STOCKS
The prior Friday's report of weak GDP growth set the tone for the markets last week. By sector, energy was notably weak while the tech sector was positive On Monday, personal income growth was healthy but markets took away the fact that consumer spending was soft - ignoring that lower gasoline prices had pulled nominal spending down sharply for nondurables. But falling oil prices did lend some support for equities. However, disappointing news from Wal-Mart and Verizon kept the Dow flat. Techs boosted the Nasdaq. On Tuesday, stocks were mixed as the Nasdaq rose, the Russell 2000 fell, and the Dow and S&P 500 were flat. The Chicago purchasing managers' report showed weakness, while the consumer confidence index slipped instead of rising as expected with both weighing on equities. On Wednesday, major indexes were down across the board despite better-than-expected showings by Ford and Chrysler. This was due to declines in the ISM manufacturing index and to a drop in construction spending as well as general profit taking. Equities were mixed on Thursday as the Dow and Russell 2000 slipped while the S&P 500 and Nasdaq were flat. On Friday, the unexpectedly strong employment report initially was seen as a positive by the equity markets - breaking a string of weak economic reports - but eventually was seen as postponing the Fed's schedule for cutting interest rates. This turned good news into bad news as most equity indexes posted declines - with the Russell 2000 an exception.

For the week, all major indexes were down, net: the Dow, down 0.9 percent; the S&P 500, down 0.9 percent; the Nasdaq, down 0.8 percent; and the Russell 2000, down 1.7 percent. Year-to-date, the Dow is up 11.8 percent; the S&P 500 up 9.3 percent; the Nasdaq up 5.7 percent; and the Russell 2000 up 11.8 percent.

The dip in equities last week came after generally strong gains during October - a typically weak month for equities.

BONDS
Interest rates took a roller coaster ride last week. Rates fell sharply through Thursday before being lifted back up by the strong employment report. Except on the ends, rates ended the week up somewhat. On Monday, rates were little changed. On Tuesday, lower oil prices and weak data for the Chicago PMI and for consumer confidence pushed rates down. Rates fell again on Wednesday due to lower-than-expected construction spending and a drop in the ISM manufacturing index. Also, the ISM price index and vendor performance index - both early indicators for inflation - fell. On Thursday, rates edged up despite soft oil prices as the productivity report showed high unit labor costs. Also, Dallas Federal Bank President Richard Fishe, said that while inflation numbers generally have been easing, they are still too high. Friday's employment report with a significantly lower unemployment rate, higher wage rates, and upward revisions to payroll employment boosted rates significantly. Also, a gain in the ISM services report indicated that the economy was not as weak as believed earlier in the week.

Net for the week the Treasury yield curve is up except on the short end. Mid-range yields are up notably. Notes and bond yields rose as follows; 2-year Treasury note, up 7 basis points; 3-year, up 7 basis points; 5-year, up 6 basis points; the 10-year bond, up 5 basis points; and the 30-year bond, up 1 basis point. The 3-month Treasury bill edged down 2 basis points.

Except on the ends, rates fell sharply early in the week before rebounding Thursday and especially Friday.

Markets at a Glance

The Economy
Last week's economic data started and ended strong but were notably weak in between. Other than for commodities, most inflation indicators remain on the high side. The week was jam packed with economic data, and the highlights may provide the clearest picture of the economy. By sectors, the consumer is healthy; manufacturing and construction are weak; and inflation is mixed but still high.

Employment is strong but with weak spots
Friday's employment report came in much stronger than expected even though the headline payroll number for October was somewhat under expectations. Nonfarm payroll jobs rose by 92,000 and was under the consensus expectation for a 130,000 gain. The big issue for the payroll portion of the report was the upward revisions to the prior two months. September jobs came in at a 148,000 gains while August posted a revised 230,000, with a net upward revision of 139,000.

For the latest month, strength was concentrated in services. Service-providing industries were up 152,000 while goods-producing jobs fell 60,000. The number of construction jobs fell 26,000 while that for manufacturing declined 39,000.

The other main upside concern from the payroll report was the rise in wage inflation as average hourly earnings increased 0.4 percent in October, following a 0.2 percent advance in September. Average hourly earnings were up 3.9 percent on a year-on-year basis in October, versus 4.1 percent in September. These continuing high numbers do raise some inflation concerns, given that productivity has fallen.

