also benefited from a successful auction of 20-year inflation-protected bonds. Late day flight to quality nudged rates down further on Wednesday. Thursday bonds rose sharply as money flowed from equities and from lower quality credit instruments. This flight to quality continued on Friday.
The Treasury yield curve was down sharply across the board last week but especially mid-range. Yields were down as follows: 3-month T-bill, down 12 basis points; 2-year T-note, down 25 basis points; 3-year, down 30 basis points; 5-year, down 28 basis points; the 10-year bond, down 19 basis points; and the 30-year bond, down 13 basis points.
Flight to quality again pushed Treasury note and bond rates down significantly last week. This time it was as much the movement out of equities as the movement out of riskier fixed income products that boosted prices for Treasuries and pushed rates lower.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
Last week’s economic data showed housing continue to worsen but the economy overall may be stronger than most believed.
The second quarter GDP report came in with higher-than-expected real growth and lower-than-expected overall inflation. Second quarter real GDP strengthened to an annualized 3.4 percent from an anemic 0.6 percent pace in the first quarter. The second quarter growth rate was above the market forecast for a 3.2 percent boost in GDP and was the strongest increase since the 4.8 percent pace set in the first quarter of 2006. The stronger second quarter growth was primarily due to a jump in nonresidential structures investment, stronger exports, and a decline in imports. Government purchases also were boosted by a jump in defense spending. As expected, residential investment was quite negative. However, personal consumption growth slowed notably.
On the inflation front, the GDP price index slowed to 2.7 percent pace, following a 4.2 percent increase in the first quarter. The second quarter price index growth rate was well below the consensus projection for a 3.4 percent annualized increase. The core PCE price index also slowed to a 1.4 percent growth rate in the second quarter, after a 2.4 percent boost in the first quarter.
The latest GDP report shows something of a shift in relative strengths in the economy. Growth is being led by exports and business investment and the consumer may be easing back. By components, a narrowing in net exports boosted GDP notably as the gap narrowed from $612.1 billion in the first quarter to $577.9 billion in the second. In the latest quarter, exports rose an annualized 6.4 percent while imports fell 2.6 percent. Indeed, business investment is a key driver in the economy currently. Nonresidential structures investment jumped an annualized 22.1 percent. As expected, the big negative was a 9.3 percent decline in residential structures – but this was not as negative as the 16.3 percent drop the prior quarter.
A slowing in personal consumption may be a concern. Overall PCEs slowed to a 1.3 percent pace in the second quarter from 3.7 percent the prior quarter. In the latest quarter, durables rose 1.6 percent, nondurables fell 0.8 percent, and services advanced 2.2 percent. Certainly, some slowing in consumer spending is appropriate to bring overall growth down to the Fed’s target of somewhat under 3 percent for GDP over the next year. But the consumer sector does not need to slow too much.
Year-on-year, real GDP growth rose to 1.8 percent in the second quarter from 1.5 percent in the first quarter. Year-on-year, the GDP price index edged down to up 2.7 percent year-on-year in the second quarter from up 2.9 percent in the prior quarter. The core PCE deflator growth rate year-on-year stood at 2.0 percent in the second quarter, compared to 2.4 percent in the first quarter.
What did not get much play in the media were the annual revisions to GDP going back through 2004. Real growth was revised down for each of the last three years. For 2006, on an annual average basis, real growth was revised down 0.4 percentage points to 2.9 percent. We will see downward revisions to productivity as a result of these downward revisions to GDP. On a fourth-quarter-over-fourth quarter basis, growth for 2006 was revised down to 2.6 percent from 3.1 percent. It turns out that the Fed’s tightening did bring real growth down below potential growth of 3 percent, beginning to ease inflation pressures somewhat over the year.
But inflation responds to changes in real growth with a lag. Last year did not see much slowing from the weaker GDP growth. In fact, overall inflation was revised up for the last three years. For 2006 on an annual average basis, the GDP price index rose 3.2 percent compared to the pre-revisions estimate of 2.9 percent. However, the core PCE price index was little revised. The core PCE deflator for 2006 came in at 2.2 percent on an annual average basis, the same as previously estimated and equal to the rise in 2005. However, 2005 previously had been estimated at 2.1 percent. At a minimum, the annual revisions are a reminder to Fed officials that they have a ways to go to get and keep the economy under potential long enough to bring inflation down on a sustained basis.
The Beige Book prepared by regional Fed banks for the upcoming August 7 FOMC meeting largely indicated that the U.S. economy continues to grow at moderate pace – above the flat first quarter. Relative strengths and weaknesses are much as in recent months. The consumer sector included spending rising at a “modest” pace although a number of districts reported sales to be “mixed or below expectations.” Various districts reported that higher gasoline and higher food prices have hurt spending. Sales related to housing – such as furniture and home repair materials – were declining or weak. Capital spending continues to increase at a healthy pace while housing continued to decline. House inventories were mixed but generally still high. Employment increased in most regions. A number of districts reported either tightening or tight labor markets.
