Equities defy soft economy and high oil prices
By R. Mark Rogers, Senior Economist, Econoday
October 26, 2007
This past week saw strong gains in the equity markets despite housing numbers still at recession levels, some softening in manufacturing, and new record highs for oil prices. And, no, earnings were not that great on average though there were a few bright spots last week. Essentially, the markets are betting on more interest rate cuts by the Fed not just on Wednesday of this coming week but again in coming months.
Last week equities ended up surprisingly strong. Gains were particularly notable for techs and small caps. But the gains were made against headwinds from negative economic data and a surge in oil prices. Stocks got some boost early in the week as investors, seeing the prior Friday’s sell-off as somewhat overdone, saw value in some oversold stocks. The big story on Tuesday was actually Monday’s after-close announcement by Apple of strong quarterly earnings that beat estimates. American Express did the same and provided additional broad support for the markets at open on Tuesday. Wednesday and Thursday saw partial reversals of these gains. What started the retrenchment was Merrill Lynch on Wednesday announcing a quarterly loss of $2.3 billion and a $7.9 billion write-down for subprime losses. The fear was that not only would Merrill have additional write-downs in coming quarters but that other financials would also. A drop in existing home sales also weighed on the markets on Wednesday. A bright spot for the day, however, was an upside surprise by Boeing. Stocks were pushed down on Thursday by a decline in durable goods orders, recession level sales of new homes being reported, and record high crude oil prices. The tech sector was also battered by negative reports from Sony, Motorola, and Raytheon. Equities got a big boost Friday from Microsoft’s after-close Thursday announcement of strong revenues and profits that significantly beat expectations. These were attributed to sales of Microsoft’s new Halo 3 video game and to sales of Vista and Office 2007. Also, the markets took comfort in Countrywide’s announcement of an expected profit in the fourth quarter.
But overall, equity gains last week were not consistent with the economic data for weak home sales and durable goods orders and with the likely inflation inducing higher oil prices. Also, overlooked by many were warnings from the consumer sector as Wal-Mart and Coach disappointed on earnings. Essentially, the stock gains were heavily based on the belief the Fed will be easing on October 31 and in coming months. Lack of rate cuts would likely lead to a significant correction in equity prices.
Last week, major indexes up notably. The following major indexes were up as follows: the Dow, up 2.1 percent; the S&P 500, up 2.3 percent; the Nasdaq, up 2.9 percent; and the Russell 2000, up 2.8 percent.
Year-to-date, the Dow is up 10.8 percent; the S&P 500, up 8.2 percent; the Nasdaq, up 16.1 percent; and the Russell 2000, up 4.3 percent.
Last week, rates were little changed except for a bump up in the 3-month T-bill. There was also some intra-week movement. To start the week, rates rose somewhat on Monday, largely on unwinding some of the prior Friday’s flight to quality as equities fell sharply. Rates headed in the other direction on Wednesday as the announcement of much larger-than-expected write-offs by Merrill Lynch resurrected flight to quality. The report of another sharp decline in existing home sales also led rates down somewhat. Later in the week, higher oil prices bumped rates up but only slightly. Flow of funds into equities helped boost the 3-month T-bill on the last day of the week.
Treasury yields that were up last week are as follows: 3-month T-bill, up 12 basis points; the 5-year note, up 4 basis points; the 10-year bond, up 2 basis points; and the 30-year bond, up 1 basis point. The 2-year note was unchanged while the 3-year note yield slipped 1 basis point.
Rates were little changed for the most part last week as traders are sitting tight heading into the Fed’s FOMC meeting this coming week.
Oil prices set new record highs last week, crossing the $90 mark for the first time. Prices actually softened early in the week as the front-month futures contract expired. Also nudging down prices were a stronger dollar (oil contracts are generally priced in U.S. dollars) and traders reconsidering the significance of Turkish troops possibly going after Kurd rebels in northern Iraq. But on Wednesday, a surprise drop in oil inventories boosted the spot price of West Texas Intermediate by $1.43 per barrel back up to $88.00 per barrel. However, the big surge was on Thursday as spot prices jumped $4.81 per barrel to a new record high of $92.81 per barrel. Thursday’s boost was due to a variety of factors: new sanctions by the Bush Administration against Iran, more saber rattling and worse between the Turks and Kurdish rebels, and news of Lebanese troops attempting to shoot down Israeli warplanes. Prices eased somewhat on Friday.
