Oil again had a significant impact on equities and bonds in the week. Due to rising inventories, a slowing in the U.S. and other economies, a milder-than-expected hurricane season, and prospects for early and full resumption of Prudhoe Bay output, oil prices dropped $2.91 net for the week to $66.33 per barrel. At Friday's close, oil prices were at their lowest since April 4 and were $10.70 lower than the August 7 high of $77.03.
The drop in oil should offer a little help on the inflation front in the coming weeks, and consumers will have a little more money in their pockets to spend on other things. Of course the decline is a negative for oil companies but a plus for companies depending on petroleum-based inputs.
STOCKS
The week began with markets closed Monday for Labor Day. Stocks ended the week down notably after a very strong prior week. Stocks were primarily weakened by high wage costs in Wednesday's report on productivity and labor costs. Stocks rebounded slightly on Friday as a speech by Cleveland Fed President Pianalto was interpreted to mean that further Fed tightening is not likely. Also on Friday a key homebuilder released a weak profits report due to the decline in residential real estate activity. A number of other homebuilders also had negative profit reports during the week, and the cumulative effect was for the markets to conclude that the odds of a resumption of Fed rate increases had gone done.
For the week, all major equity indexes were down. The Dow was down 0.6 percent, the S&P 500 0.9 percent, the Nasdaq 1.2 percent, and the Russell 2000 1.8 percent.
Year-to-date, the Nasdaq is still down at 1.8 percent. But other major indexes are positive with the Dow up 6.3 percent, the S&P 500 up 4.1 percent, and the Russell 2000 up 5.2 percent.
BONDS
Interest rates generally firmed in the week with a decline on the short end being the exception. Most of the action took place on Tuesday in reaction to a report issued by the Organization for Economic Cooperation and Development that said the Federal Reserve may have to resume raising interest rates. Additionally, some of the decline in bond prices was related to profit taking from the prior week's price gains. Wednesday's negative report on unit labor costs kept rates from easing even as oil prices declined. However, on Friday safe-haven buying did have some effect as funds flowed into U.S. instruments ahead of Monday's anniversary of 9/11. This primarily impacted the 3-month bill for which rates fell sharply.
Net for the week the yield curve was up except for the 3-month bill. The 3-month bill was down 9 basis points. Other maturities were up as follows: 2-year Treasury note up 5 basis points, 3-year up 6 basis points, 5-year up 3 basis points, 10-year bond up 5 basis points, and the 30-year Treasury bond also up 5 basis points.
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
There were few economic indicator releases this week - which led the markets to focus on other financial news more than usual. These included the Fed's Beige Book, Fed minutes on discount rate decisions, "Fed Speak," and the oil markets.
Productivity slows while unit labor costs rise further
The productivity report had mixed news with both productivity and unit labor costs up. Labor costs were up much more and had the greater impact on the markets. Nonfarm productivity in the second quarter was revised up to 1.6 percent from an initial estimate of a 1.1 percent annualized rise. This upward revision was no surprise given that second quarter GDP growth had been earlier revised from 2.5 to 2.9 percent.
But there were two big surprises in the unit labor cost numbers. First, second quarter unit labor costs were revised up sharply to a 4.9 percent increase from the initial 4.2 percent estimate. Second, the first quarter was revised up to a sharp 9.0 percent jump from the prior estimate of 2.5 percent. These two revisions paint a very different picture for the Fed in its evaluation of underlying inflation trends and how far the economy needs to decelerate. Of course labor costs are just one part of the inflation equation - but it is a significant part.
The high unit labor costs are primarily related to gains in compensation. Nominal compensation costs were revised up sharply - to an annualized 6.6 percent from the initial 5.4 percent and compared to the first quarter's annualized 13.7 percent spike.
On a year-on-year basis, productivity edged down to 2.5 percent in the second quarter from 2.7 percent in the first quarter. Unit labor costs continue to worsen with a surge to 5.0 percent year-on-year from 3.6 percent in the first quarter. Nominal compensation costs are up 7.7 percent year-on-year from 6.4 percent in the first quarter.
