Bear kills rally
By R. Mark Rogers, Senior Economist, Econoday
August 6, 2007
Equities worked hard last week to make a comeback after a miserable week before. Even after the Friday payrolls report, it looked like a positive week overall but then Bear Stearns warned Friday afternoon of further credit problems, and equities ended the week with another round of losses. But the good news during the week was that the Fed might actually be hitting its inflation target.
On the inflation front, energy is the primary remaining question mark as oil prices set a new record close during last week. Monday was a quiet day in the oil markets, but on Tuesday crude closed at a record spot price of $78.21 for West Texas Intermediate. Prices were driven up heading into Wednesday’s petroleum stocks report with traders anticipating heavy demand and higher capacity rates at U.S. refiners to be announced in the report. Also, reports of violence in Nigeria bumped up prices. With a sharp drawdown in oil stocks actually reported on Wednesday, oil set an intraday high on Wednesday of nearly $79 per barrel but closed notably $1.68 per barrel lower for the day at $76.53 per barrel. Oil rose slightly Thursday with no notable drivers for the day. Crude oil fell $1.38 per barrel on Friday largely on the view that the morning’s jobs report points to slower economic growth than previously believed and on a revised outlook for the current hurricane season, calling for fewer hurricanes this year then previously expected.
The spot price per barrel for West Texas Intermediate was down last week by $1.54 per barrel to close at $75.48 per barrel.
Equities ended the week down sharply but it did not start out that way. All major indexes were up on Monday, temporarily ending the prior week’s selloff. There was no economic news but earnings were generally positive and confidence was boosted by GMAC which reduced its exposure to subprime mortgage problems and by Chicago hedge fund Citadel Investment Group which expressed willingness to buy up troubled loans. But confidence was trampled late Tuesday as mortgage lender American Home Mortgage announced it was unable to borrow and might have to liquidate assets. Record oil prices also weighed on equities outside the energy patch as did a sluggish Chicago purchasing managers report. Stocks stayed in negative territory for most of Wednesday after release of a sluggish ISM manufacturing report. But stocks ended the day up primarily due to bottom fishing as well as relief that rumors about problems at a major home builder were not true. Stocks rallied on Thursday despite an announcement by Accredited Home Lenders Holding that it was unsure it could stay afloat and by a news report that American Home Mortgage Investment Corp would be shutting down. Outside of financials, earnings were positive. Nokia helped boost techs for the day. Also, equities got a boost in confidence from an announcement by financial data processor Fiserv that it would be acquiring Checkfree with $4.4 billion of its own cash. Traders saw this as a positive and that deal making would continue despite subprime problems. With two consecutive end-of-session rallies, equities were looking positive heading into Friday’s employment report.
On Friday, investment bank Bear Stearns held a conference call in response to Standard & Poor’s downgrading the company’s debt outlook to “negative” from “stable.” Bear Stearns' CFO described the fixed-income market as the worst in his 22 years of experience. Financials immediately fell and the rest of equities soon followed. The fears of investors included the belief that other companies must have similar problems but just have not made them public yet. Also, the credit crunch is feared to be undermining deal making as well as reducing real capital investment by firms. The Dow fell 281.42 points for the day – the third biggest drop for the index this year.
Last week, all major indexes were down. Again the small caps suffered the most damage from Friday’s selloff. Major indexes were down as follows: the Dow, down 0.6 percent; the S&P 500, down 1.8 percent; the Nasdaq, down 2.0 percent; and the Russell 2000, down 2.9 percent.
For the month of July, major indexes were down – and for the second monthly net decline in a row. The Dow was down 1.5 percent; the S&P 500, down 3.2 percent; the Nasdaq, down 2.2 percent; and the Russell 2000, down 6.9 percent.
Year-to-date last week, the Dow is up 5.8 percent; the S&P 500, up 1.0 percent; and the Nasdaq, up 4.0 percent. The Russell 2000 is down 4.1 percent.
Interest rates fell further last week on both what was seen as a softening in the economy and on flight to quality. The week started in the other direction, however, as rates were bumped up notably on Monday. The day’s boost in equities and renewed confidence in stocks led to some unwinding of the prior week’s flight to quality. Rates fell on Tuesday due to a combination of factors. First, the morning’s personal income report posted a favorable core PCE number for the fourth consecutive month. A soft Chicago purchasing managers report also dampened rates but the key factor was flight to quality as subprime concerns again pummeled equities. Higher oil prices normally would have nudged rates up during the day but the flight to quality was too strong. On Wednesday, credit markets were more volatile than usual but rates generally ended up on funds moving into equities late in the day. Rates eased on Thursday but with little real conviction as traders prepared for Friday’s employment report. On Friday, rates eased a little on what was seen by many as a soft employment report. But prices for Treasuries surged Friday afternoon on a flight to quality after Bear Stearns' conference call. Funds flowed heavily from equities to Treasuries, pushing mid-range rates down double-digit basis points for the day.