The spot price for West Texas Intermediate rose $2.92 per barrel for the week to close at $91.52 per barrel -- $1.29 per barrel below the record close of $92.81 per barrel set the day before on October 25.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
We had limited economic data this past week but all of it pointed to a slowing economy. Based on sales, housing remains very weak while manufacturing is losing some of its previous luster.
Existing homes sales fell 8 percent in September to a 5.040 million annual rate. Sales were down across regions. The headline rate of 5.040 million is in fact an historical low for the series, and is just above 5.080 million hit twice in 1999. However, the series only goes back through 1999. Nonetheless, the sales numbers are below those seen in the most recent recession.
Supply of unsold homes is a worsening problem. Unsold homes jumped to 10.5 months of supply from 9.6 months in August. The September number is the highest since 1999. According to the National Association of Realtors, current conditions have stabilized but the weakness in sales was largely due to mortgage cancellations on earlier sales.
With the high end of the housing market hurt by the recent lack of liquidity in jumbo mortgages, median sales prices have been slipping as high end sales fell notably. The median sales price dropped to $211,700 in September, down 5.7 percent from $224,400 in August.
Sales are down 19.1 percent year-on-year while the median sales price is down 4.2 percent on the year.
New home sales bumped up a little in September but the slight improvement likely was technical. New home sales in September rose 4.8 percent to an annualized rate of 770,000 after falling 7.9 percent in August. However, the August sales pace was revised down to 735,000 from the initial estimate of 795,000. Year-on-year sales were down 23.3 percent in the month.
A key difference in data methodologies between existing home sales and new home sales is that existing home sales include cancellations in the net numbers while new home sales do not. With mortgage cancellations rising recently, this would be a key reason that existing home sales would be down, more so than new home sales which are not affected by mortgage cancellations.
Supply on the market improved somewhat but it is hard to see given the magnitude of the glut. Months supply eased to 8.3 from 9.0 months in August. The bottom line is that both existing and new home markets have heavy inventory overhang. It is going to take a long time to work off the excess supply.
Until just recently, manufacturing has been a strong spot in the economy but data over the last two months are calling into question the health of this sector. There are not yet signs of recession but clearly ones for a slowdown in growth. Durable goods orders fell 1.7 percent in September and followed a 5.3 percent decline in August. Orders did jump 5.9 percent in July, but July was before the troubles of August. The Fed is paying more attention to data after the credit-market seizure. Shipments also fell for a second straight month while inventories popped higher, flashing warning signs of slowing in manufacturing.
But the slowing is not as dramatic as the headline number. September's weakness was centered in defense orders, excluding which orders rose a 0.7 percent in the month, though the gain follows a steep 6.2 percent dip in August. Orders excluding transportation showed a moderate 0.3 percent gain but follow a 1.8 percent decrease the month before. Motor vehicles showed sizable declines in both orders and shipments for a second straight month. Orders for commercial aircraft fell nearly 10 percent in the month though shipments rose nearly 20 percent.
Manufacturing can still count on backlogs to keep production going — at least for a while. Unfilled durables orders rose 1.1 percent in both September and October. On a year-on-year basis, unfilled orders were up 18.0 percent in September, compared to up 21.7 percent in August.
Overall, durables orders are softening even after special factors are taken into account. While exports are expected to be a bright spot for manufacturing, if housing continues downward (as is likely) and if the consumer sector stalls, then manufacturing is likely to soften further. A Fed rate cut at the end of this month could be crucial for propping up overall demand and manufacturing.