The household survey provided another shocker for the markets. The civilian unemployment rate fell to 4.4 percent in October from 4.6 percent in September with October's rate being the lowest since 4.3 percent in May 2001. This report continues to raise the issue that the economy is stronger than indicated by the payroll survey which is based on a small initial sample. Household employment surged 437,000 in October after September's 271,000 jump. Also, the household survey picks up growth in self-employed which the payroll survey misses.

Household employment is posting gains of over 100 thousand more per month than the payroll data.

Personal income healthy and supporting consumer spending
Last week's personal income report was quite healthy even though the markets believed spending to be weak - an incorrect interpretation of the data. Personal income posted a strong 0.5 percent boost in September, following a 0.4 percent rise in August. Notably, the wages and salaries income component rose 0.5 percent September, following a 0.2 percent gain in August.

Income gains have remained relatively healthy over recent months on a year-on-year basis. Personal income is up 6.8 percent on a year-on-year basis, compared to 9.4 percent in August while the wages and salaries component is up 7.6 percent in both September and August.

There was considerable misinformation regarding the strength of consumer spending, however. Personal consumption rose only 0.1 percent in September, following a 0.2 percent increase in August. September's overall number was held back by sharply lower gasoline prices pulling down spending on nondurables. Nondurables fell 1.2 percent in September while durables jumped 1.6 percent and services rose 0.5 percent. In real terms (year 2000 chained dollars), personal consumption actually rebounded 0.4 percent in September, following a 0.1 percent decline in August. The bottom line is that the consumer is still willing to spend - and has the income to do so.

On the inflation front, the core PCE deflator eased marginally in September with a 0.2 percent rise, following a 0.3 percent increase in August. But the bottom line is that the core deflator is still too high. On a year-on-year basis, the core deflator is up 2.4 percent in September, compared to being up 2.5 percent in August. This is above the Fed's preferred growth rate of about 1-1/2 percent annualized.

Manufacturing down on Chicago PMI, the ISM PMI, and factory orders excluding transportation
First out last week on Tuesday, the Chicago purchasing managers' index for manufacturing and non-manufacturing sectors slowed to 53.5 in October from September's 62.1. The weakness was led by new orders. Chicago's overall index, however, remains in positive territory, although just barely.

On Wednesday, the ISM's national purchasing managers' index for manufacturing also declined to 51.2 in October from 52.9 in September. Again, this level is just above the break even point of 50 which separates positive growth from negative. Both new and unfilled orders declined.

Partially in contrast, from the Census Bureau, factory orders rose a sharp 2.1 percent in September. But strength was concentrated in aircraft orders as durables orders jumped 8.3 percent in September. But overall orders were moderated by a 4.6 percent drop in non-durable orders related to declines in oil and gasoline prices. While some interpreted the data excluding transportation to be weak, the numbers should be discounted to take into account the price effects of oil on nondurables. Overall, new orders are soft but not as weak as many believe.

ISM's non-manufacturing a positive
While manufacturing was slipping, the ISM report for services, construction and mining was improving. The Institute for Supply Management's business activity index jumped to 57.1 in October from 52.9 in September. The gain was led by new orders while backlogs and employment softened. However, the inventories index rose somewhat, suggesting that respondents are more concerned about rising inventory levels. This could lead to a cut back in output in coming months.

The various manufacturing and non-manufacturing surveys did have favorable price data which are discussed below.

Construction outlays still net negative
Construction continued downward in September although there were some bright spots. Construction spending declined 0.3 percent in September following no change in August. Most of September's weakness was in private residential construction which fell 1.1 percent after a 1.6 percent drop in August. Private nonresidential outlays continued upward but at a slower pace with a 0.1 percent rise in September, following a 3.1 percent surge in August. Public outlays rose to an 11.6 year-on-year pace in September from 9.3 percent in August. The construction outlays report provided no real surprises. Residential construction remains on a downturn while nonresidential construction is still quite healthy.

Inflation is mixed but still too high.
Four reports brought attention to the fact that underlying inflation remains too high. Already noted is the continuing year-on-year growth in core PCE deflator inflation in the 2-1/2 percent vicinity while average hourly earnings growth remains in the 4 percent range as seen in the personal income and employment reports.

The two other key reports that were alarming were for employment costs and for productivity. The various manufacturing and non-manufacturing surveys were more positive but not as important.