ISM non-manufacturing remains soft, prices paid still high
The Institute for Supply Management's non-manufacturing index edged up to 57.0 in August from 54.8 in July. However, sub-indices (which are not used to compile the aggregate) indicate weakness. New orders fell sharply as did backlog orders.
Nonetheless, input prices are still a concern. Prices paid continued to show heavy month-to-month pressure at 72.4 vs. 74.8. Input prices are pressuring both profits and inflation, and with profits being squeezed, price increases are now being passed on to the consumer. And gains in unit labor costs, in combination with high input prices, may spell greater pass through ahead.
Beige Book
The Beige Book for the upcoming September 20 FOMC meeting was released last week. There were no surprises. According to reports from the individual Fed regional banks, the consumer sector is healthy other than softness in auto sales and in home improvement-related sales. Manufacturing continues to expand in all districts except related to housing and autos. Residential real estate is declining while nonresidential construction is on the rise. Labor costs, in an echo of the productivity report, remain an issue. Labor markets are described as generally "steady" but with scattered labor shortages and associated upward pressure on wages in many districts. Commodity prices are high but mostly have not been passed on to the consumer. Other than energy, retail prices are mostly steady.
Overall, the Beige Book gives credence to the majority view of the FOMC that the economy is moderating and that inflation will be decelerating.
Fed officials work hard to clarify transparency
On Thursday, San Francisco Bank President Janet Yellen spoke on the need to be vigilant against inflation but ended with comments that were interpreted to mean that further rate hikes are not likely. However, the Federal Reserve Board on the same day released minutes on regional bank requests for changes in the discount rate. The minutes show that just prior to the August 8 FOMC meeting both the Federal Reserve Bank of Richmond and Federal Reserve Bank of Philadelphia requested an increase in the discount rate from 6-1/4 percent to 6-1/2 percent, which the Board of Governors turned down. Such requests are seen as ways for the regional Fed banks to express dissatisfaction with existing monetary stance (the level of fed funds).
On Friday, Cleveland Federal Reserve Bank President Sandra Pianalto spoke on "Inflation, Inflation Expectations, and Monetary Policy." She indicated that policy is about right and stated that the pause would give her time to evaluate incoming data.
Finally, circulating late Friday was a Market News International story in which privately interviewed Fed officials said they were not pleased that the August 8 minutes were seen as indicating a likely end to further rate increases. Those interviewed indicated the minutes should have been seen to focus not on the definitiveness of the pause but on the need to evaluate incoming data. The intent of greater transparency is a good idea, and based on recent market interpretations of Fed actions and statements, the Fed is probably going to have to be a little more blunt in stating what their key focus is - at least until the markets learn not to interpret Fed statements to be what they want them to be, and there are low odds for that happening.
The bottom line
Last week's data and news point to an economic moderation that is on or near the Fed's intended path. But there clearly remain concerns about rising labor costs, and we have a little higher risk of further Fed tightening after last week than before. Separately, many of us have much to learn regarding the Fed's more open policy of transparency. The lessons from last week probably include working harder on setting our preconceived notions aside regarding Fed statements and taking the black-and-white meaning of their speeches as their intent - Fed staffs work very hard on picking the particular wording in public speeches.
Looking Ahead: Week of September 11 to September 15
Tuesday
International trade
The U.S. international trade balance narrowed in June to $64.8 billion, from revised $65.0 billion in May. Exports were strong but the trade gap narrowed primarily due to a nominal decline in the oil trade gap - at least a temporary improvement. We can continue to expect some volatility in the oil gap given both run-ups and retreats in oil prices in recent weeks. This is important for many reasons - including the impact on inflation and on discretionary spending by consumers. We also need to watch whether exports remain healthy as export growth is a key factor for keeping economic growth from slowing too much in coming quarters.
International trade balance Consensus Forecast for July 06: -$66.0 billion
Range: -$66.6 billion to -$64.0 billion
Wednesday
The U.S. Treasury will release the monthly budget report for August which typically shows a moderate deficit for the month. Over the past 10 years, the average deficit for August has been $40.5 billion.
Treasury Statement Consensus Forecast for August 06: -$65.0 billion
Range: -$69.0 billion to -$55.0 billion.