On the inflation front, businesses reported higher input prices – notably for petroleum related inputs. Wage gains were “moderate and/or similar to the previous reporting period.” Manufacturers are increasingly optimistic. Strong export demand has increased activity. However, manufacturers of housing-related products typically reported declines.
The Fed report noted some marginal changes in the financial sector: “Household lending declined in most regions, while commercial and industrial lending expanded at a modest pace ... Household credit quality deteriorated marginally, while business credit quality remained mostly favorable.”
Overall, the Beige Book reports the economy much as the Fed had been anticipating in its latest report to Congress and very similar to the minutes of the last FOMC meeting. Economic growth is expected to remain at a moderate pace but inflation concerns remain due to tight labor markets and higher energy costs. The Fed will certainly continue to monitor the impact of subprime losses elsewhere in the economy. Overall, the Fed remains in wait and see mode with interest rates on hold.
The latest reports on home sales indicate that housing remains on a downtrend. Even what little good news there is at face value disappears after technical analysis. First, existing home sales sold at an annual rate of only 5.75 million in June, down 3.8 percent from May and at an 11.4 percent year-on-year decline. Year-on-year declines have been going on for more than a year-and-a-half with the latest decline, despite an easy comparison, the steepest so far this year.
Supply on the market remains swollen at 8.8 months, the same as May and a key factor that will limit new construction.
New home sales also declined after showing temporary strength earlier in the year. New homes sold at an annual rate of only 834,000, well below expectations and down 6.6 percent from May and down 22.3 percent on a year-on-year basis. Housing is swollen with supply at 7.8 months for new homes. Until supply is brought down, builders are going to continue to pull back on new construction.
What was the good news in the home sales reports' Sales prices for existing home actually rose 3.3 percent in the month to a median $230,100. The median price for a new home sold did fall 1.3 percent in the month to $237,900 but is only down 2.2 percent year-on-year. Is the deterioration in prices coming to an end' Unfortunately, the improvement in existing home sales prices and the holding up of new prices appear to be curious outcomes of shifts in the composition of homes sold. The prices are median prices and reflect monthly changes in the distribution of types of homes sold and where the homes were sold by region. With the subprime lending problems and tightening of subprime lending standards, fewer low end houses are being sold, boosting the share of higher cost homes being sold of the total. Additionally, the subprime problems hit the South the most and this region generally has housing that costs less than in other regions. These factors come together to result in an aggregate for median home prices that looks like firming when such is not the case if the distribution shift toward higher cost houses is taken into account.
Durable goods orders rebounded 1.4 percent in June, following a 2.3 percent drop in May. However, excluding the volatile transportation component, new orders continued to decline, falling 0.5 percent in May, following a 0.2 percent dip the prior month. Excluding defense, new durables orders posted a 1.9 percent increase, following a 2.7 percent decrease in May.
Strength in durables orders in June were mixed but overall they extended their upward trend of recent months. In fact, unfilled orders are holding up well. During times of heading into manufacturing weakness, unfilled orders start to disappear as orders are canceled. But that currently is not the case. Overall shipments fell 1.1 percent in June while unfilled orders posted a 1.5 percent boost. On a year-on-year basis, unfilled orders stood at up 19.7 percent in June – little-changed from 20.1 percent the month before.
It is going to be 2008 before housing picks back up. However, the overall economy is doing quite well despite the adjustments going on in the equity and bond markets. Oil is becoming an even bigger concern on the inflation front, however. Overall, the economy remains on a moderate growth path but a few question marks are popping up about the consumer sector.
Next week brings a long list of key reports. We will get new information on the health of the consumer sector with the personal income and the employment reports. The goods-producing sectors get updates from construction outlays and both ISM reports. And we get more inflation news with data on employment costs and on hourly earnings.
Personal income rebounded 0.4 percent in May, following a 0.2 percent dip in April. With moderately healthy wage and job growth in June, we should see another good gain for personal income. Inflation is still a concern for the Fed. We already have the second quarter core PCE price index coming in at 1.4 percent annualized but we do not know the distribution of softness for each month individually. The monthly numbers will give us a better idea of price inflation on the margin. The latest reports, however, showed the core PCE price index remaining soft, rising 0.1 percent in both May and April. The advance second quarter GDP report showed second quarter real personal consumption softening to an annualized pace of 1.3 percent – a very modest increase. The latest personal income report put the latest current dollar monthly numbers for consumer spending at 0.5 percent for both May and April. Some of the strength was price related from higher gasoline prices.
