Economy shifting from consumer to exports
By R. Mark Rogers, Senior Economist, Econoday
October 12, 2007
This past week we saw significant differences between strong headline numbers and underlying detail for both producer prices and retail sales and the Fed is having to sort out which better portrays the economy. Are producer prices really as soft as the recent core numbers or will high oil prices spread into core inflation' Is the consumer as strong as headline retail sales for September or did special factors overstate strength for the month' While the Fed is sorting out those issues heading into the October 30-31 FOMC meeting, one thing is becoming clearer – the economy is shifting from dependence on robust consumer spending to more on strong export growth.
Equities were mixed last week with techs posting a healthy gain, the blue chips up slightly, and the small caps down moderately. Overall, the markets started the earnings season off cautiously. Stocks dipped on Monday ahead of earnings reports, which were feared to be coming in on the soft side. Financials were particularly weak after Merrill Lynch warned the previous Friday of a coming quarterly loss and big charge due to mortgage market problems. Transports also were weak on Ryder System lowering third quarter forecasts. But on Tuesday the equity markets had on their rose colored glasses, reacting positively to the release of the minutes of the Fed’s September 18 FOMC meeting. Equities took the view that the Fed was likely to make another rate cut by year end – in contrast to the bond market’s negative reaction that the Fed is not likely to cut on October 31.
The Dow and S&P 500 closed at historical highs on Tuesday. Starting earnings season after close on Tuesday, Alcoa’s earnings missed slightly and set the tone for Wednesday. Also, the Dow was weighed down Wednesday by Boeing announcing a delay in deliveries of its 787 Dreamliner planes and by profit warnings from Chevron and others. But techs did quite well with upside performance by Google and Research in Motion. Costco, with strong earnings, also supported the Nasdaq. Thursday saw widespread losses led by techs. Techs fell on rumors of downgrades and on profit taking. Markets overall were hurt by comments by a European Central Bank official that the ECB may be raising interest rates soon due to inflation problems. Such a move would reduce the Fed’s ability to cut rates in the U.S. Equities rebounded across the board on Friday on favorable retail sales data and an improved earnings outlook from McDonald’s. Techs were led higher by M&A activity. The Dow and the S&P 500 closed the week just shy of record highs set earlier in the week.
Last week, major indexes were mixed. The following major indexes were up as follows: the Dow, up 0.2 percent; the S&P 500, up 0.3 percent; and the Nasdaq, up 0.9 percent. The Russell 2000 was down 0.4 percent.
Year-to-date, the Dow is up 13.1 percent; the S&P 500, up 10.1 percent; the Nasdaq, up 16.2 percent; and the Russell 2000, up 6.8 percent.
Except for the long bonds, rates headed up last week – especially on the near end. The bond market took Columbus Day off but Tuesday gave the market a lot to think about with the release of the Fed’s minutes of the September 18 FOMC meeting. Essentially, the minutes gave the markets no indication that the Fed would be cutting interest rates again at the upcoming October 30-31 FOMC meeting. Treasury bill and note rates rose on release of the minutes while long bonds were little changed. During the week, off and on concerns over the subprime impact on the financial sector led to a mid-week dip in rates on 2-year, 3-year, and 5-year Treasury notes as these were seen as relatively liquid safe havens. But even rates on notes were pressured upward by the impact of the Fed minutes. While movement in rates on notes and bonds was choppy, the 3-month T-bill rate rose steadily throughout the shortened week as the market increasingly believed that the Fed will not be easing at the end of October. Helping support this view was a strong headline number for September retail sales released this past Friday. The rate on the 3-month T-bill was most affected by changing views on likely Fed moves because the 3-month Treasury is most competitive with the fed funds rate which is a short-term interest rate.
Treasury yields were up as follows in the week: 3-month T-bill, up 22 basis points; 2-year T-note, up 15 basis points; 3-year, up 11 basis points; the 5-year, up 8 basis points; the 10-year bond, up 4 basis points; and the 30-year bond, up 3 basis points.
