STOCKS
Equities ended the week with healthy net gains except for the Russell 2000 which was essentially flat. The Dow set two consecutive record closes on Thursday and Friday. Equities moved little on Monday as investors sat on the sidelines, waiting for the Fed's FOMC statement on Tuesday. The FOMC's still hawkish statement (retaining the inflation bias) weighed on stocks Tuesday. Additionally, equity indexes on Tuesday were pulled down by a drop in Apple and in Dell, both pulling down the Nasdaq. Strong retail sales numbers on Wednesday were positive but were partly offset by a spike in oil prices. On Thursday, stocks were boosted smartly by a drop in initial jobless claims and by the day-early but healthy Empire State manufacturing reports. The week ended on a positive note as the flat CPI and core CPI numbers fueled optimism in the equity markets. General Electric was a big gainer on Friday.

For the week, all major indexes were up: the Dow, up 1.1 percent; the S&P 500, up 1.2 percent; the Nasdaq, up 0.8 percent; and the Russell 2000, barely up just above 0.0 percent. Year-to-date, the Dow is up 16.1 percent; the S&P 500 up 14.3 percent; the Nasdaq up 11.4 percent; and the Russell 2000 up 17.7 percent.

BONDS
Interest rates whipsawed last week, ending up moderately. Rates fell on Monday and Tuesday on weakness in oil prices and a belief that the Fed's rate position had softened just marginally. Rates then jumped on Wednesday but less strongly on Thursday. The Wednesday jump was largely due to the spike in oil prices and very strong retail sales. The drop in jobless claims supported the rate gains on Thursday. Rates dropped sharply early on Friday on flat CPI and core CPI numbers for November but profit taking and higher oil prices pushed rates up back to Thursday's levels by close.

Net for the week the Treasury yield curve is up except on the front end. Yields rose as follows: 2-year Treasury note, up 4 basis points; 3-year, up 5 basis points; 5-year, up 4 basis points; the 10-year bond, up 3 basis points, and the 30-year bond, up 6 basis points. The 3-month Treasury bill was down 5 basis points.

Rates continued to rise last week except on the front end.

Markets at a Glance

The Economy
Last week's economic data showed improvement in consumer inflation indicators that the Fed is watching closely. Still, labor markets remain tight and consumers are readily pulling out their wallets and credit cards, boosting holiday sales. However, manufacturing remains soft.

Core CPI heads toward the Fed's comfort zone but will it continue'
Probably the biggest news of last week was the very favorable CPI report as both the overall consumer price index and the core CPI were unchanged in November. Markets had expected both to come in at 0.2 percent. The overall CPI had posted an energy-led drop of 0.5 percent in October while the core index had risen 0.1 percent the same month.

There is mainly good news in the latest CPI report. First, weakness in the core index was more broad-based than in October. The core rate's weakness in October was mainly in prices for new and used motor vehicles. For November, declines were seen in a broad number of categories. Some of these were weakened by aggressive holiday discounting by retailers. Primarily helping keep the core flat were the drop in apparel prices, in education & communication and most importantly a 0.9 percent drop in prices for new and used vehicles (part of the transportation component).

Second, the November figures put inflation much closer to the Fed's target range and, at least for now, inflation is in the target range based on growth rates in the most recent months. Based on a 3-month-ago annualized rate, the core CPI is now at a 1.6 percent pace, down from 2.3 percent in October. However, the Fed is not going to "declare victory and go home" just based on the last couple of inflation reports. The Fed is well aware of the improvement on the margin but will still be looking at a broader trend.

Based on a broader trend, year-on-year core inflation growth slipped to at 2.6 percent from October's 2.8 percent figure. The overall CPI's year-on-year growth rate rebounded to 2.0 percent in November from 1.3 percent the prior month. The Fed also knows year-on-year rates lag and it will take into consideration both the latest monthly changes as well as the longer trend.

The negative in the latest report is still that housing inflation (outside of energy) remains high. The owners' equivalent rent component has not been under 0.3 percent for a number of months. Also, oil prices are rebounding somewhat and we will not get as much help from energy as we thought a few weeks ago. Indeed, a Labor Department spokesperson indicated that if gasoline prices hold at current levels for December and the remaining CPI components rise or fall at the same rate in November, then the December CPI would come in at 0.3 percent. This, of course, was not a prediction, but a hypothetical that indicates that energy costs will now have at least for a little while some negative effects on inflation.

Import prices turning back up - not helping overall inflation
Import prices rose 0.2 percent as a surge in natural gas prices offset a dip in petroleum prices. Excluding all fuels, import prices showed a very tame 0.1 percent increase, following. a 0.1 percent decline in October. Year-on-year, import prices excluding all fuels are up a moderate 2.8 percent, with overall import prices up a very mild 1.2 percent. The point is not that import prices are heating up, because they are not - at least not notably. But with the continued weakness in the dollar, import prices are under upward pressure and will not be helping to bring down consumer price inflation. At this point, core inflation will have to come down based primarily on domestic demand factors.

