Equities continued to slump in the New Year as early earnings reports pointed to continued losses in the financial sector and as Fedspeak reminded the markets of a weak economy.

Recap of US Markets

STOCKS

Equities fell for the third straight week, hung over from recession talk and more subprime losses. Most equity indexes fell sharply on Tuesday, resulting in cumulative declines of more than 10 percent since cycle highs, indicating markets are in a true correction. A number of factors were behind the sell-off, including Treasury Secretary Henry Paulson’s remarks that housing problems are not yet improving, announcements of management shake-ups at financial firms, and Boston Fed President’s comments on the severity of the housing recession. Also, investors were reallocating portfolios with the onset of an uncertain earnings season.  The markets did get some mid-week lift on Wednesday and Thursday. Wednesday’s rebound was basically bargain hunting after Tuesday’s sell-off. Thursday was boosted by comments by Fed Chairman Bernanke that the Fed is ready to act “substantively” if needed – even though second thoughts on Friday by investors focused more on the implication that the economy is weak. The week ended down sharply on Friday with equities weighed down by announcements from American Express for lower than expected profits in 2008 and by analysts who said Merrill Lynch will likely take write-downs in the vicinity of $12 billion. American Express raised concerns about the consumer sector with announcements of increased delinquencies on credit cards.

Last week, major indexes were down sharply: the Dow, down 1.5 percent; the S&P 500, down 0.8 percent; the Nasdaq, down 2.6 percent; and the Russell 2000, down 2.3 percent.

Since year end, major equity indexes are down with some indexes having lost this year more than they gained net for last year with the Dow, down 5.0 percent; the S&P 500, down 4.6 percent; the Nasdaq, down 8.0 percent; and the Russell 2000, down 8.0 percent.

BONDS

Treasury yields fell last week except for the long bond. Rates started the week soft on Monday and Tuesday, largely on flight to safety. Rates rose somewhat on Wednesday and even on Thursday despite comments by Fed Chairman Bernanke that strongly hinted the Fed will be cutting rates aggressively. The rate movement was a reversal of flight to quality as funds moved into equities both days. Rates fell again on Friday on the sell off at week end of equities. For the week, however, the long bond yield actually edged up 2 basis points as stagflation is a growing concern. Traders see the Fed cutting rates to help boost economic growth but with the result that inflation does not come down as expected.

Treasury yields were down last week except for the long bond follows: 3-month T-bill, down 10 basis points, the 2-year note; down 15 basis points; the 5-year note, down 11 basis points; and the 10-year bond, down 6 basis points. The 30-year bond edged up 2 basis points.

Since year end, the 2-year T-note has fallen 47 basis points while the 10-year T-note has slid 23 basis points. Flight to quality has been a factor for both but fears of recession have weighed more on the shorter maturity.

OIL PRICES

Forecasts for mild winter weather and for weak economic growth pulled oil prices down last week. The price for spot West Texas Intermediate fell $2.82 a barrel this past Monday on reports this will prove to be a mild winter in the Northeast and Midwest — heavy users of heating oil. There was a mild rebound in prices on Tuesday as Monday’s close was seen as oversold. Adding to upward pressure were reports of a planned attack on Nigerian oil facilities by armed militants. Despite a report on Wednesday of a sharp drawdown in inventories, prices edged down net for the day on fears of recession. Recession concerns weighed on prices on Thursday and Friday with declines of about $2 and $1 per barrel, respectively.

The spot price for West Texas Intermediate fell $5.22 per barrel for the week to settle at $92.69 per barrel, $6.93 below the record high of $99.62 set January 2nd.

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

This past week, economic data were scarce but Fedspeak filled in some of the gaps. The limited amount of data suggested some slowing in export growth. Fed Chairman Ben Bernanke and other Fed officials strongly hinted that a rate cut is imminent for January 30 at the Fed’s next FOMC meeting.

International trade deficit widens from record high oil imports

The U.S. trade gap worsened in November to $63.1 billion from a revised $57.8 billion shortfall in October. The November shortfall was the largest since $64.1 billion seen in September 2006. The deterioration in the gap was due to an acceleration in import growth while exports gains slowed. Both petroleum and nonpetroleum imports jumped in the latest month. On the export side, the softening was mainly due to a drop in aircraft shipments.