Short-term rates continue to rise as an October cut in interest rates by the Fed is seen as increasingly unlikely. Bond rates remain elevated since mid-September over somewhat higher inflation premiums.
Oil prices set another record close at week end but it did not start that way. Oil prices dipped on profit taking at the start of the week, with spot prices for West Texas Intermediate falling $2.18 per barrel on Monday and slipping below the $80 mark to settle at $79.02 per barrel. The rest of the week, however, was spent with prices steadily heading back toward and over the historical high set in late September. Boosting prices were a U.S. government forecast for a cold winter, news of a fire at a BP production unit in Prudhoe Bay, Alaska, an unexpected drop in crude oil inventories, saber rattling by the Turkish government on planning a military incursion into Kurdish areas of northern Iraq, as well as strong retail sales numbers. In particular, Thursday saw a $2.33 per barrel surge over concerns over low inventories.
The spot price for West Texas Intermediate rose $2.49 per barrel for the week to close at $83.69 per barrel - $0.27 per barrel above the previous record close of $83.42 per barrel set on Friday, September 21.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
News on the economy was dominated last week by the Fed’s FOMC minutes, retail sales, and producer prices.
The latest minutes from the Fed for its September 18 policy meeting indicate that the Fed decisively cut the fed funds target rate by 50 basis points due both to concerns about instability in the financial markets and over the credit crunch’s likely impact of weakening economic growth. Nonetheless, the bottom line from the minutes is that the Fed remains concerned about too weak economic growth and also the risk of high inflation. But as noted with the anti-inflation bias that ended up in the latest FOMC statement, currently the greater of these worries is inflation. But both the minutes and more recent Fed Speak leave the door wide open for the Fed to decide to either cut rates on October 31 or leave them unchanged and neither the minutes nor recent Fed Speak tip their collective hand on which is likely.
What tipped the balance and motivated the Fed to cut rates on September 18' The minutes of the FOMC meeting show that the Fed was clearly concerned about subprime credit problems leading to more adverse effects on the economy. The Fed was particularly concerned about how financial markets essentially were seizing.
"Short-term financial markets came under pressure over the intermeeting period amid heightened investor unease about exposures to subprime mortgages and to structured credit products more generally.” The result was that some issuers of subprime mortgages found it difficult to roll over maturing mortgage-backed assets. “As a result, asset-backed commercial paper outstanding contracted substantially. Investors sought the safety and liquidity of Treasury securities, and yields on Treasury bills dropped sharply for a period; trading conditions in the bill market were impaired at times.” The Fed noted that banks became cautious and “took measures to conserve their liquidity.” Along with loosening lending practices at the discount window (extended lending periods), the Fed primarily cut rates to unseize the credit markets and to limit the impact of subprime lending problems and also housing’s decline on the rest of the economy.
Basically, the Fed saw the risks of not cutting rates greater than cutting rates. In effect, the rate cut was an insurance policy to keep the economy growing.
But how does the Fed see the economy in coming quarters' The Fed lowered its outlook for real growth in the fourth quarter slightly but still sees growth rebounding thereafter due to a strong international sector and business investment while the consumer continues to contribute positively.
The FOMC members remain cautious on inflation risks, however. The Fed acknowledged recent improvement in core inflation but is taking a longer-term focus. The Fed still sees upside risks from "rising unit labor costs," high resource utilization, and a decline in the dollar. Notably, the FOMC apparently never did believe that labor markets were as weak as indicated by the initially reported decline in August payrolls.
But net, the markets are seeing the combination of the Fed minutes position on whether there will be a rate cut as being data dependent. More recent, healthy-on-average economic data suggest that there will be no rate cut on Halloween afternoon but that rate cuts will be more spread out than believed immediately after the September 18 cut. Additionally, Fed officials this past week generally reiterated that markets should not assume a rate cut on October 31 and that the decision is still data dependent.