Consumers making a very merry Christmas for retailers
While a positive for economic growth, red hot consumer spending in November must raise some questions regarding consumer price inflation staying down for more than just the last three months. Overall retail sales numbers came in strong in November despite the downward tug by falling gasoline prices. Retail sales rose a robust 1.0 percent in November, following a 0.1 percent dip in October. Excluding motor vehicles, retail sales rebounded 1.1 percent in November, following a 0.3 percent drop in October. Excluding both gas station and motor vehicles components, retail sales rose 0.9 percent in November, following a 0.3 percent gain the prior month.

Component gains were broad based but led by a monthly 4.6 percent jump in electronics sales. Some questioned the legitimacy of such a large number but apparently the big items this Christmas are not under the tree but on the wall and in home entertainment centers as HDTV sales are probably part of the surge in electronics sales. Most of these are being financed, are VERY big ticket items, and count 100 percent in retail sales even though financed instead of purchased with cash. This effect would "leverage" electronics sales more than usual. This would even boost sales of electronics since last year's big items were more toward iPods, computers, and cameras - which, of course, are still selling this year. HDTV was big last year but not like this year. November retail sales gains were also seen in auto dealers, building materials, food & beverage stores, health & personal care, gasoline stations, sporting goods, general merchandise, miscellaneous stores, nonstore retailers, and food services. Furniture store sales slipped 0.1 percent while clothing store sales were flat.

Year-on-year, overall retail sales in November are up 5.6 percent, notably higher than 4.9 percent in October. Excluding motor vehicles and gas station sales, year-on-year sales November rose to up 6.4 percent from 5.5 percent the prior month.

Given the negative CPI in October and flat CPI in November, the nominal retail sales numbers are going to translate into healthy real personal consumption spending in the fourth quarter.

Manufacturing stays on soft landing
Industrial production has been soft the last three months and inventory numbers reflect that. However, more recent consumer spending and export numbers indicate that manufacturing is not headed for a downturn - at least not a notable one. Overall industrial production rose 0.2 percent in November, following no change in October. Meanwhile, manufacturing output rebounded 0.3 percent in November, following a 0.5 percent drop in October. However, most of the strength in manufacturing was in motor vehicles which posted a 3.7 percent rebound after a 3.4 percent drop in October. Excluding motor vehicles, manufacturing output was flat in November, following a 0.3 percent dip in October. This week's durables orders will be important to see if consumer spending and exports are helping to bolster the factory sector.

Overall capacity utilization in November was unchanged from 81.8 percent in October. Overall industrial output is up 3.8 percent year-on-year in November while manufacturing output is up 3.4 percent.

Trade deficit sharply narrows
The international trade sector has been helped both by lower oil prices and higher exports. This latter improvement is important for supporting key sectors in U.S. manufacturing. Lower oil prices and perhaps economic slowing helped to ease the nation's trade deficit which came in at a much lower-than-expected $58.9 billion in October compared to September's $64.3 billion. October's gap is the smallest in more than a year.

Exports continued to rise but only by 0.2 percent in November. Meanwhile, imports fell a sharp 2.7 percent, primarily reflecting lower oil prices, which averaged $55.47 per barrel vs. $62.52 in September. The oil price decline was a record 11 percent drop.

Continued export growth is important for U.S. manufacturing. Over the past year, exports have been led by industrial supplies but capital goods and consumer goods exports also have been robust. Goods exports are up 16.7 percent on a year-on-year basis.

Inventories rise but retail sales surge makes them old news
Business inventories rose 0.4 percent in October though business sales fell 0.2 percent. In turn, the stock-to-sales ratio edged up to 1.31 from 1.30 in September. This overhang has weighed somewhat on manufacturing but November's robust retail sales numbers likely helped reduce inventories. If so, this will help stem weakness in manufacturing.

The Fed Continues to Hold Steady, Still Sees Inflation as a Risk
Last week, the Fed left its target for the fed funds rate unchanged at 5-1/4 percent as expected by the markets. The FOMC meeting statement continued to retain an anti-inflation bias, noting that "inflation risks remain." The Fed still holds to a forecast calling for both moderation in economic growth and in inflation. Even though the statement came out last Tuesday ahead of Friday's benign CPI inflation report, it is unlikely the Fed would have voted any differently if the CPI report had come out earlier. Prior to the meeting the Fed had been concerned about tight labor markets. This concern likely continues with the November unemployment rate remaining low despite rising slightly. Since the meeting, we have had a very good CPI report but we also have had robust retail sales and a drop in jobless claim. Plus CPI housing inflation remains high. Most likely the economy and inflation indeed are on a Goldilocks soft landing - the economy is just right. But upside risks for inflation remain higher than downside risks to economic growth. The markets do not see the Fed cutting interest rates before May 2007 and that may be just right - but only if the Fed is convinced that labor markets are loosening a little and core inflation has stayed down for a number of months.