The employment cost index rose a quarterly (not annualized) 1.0 percent in the third quarter, coming in a little higher than the 0.9 percent rise in the second quarter. The third quarter boost was the highest in over two years. Year-on-year, the ECI was up 3.3 percent in the third quarter, compared to 3.0 percent in the second quarter. The benefits component was behind the third quarter acceleration, rising 1.1 percent, following the second quarter's gain of 0.8 percent. However, wages and salaries costs remained strong with a quarterly 0.9 percent increase - the same as in the second quarter. The year-on-year rate for wages and salaries is 3.2 percent, up significantly from 2.8 percent in the second quarter.

Third quarter productivity growth slowed further - to no change from 1.6 percent in the second quarter. This slowing in productivity is having a negative effect on unit labor costs. Third quarter unit labor costs came in at a strong annualized 3.8 percent, following an upwardly revised 5.4 percent surge in the second quarter. On a year-on-year basis, productivity fell to a 1.3 percent increase in the third quarter from 2.4 percent in the second quarter. Unit labor costs edged up to 5.3 percent year-on-year gain from 5.1 percent in the second quarter. The bottom line is that these productivity and unit labor costs will raise concern at the Fed that core inflation is running too high and that cost push factors may be keeping it there.

The positive news on the inflation front did come from the manufacturing and non-manufacturing surveys. The ISM manufacturing and ISM non-manufacturing surveys showed sharp drops in their prices paid indexes. For manufacturing, this index fell to 47.0 from 61.0 in September. The October figure is the lowest in 4-1/2 years. For the ISM non-manufacturing survey, the prices paid index fell to 51.9 in October from 56.7 the prior month. The Chicago purchasing managers' report also shows prices paid declining sharply.

The bottom line
The economy is slowing and it is not doing so evenly. This unevenness should not come as a surprise but markets seem to have forgotten this. When the economy is in transition, it is common for different sectors to be experiencing different levels of weakness and strength. Currently, construction and manufacturing are weakest and this is very typical for an economy that has seen a recent runup in interest rates. We can continue to expect some weakness in these sectors while services remain moderately healthy. As before, the critical issue is the lagging in core inflation and related inflation measures. Commodity prices are down but they are known for giving false signals of change in overall inflation. It is the lagging costs of services and labor that are the hold ups for core inflation to ease sufficiently. Basically, the economy is still in soft landing mode but core inflation is taking its time to come down. And the Fed remains on hold.

What a difference a day can make. A spate of weak economic reports during the first part of last week pulled fed funds futures implied rates down sharply, only for the employment report to boost them back up.

Looking Ahead: Week of November 6 to November 10

Tuesday
Consumer credit rose $5.0 billion in August, led by a jump in revolving credit. Notably, July was revised up sharply $8.3 billion from $5.6 billion. Will any slowing in consumer spending show up in the credit data'

Consumer credit Consensus Forecast for September 06: +$6.0 billion
Range: $1.2 billion to +$7.0 billion

Thursday
Initial jobless claims jumped unexpectedly in the Oct. 28 week by 18,000 to 327,000. Given that there were no special factors to explain the rise and that October unemployment fell significantly, markets will be looking to see if there is an improvement in the claims numbers.

Jobless Claims Consensus Forecast for 11/4/06: 315,000
Range: 310,000 to 330,000

The U.S. international trade gap widened to another record $69.9 billion in August. Thus far in recent months the numbers have reflected on average both strong import and export growth. U.S. businesses have imported to meet previous expectations of strong consumer demand and demand for capital equipment. Overseas businesses also have been snapping up U.S. capital equipment exports. Now there is concern that consumer spending is slowing. Will this show up in slower import growth' Also, with manufacturing posting some recently weak numbers, it is even more important that the exports figures continue to rise.

International trade balance Consensus Forecast for September 06: -$66.0 billion
Range: -$68.6 billion to -$63.3 billion

Import prices showed notable improvement in September due mainly to lower oil prices but also somewhat due to slower growth in non-petroleum prices. Import prices in September fell 2.1 percent for the first decline in six months. Excluding petroleum, import prices rose a modest 0.1 percent. We should see further improvement in the overall import price figure for October due to further weakness in oil prices. But the non-petroleum component will get market attention given that inflation numbers have not been so good over the last couple of weeks.

Import prices Consensus Forecast for October 06: -0.8 percent
Range: -1.8 to -0.5 percent

Friday
The University of Michigan's Consumer sentiment index jumped to 92.3 in mid-October vs. 85.4 in September. More recently we saw a slight reversal in confidence with the Conference Board's index. To keep the soft landing on track we need to at least see consumer sentiment holding steady if not improving.

Consumer sentiment Consensus Forecast for November 06: 93.4
Range: 90.0 to 95.5