Personal income Consensus Forecast for June 07: +0.6 percent
Range: +0.4 to +0.6 percent
Personal consumption expenditures Consensus Forecast for June 07: +0.2 percent
Range: -0.1 to +0.5 percent
Core PCE price index Consensus Forecast for June 07: +0.2 percent
Range: +0.1 to +0.2 percent
The employment cost index for civilian employees rose a softer-than-expected 0.8 percent in the first quarter though the wage & salary component did show pressure, up 1.1 percent for the steepest gain in six years. The benefit reading, subdued by lower employer contributions to retirement plans, is the lowest in eight years. The Fed will be watching this release closely, given that labor markets remain tight. If the benefits component rebounds, the second quarter overall cost index could be quite strong.
Employment cost index Consensus Forecast for Q2 07: +0.9 percent simple quarterly rate
Range: +0.7 to +1.0 percent simple quarterly rate
The NAPM-Chicago purchasing managers’ index remained relatively strong in June at 60.2 vs. 61.7 in May. We could see some strengthening, given that new orders were strong in both May and June.
NAPM-Chicago Consensus Forecast for July 07: 58.0
Range: 56.0 to 64.0
Construction spending jumped 0.9 percent in May, following a 0.2 percent increase in April. The May increase was well above the market forecast for a 0.2 percent rise in construction outlays. We are likely to see a continuation of the trend for healthy gains in nonresidential and public construction offsetting a decline in residential outlays.
Construction spending Consensus Forecast for June 07: +0.2 percent
Range: -0.1 to +0.4 percent
The Conference Board's consumer confidence index fell sharply to 103.9 in June from 108.5 in May. Assessments of both the present situation and future outlook fell back. And inflation expectations failed to improve, showing 12-month expectations at 5.4 percent unchanged from May. But last week, the end-of-month reading of the Reuter’s/University of Michigan consumer sentiment index showed some strength, largely holding onto a mid-month level that was above June’s. A gain in the Conference Board’s index would help confirm that the consumer sector is not weakening.
Consumer confidence Consensus Forecast for July 07: 105.0
Range: 103.0 to 109.0
The Institute for Supply Management’s manufacturing index rose to 56.0 in June from 55.0 in May. New orders were especially strong, improving to 60.3 in June from 59.6 the prior month. Exports have been particularly robust and this is likely to continue given the weak dollar.
ISM manufacturing index Consensus Forecast for July 07: 55.0
Range: 54.0 to 56.7
Motor vehicle sales have been a soft sector for consumer spending with June sales for domestic made vehicles dropping to an 11.6 million unit pace from 12.2 million in May. Higher gasoline prices have especially cut into sales of light trucks – which include SUVs and minivans.
Motor vehicle sales Consensus Forecast for July 07: 12.2 million-unit rate
Range: 11.5 to 12.4 million-unit rate
Initial jobless claims dipped 2,000 in the July 21 week to 301,000. There were no special factors in the latest week. The four-week average of 308,500 is the lowest since early June. Claims clearly indicate that the labor market remains tight and that job growth continues at a reasonably healthy pace.
Jobless Claims Consensus Forecast for 7/28/07: 310,000
Range: 308,000 to 315,000
Factory orders fell 0.5 percent in May, pulled down by a 2.8 percent drop in durables orders (as estimated at that time). Nondurables posted a 1.6 percent gain for the month. More recently, durable goods orders rebounded 1.4 percent in June, following a revised 2.3 percent drop in May. We should see a moderate gain in overall orders for June.
Factory orders Consensus Forecast for June 07: +1.0 percent
Range: +0.5 to +1.8 percent
Nonfarm payroll employment posted a 132,000 gain in June, following a 190,000 jumped in May and 122,000 in April. Payroll gains have been healthy over the first half of 2007, averaging 145,000 per month. With initial unemployment claims declining in four out of the last five weeks, we are likely to see a somewhat strong jobs gain in July. Average hourly earnings eased slightly to a 0.3 percent in June from a 0.4 percent boost in May. Another 0.3 percent rise would be seen as favorable progress on the labor cost portion of inflation. The civilian unemployment rate was unchanged at 4.5 percent in June and remained barely above the cycle low of 4.4 percent most recently seen in March.
Nonfarm payrolls Consensus Forecast for July 07: +125,000
Range: +60,000 to +160,000
Unemployment rate Consensus Forecast for July 07: 4.5 percent
Range: 4.4 to 4.6 percent
Average workweek Consensus Forecast for July 07: 33.9 hours
Range: 33.8 to 33.9 hours
Average hourly earnings Consensus Forecast for July 07: +0.3 percent
Range: +0.2 to +0.4 percent
The business activity index from the ISM non-manufacturing survey was healthy in June, rising to 60.7 from 59.7 in May. Incoming orders remain brisk, at 56.9 vs. May's 57.4. Price increases for raw materials held steady at a moderate 65.5 vs. 66.4 in May.
Business activity index Consensus Forecast for July 07: 58.5
Range: 57.0 to 60.7
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