The economy is moderating while higher oil prices threaten stronger inflation. The Fed likely will tilt its concern toward the risk of too weak economic growth but inflation has not been fully wrung out either. The Fed is likely to cut the fed funds target rate by 25 basis points but inflation is still a concern. This will limit the extent of Fed rate cuts further down the road.
The latest rash of weak economic data and news of worse losses from subprime fallout have actually led to expectations for Fed rates cuts to be stronger than right after the September 18 rate cut by the Fed. Expectations had been trimmed earlier in the month rate after the relatively strong employment report for September released on October 5.
This coming week brings a boat load of economic data and the FOMC interest rate decision on Wednesday. Highlights for the economic data will be the advance GDP numbers for the third quarter, personal income, and Friday’s employment situation report.
The Conference Board's consumer confidence index tumbled in September to 99.8 from 105.6 in August. Confidence in the present situation fell to 121.7 from 130.1 while the expectations index declined to 85.2 from 89.2 in August. Surprisingly, inflation expectations were stable.
Consumer confidence Consensus Forecast for October 07: 99.0
Range: 97.0 to 100.5
GDP came in at an annualized 3.8 percent for the second quarter — a fairly robust number. Strength was generally widespread outside of residential investment. But the subprime mess and worse-than-expected housing have been damping the consumer sector along with manufacturing. On the positive side, business investment and exports are likely to keep growth moderately positive for the quarter. But with subprime lending problems now creeping into the overall economy somewhat, third quarter GDP numbers are not as relevant as they would be otherwise. On the inflation front, the GDP price index rose 2.6 percent annualized in the second quarter, following a 4.2 percent jump in the first quarter.
Real GDP Consensus Forecast for advance Q3 07: +3.2 percent annual rate
Range: +2.5 to +4.0 percent annual rate
GDP price index Consensus Forecast for advance Q3 07: +2.0 percent annual rate
Range: +0.8 to +2.3 percent annual rate
The employment cost index for civilian workers rose 0.9 percent in the second quarter for a year-on-year pace of 3.3 percent. These overall rates are moderate but there are cross currents in wage inflation between a labor market in which skilled labor is hard to find and an overall economy that appears to be slowing. The Fed will be picking apart these numbers just prior to its interest rate decision Wednesday afternoon.
Employment cost index Consensus Forecast for Q3 07: +0.9 percent simple quarterly rate
Range: +0.9 to +1.0 percent simple quarterly rate
The NAPM-Chicago purchasing managers’ index was steady and moderate coming in at 54.2 in September vs. 53.8 in August. New orders dipped back a bit but remain a highlight of the report, at 56.2 vs. 58.4. Backlog orders, which contracted steeply in August, showed month-to-month improvement in September at 50.5 (note a 50 reading indicates no month-to-month change). Production is strong at 58.3 vs. 55.7.
NAPM-Chicago Consensus Forecast for October 07: 53.5
Range: 50.1 to 56.0
Construction spending posted a 0.2 percent partial rebound in August, following a decline of 0.5 percent. As has been the story all year, non-residential and public construction offset weakness on the residential side. Non-residential private construction jumped 2.3 percent in the month while public construction was up 0.7 percent for the month. Private residential construction fell 1.5 percent. Expect more of the same for September.
Construction spending Consensus Forecast for September 07: -0.5 percent
Range: -1.0 to 0.0 (flat) percent
The FOMC announcement for the October 30-31 FOMC policy meeting is expected to result in another interest rate cut by the Fed but by 25 basis points instead of the double whack of 50 basis points on September 18. Even though Fed officials have indicated that inflation was still its primary concern in the minutes of the September 18 FOMC meeting, economic data since have come in notably soft nearly across the board. Subprime losses still haunt the financial sector and housing is still declining. Fed officials have repeatedly cautioned that they would be concerned if housing continued to be too weak for too long and spread weakness to other sectors of the economy — notably the consumer sector and manufacturing.