Two key real sector indicators that came out last week were retail sales and international trade. Two important take-aways from those reports are that they suggest the economy is strong enough that the Fed does not need to ease again immediately and that the economy is undergoing an important transition – that of being less dependent on the consumer and more on exports.
Retail sales in September surprised the markets with better-than-expected numbers – especially after recently soft chain store sales numbers. Overall retail sales rose 0.6 percent in September, following a 0.3 percent gain in August. Excluding auto sales, retail sales rose 0.4 percent in September, following a 0.4 percent drop in August. Excluding both motor vehicles and gas stations, retail sales posted a more moderate 0.2 percent gain, following a 0.1 percent dip the month before.
Even though a “core” spending figure was modest, on average spending was healthy with strength spread in numerous components. September’s increase in overall sales was led by gasoline sales, up 2.0 percent; motor vehicles, up 1.2 percent; and electronics, up 0.9 percent. Also strong were food & beverage stores, health & personal care stores, and nonstore retailers. Weakness was primarily in miscellaneous store retailers and sporting goods, down 1.3 percent and 0.7 percent, respectively. Furniture stores, clothing stores, and general merchandise stores also were weak. Nonetheless, strength was pervasive enough in the report to likely convince the Fed that the consumer sector does not yet need further stimulus from another rate cut.
With the exception of coming out of the first quarter slow-down at the first of this year, retail sales have been on a slowing trend since early 2006.
The latest international trade report emphasizes some recent economic trends with a narrowing in the U.S. trade gap in August. Exports continue to support economic growth in the U.S. due to strong economic growth overseas and a weak dollar. However, import trends suggest that domestic demand may be moderating. Although the weak dollar is of concern to the Fed on the inflation front, continued positive gains in exports help alleviate Fed worries about too much of a slow-down in economic growth, reducing the likelihood for an October rate cut.
What are the details' The nation's trade gap narrowed noticeably in August to $57.6 billion from a revised $59.0 billion in July. The improvement reflects both a decline in imports and a rise in exports.
The merchandise trade gap (Census basis) in August improved to $64.5 billion from a revised $65.5 billion deficit in July. Within merchandise trade, export strength was in industrial supplies, up $927 million; food, feeds & beverages, up $606 million; and consumer goods, up $186 million. Capital goods were down $216 million while automotive exports were down $952 million. However, both of these declines were coming off very strong numbers in July with the capital goods swing in the volatile civilian aircraft component. Overall, exports remain on a healthy uptrend.
Import weakness was led by industrial supplies, down $689 million; automotive, down $379 million; and consumer goods, down $201 million. Lone strength was in capital goods which posted a $330 million increase. The import numbers are showing some softening in consumer spending in the U.S. while investment in capital equipment is holding up so far.
Overall, the numbers are showing a slowing in domestic demand in the U.S. but indicate exports are providing a boost to the economy. The narrowing of the trade gap will add to third quarter GDP growth.
The latest international trade report is mixed in terms of impacting Fed thinking. In the very near term, with exports up and the gap down, there is not yet a compelling case for an immediate additional rate cut. Also, on the side of Fed restraint is the related fact of a weak dollar – which both boosts exports but also boosts imported inflation. On the other hand, the latest report implies a slowing in consumer spending and if that continues it will give the Fed more room to consider lower interest rates sooner than later.
Overall producer prices in September rebounded sharply on higher oil prices while the core rate was subdued, giving the Fed a mixed picture on inflation. The overall PPI rebounded 1.1 percent, following a 1.4 percent drop in August. However, the core rate slowed to a 0.1 percent rise in September, following a 0.2 percent gain in August.
For the overall PPI, the rebound was primarily due to an increase in energy prices. By special groupings, energy increased 4.1 percent, following a 6.6 percent drop in August. Consumer food prices rebounded a sharp 1.5 percent, following a 0.2 percent dip the month before. Within the core index, consumer goods rose 1.6 percent while capital equipment prices slipped 0.1 percent.