The bottom line
Even though inflation numbers have come down, there are signs of a healthy economy - at least as seen through the consumer sector. Inflation has moved toward the Fed's comfort zone but there is no guarantee it will stay there, given low unemployment and strong consumer spending. But manufacturing is soft and we may see some spillover into slower consumer spending. But the Fed is likely to remain vigilant on the inflation front and take a little longer to cut rates than currently expected by the markets.

Looking Ahead: Week of December 18 through December 22

Tuesday
Housing starts dropped 14.6 percent in October, following a 4.9 percent rebound in September. Starts in October declined to an annualized pace of 1.486 million units from the revised 1.740 million units for September. Inventory overhang of unsold homes is still a problem even though mortgage rates have been down in recent weeks. We will likely still see a soft number for starts in November as homebuilders make final adjustments to bring inventories in line.

Housing starts Consensus Forecast for November 06: 1.55 million-unit rate
Range: 1.40 million to 1.58 million-unit rate

The producer price index fell 1.6 percent in October, following a 1.3 percent drop in September. The core rate surprisingly dropped 0.9 percent, following a 0.6 percent jump in September. We have seen weakness not just in oil prices but also in capital equipment and in passenger autos. With the PPI coming out after the CPI this month (opposite the usual pattern), the PPI will not be getting as much attention by the markets. Still, look to see if the softness outside of autos and oil continues or whether weakness is narrowly focused.

PPI Consensus Forecast for November 06: +0.4 percent
Range: -0.1 to +1.5 percent

PPI ex food & energy Consensus Forecast for November 06: +0.2 percent
Range: -0.1 to +0.4 percent

Thursday
GDP growth for the third quarter was revised up to 2.2 percent annualized from the initial estimate of 1.6 percent. Since that revision, we have had moderately strong inventory numbers and we may get an upward revision from that. This is the final revision to the third quarter until annual revisions next summer. Markets are now focused on the fourth quarter and any revisions will likely have little market impact.

Real GDP Consensus Forecast for final Q3 06: 2.2 percent annual rate
Range: 2.0 to 2.4 percent annual rate

GDP deflator Consensus Forecast for final Q3 06: 1.8 percent annual rate
Range: 1.7 to 1.8 percent annual rate

Initial jobless claims fell sharply again in the week ending December 9, falling 20,000 to 304,000. There appeared to be no special factors affecting the data but hiring during the holiday season is difficult to seasonally adjust on a weekly basis. Nonetheless, labor markets remain tight and remain a key focus for the Fed.

Jobless Claims Consensus Forecast for 12/16/06: 310,000
Range: 306,000 to 315,000

The Conference Board's index of leading indicators rose 0.2 percent in October. This index has been soft all year and continues to point to modest economic growth.

Leading indicators Consensus Forecast for November 06: 0.0 percent (flat)
Range: -0.3 to +0.2 percent

The general business conditions component of the Philadelphia Fed's business outlook survey index rebounded to 5.1 in November from minus 0.7 in October, but new orders fell sharply to minus 3.7 from plus 13.4 in October. Last week's national figure for industrial production was soft outside of autos, and markets will be looking to see whether manufacturing is likely to improve based on the regional survey data.

Philadelphia Fed survey Consensus Forecast for December 06: 3.0
Range: -3.0 to 10.0

Friday
Durable goods orders fell a sharp 8.2 percent in October, following an 8.7 percent surge in September. The vast majority of the weakness was due to a drop in civilian aircraft orders. Yet, softness in other sectors is showing up. Excluding transportation, durables orders fell 0.8 percent in October, following a 3.1 percent decline in September. This is bringing backlogs down and suggesting softening in manufacturing. A pickup in orders is needed to keep manufacturing in the soft landing scenario.

New orders for durable goods Consensus Forecast for November 06: +1.2 percent
Range: -1.5 percent to +3.5 percent

Personal income increased 0.4 percent in October, following a 0.5 percent boost in September. The latest gains were led by wages and salaries - the key source of income for consumer spending. The latest employment report data suggest another healthy gain in November. After last week's very favorable core CPI number for November, markets will be looking to see if the broader inflation measure of the core PCE deflator provides any different information on inflation. But given that the CPI detail goes into most of the PCE deflator components, any difference is likely to be slight.

Personal income Consensus Forecast for November 06: +0.4 percent
Range: +0.3 to +0.6 percent

Personal consumption expenditures Consensus Forecast for November 06: +0.6 percent
Range: +0.4 to +0.8 percent

Core PCE deflator Consensus Forecast for November 06: +0.2 percent
Range: 0.0 (flat) to +0.2 percent

The University of Michigan's consumer sentiment index slipped in December to 90.2 from November's 92.1. There has been a curious recent divergence in healthy consumer spending from soft consumer sentiment numbers. Still, healthy confidence numbers are needed for moderately healthy consumer spending to continue.

Consumer sentiment index Consensus Forecast for final December 06: 91.0
Range: 90.0 to 92.0

Simply Economics will be taking off next week.
Simply Economics will return on January 2, 2007.
Happy New Year from all of us at Econoday!