The Treasury yield curve fell further last week. Yields were down as follows: 3-month T-bill, down 1 basis point; 2-year T-note, down 9 basis points; 3-year, down 8 basis points; 5-year, down 9 basis points; the 10-year bond, down 9 basis points; and the 30-year bond, down 7 basis points.
The flight to quality outweighed any concern over high oil prices last week. The 10-year Treasury bond is at its lowest rate since mid-May.
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 a little softening in manufacturing and continued good news on the inflation front. Some saw the consumer sector also softer from a sluggish jobs report, but the details of the employment report suggest that may not be the case.
The headline for the July employment report was that payrolls rose by “only” 92,000 – much lower than the expectation for a 125,000 boost and the gains of 126,000 in June and 188,000 in May. However, most of the softening in payrolls in July was in a 28,000 drop in government payrolls. Private payrolls rose by 120,000 in July after a 107,000 boost in June and by this measure the labor market is doing just fine. The decline in government jobs primarily was in local and state government education — categories that can have difficult-to-adjust seasonal swings at the start and end of summer.
On a year-on-year basis, nonfarm payroll employment rose 1.4 percent in July, down slightly compared to being up 1.5 percent in June.
Within the payroll survey, gains primarily were in service-providing industries – goods-producing industries were mostly down. Manufacturing slipped 2,000, following a 13,000 decline in June. Natural resources & mining jobs increased by 2,000 in July while construction fell 12,000 in June after rising 3,000 in June. Overall service-providing industries increased 104,000 in July, following a 133,000 gain in June.
The Fed certainly liked July’s wage number. Average hourly earnings increased 0.3 percent in July, after posting a 0.4 percent boost in June. The Fed has been concerned that a tight labor market might be pushing wages up faster than productivity gains. Average hourly earning are running at a 3.9 percent pace year-on-year.
The household survey showed some marginal loosening in July. The civilian unemployment rate edged up to 4.6 percent in July from 4.5 percent the month before. Household employment slipped 30,000 in July, following a 197,000 boost in June. The labor force rose 159,000 in July, while the number of unemployed rose 188,000.
Even though July’s unemployment rate is the highest since January’s 4.6 percent, it is going to take some more loosening in the labor markets to make the Fed happy. In the July semiannual report to Congress, the Fed projected the unemployment rate to be “4-1/2 percent to 4-3/4 percent” in the fourth quarter of 2007 and “about 4-3/4 percent” in the fourth quarter of 2008.
Overall, the July employment report indicates there has been incremental softening at the most in the labor markets. Employment growth remains healthy and the unemployment rate is still low and tight.
The Fed may be getting its wish for below trend economic growth and lower inflation if last week’s personal income report is any indication. But importantly income growth remains healthy. Personal income increased 0.4 percent in June, following a 0.4 percent gain also in May. Within personal income, the wages and salaries component posted a 0.5 percent gain in June, following a 0.5 percent rise the month before. The consumer clearly has the income for healthy spending even though personal income on a year-on-year slipped to up 6.1 percent from up 6.5 percent in May. This is still a healthy pace. But other factors – such as high gasoline prices – may be causing some consumer hesitation on the spending side.
Personal consumption edged up only 0.1 percent in June, following a 0.6 percent boost in May. Spending was led by services with a 0.5 percent increase while nondurables were flat and durables fell 1.6 percent.
But the biggest news from the personal income report was on core inflation. The core PCE price index rose 0.1 percent – the same as in the prior three months. And at least temporarily, the overall PCE price index eased, rising 0.1 percent in June, following a 0.5 percent jump in May. Energy was soft in June as gasoline prices have eased with U.S. refiners getting capacity up.
The core PCE price index now has a more convincing track record for having eased into the Fed’s implicit target range of 1 to 2 percent annualized growth. This index stood at 1.9 percent in June on a year-on-year basis, compared to 2.0 percent in May. Still, the Fed is likely to want to see further signs of improvement in inflation before cutting interest rates. But the Fed is likely to move to a neutral policy stance by the FOMC September meeting if these numbers hold up. Some even think the Fed will change its FOMC statement to neutral during the Tuesday, August 7 meeting, eliminating its anti-inflation bias.
Vehicle sales were soft once again in July. Domestic-made vehicles sold at an annual rate of 11.5 million, down from 11.6 in June and well down from a 12.2 million rate in May. The motor vehicle sales numbers suggest that the third quarter is getting off to a slow start.
The employment cost index rose an as-expected 0.9 percent in the second quarter for a year-on-year pace of 3.3 percent. These rates are moderate but any acceleration would be a concern for the Fed. The second quarter increase was led by the benefits component which was up 1.3 percent in the quarter for a 3.4 percent year-on-year rate. But the second quarter spurt was due to state and local governments boosting retirement and health plans and the 1.3 percent jump followed an unusually low 0.1 percent rise in the first quarter. Taken together, benefits are in line with wages & salaries, which rose 0.8 percent in the second quarter for a year-on-year pace of also 3.4 percent.