The merchandise trade deficit (Census basis) in November soared to $70.6 billion from a revised $65.0 billion deficit in October. The goods gap excluding petroleum grew to $40.6 billion in November from $38.6 billion in October. Oil prices continue to rise, boosting the oil deficit and the overall trade gap. The oil trade deficit widened in November to a record $30.0 billion from $26.3 billion the month before. Crude oil prices in November spiked to a record $79.65 per barrel from $72.49 per barrel in October.

Goods export strength in November according to end-use categories was in foods, feeds & beverages, followed by industrial supplies. Declines were led by capital goods ex autos with a $902 million drop with civilian aircraft pulling that category down by $948 million. Exports of consumer goods slipped $115 million. 

Not surprisingly, goods import strength in November was in industrial supplies which jumped $4.655 billion and included a $3.716 billion boost in crude oil imports. Gains were also seen in foods, feeds & beverages, capital goods ex autos, automotive, and consumer goods. Consumer goods actually rose sharply, up $796 million.

As always, one should remember that one month does not make a trend. But the November data raise some questions. Are exports slowing despite the weaker dollar' They probably are not slowing as much as suggested by the November data but economic growth overseas is starting to come off rapid growth that has supported robust export gains for the U.S.  The weaker dollar will continue to be favorable but not as much as when foreign economic growth was more robust.

Overall, imports continue to surge despite the weaker dollar. While much of the gain is due to higher oil prices, even consumer goods spiked – which makes no sense with the softening in the U.S. economy. Apparently, U.S. businesses did not do a good job foreseeing the current slowdown in consumer and business spending. There likely will be significantly weakening in that component soon.

Import prices pause temporarily

Import price inflation paused in December, coming in flat for the month, following a 3.3 percent monthly surge in November. The December slowing was due to temporary weakness in oil prices. Excluding petroleum, import prices rose a noticeable 0.3 percent after a 0.7 percent jump in November. 

Year-on-year rates for import price inflation remain elevated with December coming in at 10.9 percent. Year-on-year rates have been in double digits since October, reflecting not just higher energy prices but also high prices of foreign goods in general. Excluding petroleum, the year-on-year rate stood at 2.9 percent in December, notably above a roughly 1-1/2 percent pace most of 2006. Import price inflation may not be runaway but it clearly is adding to overall inflation.

Fedspeak boosts rate cut expectations and raises recession worries

A number of Fed officials spoke last week – including the Fed Chairman. While Fed officials appeared to acknowledge that further interest rate cuts would actually take place, the markets reacted negatively by the end of the week, thinking that the economy must be worse than believed. The key remarks were by Federal Reserve Chairman Ben Bernanke. Key points were that additional policy easing may be necessary and that FOMC members "stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks." The use of “substantive” caused markets to lock in a belief that the next rate cut will be at least 50 basis points.

On Friday, Federal Reserve Board Governor Frederic Mishkin was seen as indicating that there is some urgency for rate cuts. The Fed governor indicated that when there are financial disruptions “monetary policy needs to be timely, decisive, and flexible.” “First, timely action is crucial when an episode of financial instability becomes sufficiently severe to threaten the core macroeconomic objectives of the central bank.”  “Second, policymakers should be prepared for decisive action in response to financial disruptions.” These comments helped calm credit markets but weighed on equities – again raising market suspicion that the economy is doing worse than believed.

Fedspeak during the week also included comments by Boston Federal Reserve Bank President Eric Rosengren and Philadelphia Fed President Charles Plosser. Rosengren’s comments focused on weakness in housing which he sees spilling over into the consumer and business sectors.

Philadelphia Fed President Charles Plosser, an FOMC voting member, said economic growth is likely to be weak for the first half of the year and also that inflation risks appear to have grown. Plosser made a point that the Fed is trying to distinguish between a need to help credit markets function properly versus economic conditions that call for a change in overall monetary policy. The implication is that the Fed sees credit markets needing focused attention -- such as with the Term Auction Facility -- versus the overall economy needing further rate cuts. But the bottom line is that both appear necessary for now.

Due to increased concern of the possibility of recession, expectations for future rate cuts by the Fed have grown sharply. At the end of October, expected rate cuts were seen as being slow and steady. But after Chairman Bernanke’s comments last week, traders in the fed funds futures market have bet that the fed funds target rate will be down to 2-3/4 percent by the end of this year.