Both the overall PPI and the core PPI are somewhat elevated on a year-on-year basis. The year-on-year rate for the overall PPI jumped to up 4.4 percent in September from up 2.1 percent in August. The year-on-year core rate came in at 2.0 percent in September, compared to up 2.2 percent in June.
From the Fed’s perspective, while the core looks good, a major issue is whether higher oil prices will be feeding into overall inflation – another reason for the Fed to defer a rate cut.
Import prices surged in September, largely on higher oil prices. Nonpetroleum oil prices edged down in the latest month but a peek at components raises the issue of whether import prices for the consumer are stronger than most have noticed. Import prices jumped 1.0 percent in September reflecting a 5.4 percent surge in petroleum prices. But excluding petroleum, import prices dipped 0.2 percent in September for a year-on-year increase of 2.0 percent.
But the decline in nonpetroleum import prices was primarily due to a 1.4 percent drop in industrial supplies & materials excluding petroleum. Imported capital goods prices were flat in September. But autos and consumer goods excluding autos both rose 0.2 percent in both September and August. Indeed, strong demand worldwide and a weak dollar are boosting import inflation for the consumer as seen in year-on-year rates.
First, year-on-year rates are up 5.2 percent for import prices overall while nonpetroleum import prices are up 2.0 percent in September. Petroleum import prices on the same basis are up 20.1 percent.
Since early 2006, there has been a steady uptrend for import price inflation for consumer goods. For automotive, the year-on-year rate is now 1.1 percent, compared to 0.5 percent as recently as September 2006 and negative rates in 2002. For consumer goods excluding autos, the September rate stood at 1.5 percent, compared to minus 0.3 percent in April 2006 and even lower negative numbers in 2002. Import inflation has been rising for the consumer – a key concern for the Fed.
The latest retail sales and international trade numbers are telling the Fed that the economy is holding up reasonably well despite the recession in housing and the credit crunch. Higher oil prices and imported consumer goods prices keep the Fed worrying about their impact on inflation. We still have plenty of important data this coming week, but currently the case for an October 31 rate cut by the Fed is not compelling. Meanwhile, the economy continues to grow but with a shift away from the consumer and toward exports.
This coming week has a number of market moving indicators that also could tip the balance on whether the Fed eases again on October 31. For manufacturing, we get updates on industrial production as well as the Empire State and Philly Fed manufacturing surveys. Housing starts for September give us an update on the recession in housing. The all important CPI report gives the Fed a key inflation indicator before its upcoming policy meeting. Also, at mid-week, the Fed issues its Beige Book report – a compilation of anecdotal data from regional Fed banks that the Fed is giving more attention to than usual since the July/August credit crunch.
The Empire State manufacturing index fell back from 25.1 in August to 14.7 in September as a number of manufacturing surveys are indicating a moderation in manufacturing. Also indicating a slowing were new orders, shipments, and the employee workweek although the index for the number of employees did rise somewhat. Both price indexes showed a firming in price pressure with the prices paid index rising from 34.4 in August to 35.1 in September while prices received increased from 3.2 to 11.7.
Empire State Manufacturing Survey Consensus Forecast for October 07: 12.5
Range: 9.5 to 18.5
Industrial production increased by 0.2 percent in August, following a 0.5 percent boost in July. However, the latest gain was based on an isolated spike in utilities output as manufacturing production slipped. The manufacturing component fell 0.3 percent in August, following a 0.7 percent boost in July. For August, utilities output surged 5.3 percent from higher electricity production while mining output fell 0.6 percent. Since manufacturing is a leading cyclical part of the economy, the Fed will be closely watching whether this sector rebounds after the August dip. Another decline in manufacturing in September would make another Fed rate cut on October 31 almost certain. Overall capacity utilization was unchanged at 82.2 percent in August but the capacity utilization rate for manufacturing fell to 80.7 percent in August from 81.0 percent in July.