FOMC Consensus Forecast for the 10/31/07 policy vote on the fed funds target: down 25 basis points to 4.5 percent
Range: 92 percent probability for a 25 basis point cut versus 8 percent probability for a 50 basis point cut based on fed funds futures at settle on 10/26/07
Initial jobless claims dipped 8,000 in the week ending October 20 but remained a little on the high side at 331,000. The previous week, initial claims had jumped 30,000. Labor markets cannot yet be described as weak but they have softened a bit over the last two weeks. A tight labor market has been one of the key areas of concern for the Fed and the recent mild softening might be the right balance that allows the Fed to ease on October 31. The next claims report is after the Fed decision but it will help begin the debate over whether the Fed considers cutting rates again this year or early next year.
Jobless Claims Consensus Forecast for 10/27/07: 330,000
Range: 315,000 to 345,000
Personal income rose a moderate 0.3 percent in August, held down by a slowing gain in wages and salaries of 0.2 percent. We did get stronger increases in September in employment and in wages so we will likely see a little stronger number in income for the month. Although the personal income report is released the day after the October 30-31 FOMC meeting ends, this report is likely to be the key release that starts the debate over the next Fed move after this one. And a key piece of information will be the core PCE price index. This inflation measure rose only in August with the year-on-year rate up only 1.8 percent, the lowest in 3-1/2 years and under the Federal Reserve's 2 percent comfort limit for the third straight month. But the core CPI index firmed to an unrounded 0.2196 percent boost in September, following a 0.1503 gain in August. That is, we will likely see the core PCE price index post a gain that exceeds the Fed’s comfort zone.
Personal income Consensus Forecast for September 07: +0.5 percent
Range: +0.3 to +0.5 percent
Personal consumption expenditures Consensus Forecast for September 07: +0.4 percent
Range: +0.2 to +0.5 percent
Core PCE price index Consensus Forecast for September 07: +0.2 percent
Range: +0.2 to +0.2 percent
The Institute for Supply Management’s manufacturing index dipped to 52.0 in September from 52.9 the prior month. New orders and production both slowed remained moderately positive. Cost pressures remain elevated but are slowing, with the prices paid index down 4 points to 59.0. The most recent ISM report was consistent with other surveys and manufacturing sector data showing a moderation in factory activity.
ISM manufacturing index Consensus Forecast for October 07: 51.5
Range: 50.0 to 53.0
Motor vehicle sales came in at a 12.2 million annual rate versus a 12.4 million rate in August. For September, we will have competing factors likely affecting the numbers. Consumers have become wary about economic conditions with the recent subprime problems receiving so much attention — plus the economy is slowing. On the other hand, the Fed cut short-term rates by 50 basis points and lower financing rates may have helped sales in the latter part of the month.
Motor vehicle sales Consensus Forecast for October 07: 12.4 million-unit rate
Range: 12.0 to 12.6 million-unit rate
Nonfarm payroll employment in September came in relatively strong compared to recent months with a 110,000 gain, following a revised rise of 89,000 in August and a 93,000 boost in July. But with initial claims on a recent uptrend, job growth could slow notably in September. Wage costs are still a concern for the Fed as average hourly earnings increased 0.4 percent in September, following a 0.3 percent rise the month before. But the civilian unemployment rate edged up to 4.7 percent in September from 4.6 percent in August, indicating some marginal loosening of labor market tightness. The Fed’s next FOMC meeting after October 30-31 is on December 11 and this jobs report and the one next month will play a key role in whether the Fed cuts interest rates in December.
Nonfarm payrolls Consensus Forecast for October 07: +80,000
Range: +10,000 to +110,000
Unemployment rate Consensus Forecast for October 07: 4.7 percent
Range: 4.6 to 4.8 percent
Average workweek Consensus Forecast for October 07: 33.8 hours
Range: 33.8 to 33.9 hours
Average hourly earnings Consensus Forecast for October 07: +0.3 percent
Range: +0.2 to +0.3 percent
Factory orders fell back 3.3 percent in August with weakness in both nondurables and durables. But more recently, durables continued to fall further in September with a 1.7 percent drop, following a revised 5.3 percent decline in August.
Factory orders Consensus Forecast for September 07: -0.5 percent
Range: -1.0 to +1.0 percent
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