The good news does include the fact the Chairman Bernanke’s remarks have helped to calm the credit markets. The spread between the Libor (3-month) and fed funds rates dropped sharply Thursday and Friday, indicating a greater willingness to lend in the credit markets. The Libor is discussed in greater detail in a Short Take posted on the January 10, 2008 calendar.

The bottom line

We had very little economic data last week. Important news included the Fed pointing to the need to cut rates further due to potential fallout from depressed housing and from credit markets that still are having problems functioning smoothly. While we had some bad news from financial firms on depressed earnings due to subprime problems, it looks like we are getting closer to full disclosure on subprime losses. This can only help the economy move forward. The Fed’s recent and pending rate cuts will eventually boost the economy but for the near term, growth is likely to be flat.

Looking Ahead: Week of January 14 through January 18

This coming week the markets will be overrun with market moving indicators. On the inflation front, we get updates on the PPI and CPI for year end. December retail sales will tell us if the consumer sector is as soft as the weekly numbers have been portraying. Industrial production and housing starts reports fill us in on the goods-producing sectors. By Friday, we will have a better idea of what kind of shape the economy is in as the Fed thinks about its next rate move at month end. 

Tuesday

The producer price index spiked 3.2 percent in November, following a 0.1 percent uptick in October. Meanwhile, the core rate jumped to a 0.4 percent increase, following no change in October. Price gains in November were led by energy and by motor vehicles. With oil prices rising, the headline number is likely to remain strong in December, but softer consumer and business spending could slow the core rate.

PPI Consensus Forecast for December 07: +0.2 percent
Range: -0.1 to +0.5 percent

PPI ex food & energy Consensus Forecast for December 07: +0.2 percent
Range: +0.1 to +0.2 percent

Retail sales were surprisingly strong in November, posting a 1.2 percent gain overall, following a 0.2 percent rise the prior month. Excluding motor vehicles, the increase was a robust 1.8 percent, after a 0.4 percent boost in October. Gasoline was the key factor in the gain as gasoline sales spiked 6.8 percent after a 3.1 percent rise in October. Nonetheless, sales excluding gasoline rose 0.6 percent in November, compared to a 0.1 percent decline in October. But large retailers have been reporting much softer sales over the holidays following the strong start after Thanksgiving. Retail sales outside of service station sales and electronics are likely give up a good portion of November’s gains.

Retail sales Consensus Forecast for December 07: 0.0 percent
Range: -0.4 to +0.3 percent

Retail sales excluding motor vehicles Consensus Forecast for December 07: -0.1 percent
Range: -0.4 to +0.3 percent

The Empire State manufacturing index fell back a very steep 17 points in December for a 10.3 reading that points to only a moderate rate of growth in the area's manufacturing sector. With the ISM and Philly Fed indexes recently turning negative and with December manufacturing hours falling, markets will be looking for more current data on whether this sector is in recession. But we may get one more month in positive territory as in December the new orders index for the Empire State survey was still moderately positive even though it fell back to 14.3 from November's 24.5.

Empire State Manufacturing Survey Consensus Forecast for January 08: 9.75
Range: 7.00 to 20.0

Business inventories rose 0.1 percent in October, well below a 0.7 percent rise in business sales. But inventories may be starting to be a modest problem. More recent data show a 0.8 percent spike in manufacturers’ inventories for November and we got a surge in November imports which may still be sitting on store shelves. With the economy slowing, businesses may have a mild inventory problem to deal with. With the economy at a possible turning point, markets should be paying more attention to the inventory numbers.

Business inventories Consensus Forecast for November 07: +0.5 percent
Range: +0.2 to +0.6 percent

Wednesday

The consumer price index surged in November, up 0.8 percent overall with the core breaking a long streak of moderate 0.2 percent gains with a 0.3 percent rise. Year-on-year prices are elevated, especially the overall rate at an unwanted 4.3 percent. The core rate is at 2.3 percent, above the 2.0 percent Federal Reserve comfort limit. We can expect another bad headline number due to continued increases in oil prices. But if we get a strong core increase, it could undermine the Fed’s ability to cut interest rates by 50 basis points as traders are now pricing into the markets.