Industrial production Consensus Forecast for September: +0.1 percent
Range: -0.3 to +0.3 percent
Capacity utilization Consensus Forecast for September 07: 82.1 percent
Range: 81.8 to 82.4 percent
The consumer price index in August fell 0.1 percent, following a 0.1 percent up tick in July. A sharp 3.2 percent drop in the energy component was responsible for pulling down the overall CPI in the latest month. For August, the core CPI inflation rate posted a 0.2 percent increase, after rising 0.2 percent in each of the prior two months. In the latest FOMC minutes, the Fed acknowledged that core inflation has been relatively well behaved in recent months but still maintained that upside risks remain on inflation staying too high. Markets are expecting higher oil prices to boost overall consumer prices so a tame core number is really needed for the Fed to feel good about handing out a treat — another rate cut — Halloween afternoon.
CPI Consensus Forecast for September 07: +0.2 percent
Range: +0.1 to +0.4 percent
CPI ex food & energy Consensus Forecast for September 07: +0.2 percent
Range: +0.1 to +0.2 percent
Housing starts fell 2.6 percent in August to a 1.331 million unit rate, the lowest rate since June 1995. Permits fell more steeply, down 5.9 percent to a 1.307 million rate, also the lowest rate since June 1995. Everyone has essentially written this sector off for at least the near future — the big question being when is housing going to stop declining' Extremely high inventories of new and existing homes for sale point to another decline in starts in September. Also, the recent credit crunch likely cut into construction funding for builders. Between unsold inventories and financial difficulties of some homebuilders, starts could be under heavy pressure for a few months. This and additional ripple effects of housing weakness on consumer spending could help nudge the Fed into a rate cut on October 31.
Housing starts Consensus Forecast for September 07: 1.30 million-unit rate
Range: 1.25 million to 1.35 million-unit rate
The Beige Book prepared for the October 31 FOMC meeting is released today at 2:15 p.m. ET. Very little of official government data on the economy is current enough to give the Fed a view of how the economy is doing since the July/August credit crunch and the September 18 cut in the fed funds target. Hence, the Fed likely is still giving the anecdotal information in the Beige Book more weight than usual in helping to decide on whether to cut interest rates. The Fed will be balancing the information on the real economy versus that on inflation fundamentals. Watch for commentary on whether the consumer sector is slowing too much and whether wage pressures are easing or firming. A new wrinkle might be whether the declining dollar is creating upward pressure on prices. These are the key areas on which Fed officials have expressed concern.
Initial jobless claims fell 12,000 to 308,000 in week ending October 6 week, bringing down the four-week average to 310,250, the lowest level since early August. While employers are still cautious about hiring, employers also are very cautious about laying off quality workers with the labor market still tight. Initial claims have fallen in three of the last four weeks.
Jobless Claims Consensus Forecast for 10/13/07: 312,000
Range: 300,000 to 328,000
The Conference Board's index of leading indicators fell 0.6 percent in August, not quite reversing a 0.7 percent rise in July. The largest negatives in August were consumer confidence, jobless claims, and the stock market.
Leading indicators Consensus Forecast for September 07: +0.3 percent
Range: -0.3 to +0.6 percent
The general business conditions component of the Philadelphia Fed's business outlook survey index rebounded to 10.9 in September from a dead flat 0.0 reading in August. While not yet in the robust range, the Philly Fed index currently is alone among major manufacturing surveys with the notable improvement for the latest month. The ISM, Chicago-NAPM, and Empire State surveys either weakened in their latest reading or were only modestly positive. For the Philly Fed index, the latest report pointed toward continuing better health as both the new orders and shipments indexes showed moderate improvement. Price readings were mixed with prices paid up sharply but prices received down slightly.
Philadelphia Fed survey Consensus Forecast for October 07: 7.0
Range: 4.6 to 15.0
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