Thursday
Retail Sales jumped 1.4 percent in July following a 0.4 percent drop in June. Strength for the month was broad based, including the typically volatile autos and gasoline components. Still, excluding both gas stations and motor vehicles, sales were robust with a 0.7 percent gain in July vs. no change in June. The bottom line is that we are not seeing a broad based slowing in consumer spending, and this is a concern for ensuring a slowing in inflation. It would be good to see more moderate retail sales numbers for us to get the soft landing that the Fed envisions and the markets expect.
Retail sales Consensus Forecast for August 06: -0.2 percent
Range: -0.8 to +0.1 percent
Retail sales excluding motor vehicles Consensus Forecast for August: +0.3 percent
Range: -0.2 to +0.5 percent
Initial jobless claims declined by 9,000 in the Sept. 2 week to a six-week low of 310,000. The four-week average also is down, to a three-week low of 315,250. Payroll employment growth has been one of the key areas that the Fed and others can point to in order to show a slowing economy. The claims numbers do not suggest any dramatic reversal of that trend, but if the improvement in initial claims continues, we may see modest improvement in payroll employment which could add to the argument for a resumption of Fed interest rate increases.
Jobless Claims Consensus Forecast for 9/9/06: +315,000
Range: +305,000 to +315,000
Business inventories rose a strong 0.8 percent in June, led primarily by a 0.9 percent rise in retail inventories. More recently, wholesale inventories - a component of overall business inventories - increased 0.8 percent in July while wholesale sales advanced only 0.4 percent. We can expect the recently strong retail sales figures to help constrain inventories at the retail level, but overall we are seeing some upward drift in inventory-to-sales. If demand moderates, inventory growth should do likewise. What we want to see is moderation in sales and in inventories much at the same pace. If inventories get ahead too much, we could see a sharp but temporary reduction in output to offset. But this is not yet an issue.
Business inventories Consensus Forecast for July 06: +0.6 percent
Range: +0.4 to +0.8 percent
Friday
Consumer price index rose 0.4 percent in July following a 0.2 percent rise in June. However, the core CPI moderated somewhat, rising 0.2 percent in July following four consecutive 0.3 percent gains. The Fed is forecasting a deceleration in core inflation in coming quarters, but the 0.2 percent rise on a monthly basis will not get inflation down to the Fed's annualized target range of 1 to 2 percent. But will we at least get another 0.2 percent in August and a sign that moderation is at least partly underway' The consensus thinks so.
CPI Consensus Forecast for August 06: +0.3 percent
Range: +0.1 to +0.3 percent
CPI ex food & energy Consensus Forecast for August 06: +0.2 percent
Range: +0.2 to +0.3 percent
Empire State manufacturing index edged down again in August to 10.3 from 16.6 in July and 29.0 in June. The New York Fed's index in recent months has been weaker than the nation as a whole. The September 6 edition of the Fed's Beige Book indicated that manufacturing was softer in the New York region so we should see further weakening in this index for September. However, the consensus expects a marginal increase but to still modestly positive levels.
Empire State Manufacturing Survey Consensus Forecast for September 06: 12.5
Range: 8.0 to 15.0
Industrial production has been quite strong in recent months with only the July numbers showing signs of deceleration. Overall industrial production rose 0.4 percent increase in July while the manufacturing component edged up only 0.1 percent. However, manufacturing weakness was primarily in autos. Excluding autos, manufacturing output was up a healthy 0.7 percent after a 0.6 percent gain in June. But production hours in manufacturing - from the employment report - were down 0.3 percent in August and this suggests moderation in output.
Industrial production Consensus Forecast for August: +0.1 percent
Range: -0.1 to +0.4 percent
Capacity utilization Consensus Forecast for August 06: 82.4 percent
Range: 82.0 to 86.0 percent
The University of Michigan's consumer sentiment index slipped to 82.0 in August, from 84.7 in July. The August report showed a rise in inflation expectations. With the recent decline in oil prices, markets will be watching for the impact on both overall confidence and on inflation expectations.
Consumer sentiment Consensus Forecast for September 06: 84.0
Range: 82.0 to 86.0
Pressures on prices and Fed transparency