Both the ISM and Chicago purchasing managers reports came in weaker-than-expected for July. The ISM manufacturing index slipped in July to 53.8, down 2.2 points from June. New orders slowed a bit but are still at a solid 57.5, down 2.8 points from June. The Chicago purchasers' index – which also includes non-manufacturing firms in its survey – fell more sharply, to 53.4 in July from 60.2 in June. New orders in the Chicago survey also fell sharply, to 53.4 from 65.7 in June. Still, both indexes are notably above the flat readings at the first of the year, indicating moderate growth is still expected.
But the two surveys headed in opposite direction on the inflation front, In the ISM manufacturing report the prices paid index slipped to 65.0 from 68.0 in June while in the Chicago report prices paid rose to 73.1 in July from 68.1 the prior month.
The ISM non-manufacturing index eased to 55.8 in July from 60.7 in June, suggesting that the second half of 2007 may not be as strong as some have been expecting.
Despite some noise in the numbers, recent trends appear to be continuing in construction. Construction spending fell 0.3 percent in June, following a 1.1 percent surge in May. The June drop in construction was led by private residential outlays with public construction outlays flat. Private residential spending declined 0.7 percent in June, following a 0.6 percent drop the prior month. Private nonresidential outlays advanced 0.3 percent, after posting a 2.8 percent surge in May. Overall, both public construction and nonresidential construction remain on healthy up-trends, essentially offsetting the continuing decline in housing.
On a year-on-year basis, overall construction outlays edged up to down 2.4 percent in June from down 2.6 percent in May.
Economic growth does not follow a smooth path from month to month and the latest numbers show a modest deceleration from strong growth seen early in the second quarter. Currently, the end of the second quarter and start of the third indicates that the third quarter may be a little less robust than the 3.4 percent second-quarter real GDP pace. Core inflation is looking like it has come down to within the Fed’s target zone. Both of these trends fit the Fed’s plans.
This coming week brings only a few indicators, focusing mainly on inflation trends with the productivity and import price reports. The highlight will be Tuesday’s FOMC meeting announcement on the Fed’s monetary policy.
Nonfarm productivity rose an annualized 1.0 percent in the first quarter – low pace held down by the first quarter’s weak output. Second quarter productivity should be up, reflecting stronger GDP growth. Unit labor costs were better behaved in the first quarter with a 1.8 percent rise, following an 8.9 percent spike in the fourth quarter. The Fed certainly will be reviewing this report Tuesday morning before the FOMC votes on monetary policy later in the day.
Nonfarm Productivity Consensus Forecast for initial Q2 07: +2.1 percent
Range: +1.4 to +3.0 percent
Unit Labor Costs Consensus Forecast for initial Q2 07: +1.6 percent rate
Range: +0.5 to +3.0 percent rate
The FOMC announcement for the August 7 FOMC policy meeting is expected to leave the fed funds target unchanged where it has been since the June 2006 policy meeting. The big question is whether the Fed will change its anti-inflation bias in the statement and move to a neutral position. Given the recent string of good core inflation numbers, this may be the meeting in which the Fed makes that change in its policy stance.
FOMC Consensus Forecast for 12/12/06 policy vote on fed funds target: unchanged at 5-1/4 percent
Range: 87.6 percent probability for no change and 12.4 percent probability for a 25 basis point cut based on fed funds futures close on August 3
Consumer credit jumped $12.9 billion in May showing big gains for both revolving credit, up $7.2 billion, and non-revolving credit, up $5.7 billion.
Consumer credit Consensus Forecast for June 07: +$4.0 billion
Range: +$2.0 billion to +$8.2 billion
Initial jobless claims rose only 4,000 to 307,000 for the week ending July 28. Labor markets remain tight as the four-week average fell by 3,500 to 305,500.
Jobless Claims Consensus Forecast for 8/4/07: 310,000
Range: 306,000 to 315,000
Import prices increased 1.0 percent in June – a strong pace but lower than May's increase of 1.1 percent. Excluding petroleum, import prices edged up only 0.2 percent in June.
Import prices Consensus Forecast for July 07: +1.0 percent
Range: -0.2 to +1.8 percent
The U.S. Treasury monthly budget report showed a surplus of $27.5 billion in June, pushing down the fiscal-year-to-date deficit to $121.0 – well down from $206.5 billion at this time last year. Looking ahead, the month of July typically shows a moderate deficit for the month. Over the past 10 years, the average deficit for the month of July has been $30.7 billion.
Treasury Statement Consensus Forecast for July 07: -$34.0 billion
Range: -$60.0 billion to -$26.5 billion.
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