CPI Consensus Forecast for December 07: +0.2 percent
Range: +0.1 to +0.6 percent

CPI ex food & energy Consensus Forecast for December 07: +0.2 percent
Range: +0.1 to +0.2 percent

Industrial production bounced back in November, rebounding 0.3 percent after a 0.7 percent drop in October. The gain was centered in manufacturing which rose 0.5 percent to almost reverse October's 0.6 percent drop. Strength was in business equipment. But there are signs that manufacturing could be tipping into recession even if the overall economy may not. The Philly Fed and ISM indexes fell into negative territory in December and aggregate production hours in manufacturing fell a sharp 0.7 percent, according to the jobs report. While one month does not make a trend, it looks almost certain that we will get a negative number for December industrial production – at least for the manufacturing component.  With housing already in depression, count on a negative production number raising further talk of overall recession.

Industrial production Consensus Forecast for December 07: -0.2 percent
Range: -0.5 to +0.1 percent

Capacity utilization Consensus Forecast for December 07: 81.2 percent
Range: 80.9 to 81.4 percent

The Beige Book for the January 29-30 FOMC meeting is released this afternoon. Following Fed Chairman Ben Bernanke’s comments that strongly hinted at following through with a rate cut on January 30, the Beige Book may give corroborating anecdotal information on whether the economy and financial markets need the extra help on the 30^th.

Thursday

Housing starts in November slipped 3.7 percent, following a revised 4.2 percent partial rebound in October. November's 1.187 million unit annual rate puts starts down 24.2 percent on a year-on-year basis. With supply for both existing and new homes still near record levels, we could still see another decline in starts.

Housing starts Consensus Forecast for December 07: 1.14 million-unit rate
Range: 1.08 million to 1.18 million-unit rate

Initial jobless claims fell 15,000 in the week ending January 5 to 322,000 after dropping 20,000 the prior week. Continuing claims, reported for the December 29 week, also showed improvement, falling 51,000 to 2.702 million. Currently, the weak jobs report for December is still setting the mood for how the markets are viewing labor market data. While most indicators are pointing to a slowing economy overall, the latest two claims reports suggest that the December jobs report may have overstated weakness a little. Still, it is difficult to seasonal adjust data during the holidays and traders will be slow to believe any positive news on the labor front. But investors will certainly be watching the timely claims numbers for hints on the direction of the consumer and the economy.

Jobless Claims Consensus Forecast for 1/12/08: 335,000

Range: 330,000 to 340,000

The general business conditions component of the Philadelphia Fed's business outlook survey index fell to minus 5.7, its lowest reading in five years and compared to plus 8.2 in November. Despite the negative number for general business conditions, some indexes in the December report suggest that there could be a mild rebound in January. New orders improved in December, rising to 10.7 from November's 3.5. Inventories fell to minus 6.7 from plus 2.5 in November, but the dip in inventories could point to a need to nudge production up in the mid-Atlantic region.  Any rebound would be welcome relief with more investors starting to worry about manufacturing being in recession.

Philadelphia Fed survey Consensus Forecast for January 08: -1.3
Range: -7.0 to +5.3

Friday

The Conference Board's index of leading indicators fell 0.4 percent in November, following a 0.5 drop in October. Negative factors in the month included stock prices, jobless claims and consumer expectations. With more talk of the “R” word, markets will be giving this indicator a little more attention than usual.

Leading indicators Consensus Forecast for December 07: -0.1 percent
Range: -0.2 to +0.1 percent

The Reuters/University of Michigan's consumer sentiment index rose in December, up 1 point to a still mild 75.5. With recent increases in oil prices and declines in the stock market, we may see some slippage in consumer confidence. With the Fed worried still about inflation despite recession concerns – at least based on Fedspeak – the Fed and markets should still be paying attention to the inflation expectations numbers. Inflation expectations eased back 1 tenth for the one-year outlook to 3.4 percent. Five-year expectations are at 3.1 percent, up 2 tenths compared with November. Fed officials continue to emphasize the importance of inflation expectations remaining anchored and these data are key indicators on whether inflation expectations are not rising.

Consumer sentiment index Consensus Forecast for preliminary January 08: 74.7
Range: 70.0 to 75.5