The Nasdaq composite index once again posted the largest monthly decline in July, followed closely by the Russell 2000 index, a measure of the small cap market. In April, the Russell posted the largest decline followed by the Nasdaq. However, the Nasdaq market has shown more consistent declines in 2004 relative to other key market indexes. After all is said and done, the Wilshire 5000 (now called the Dow Jones Wilshire 5000 Composite) is the best performer to date - with a 0.9 percent drop (100 - 99.1 = 0.9 percent) matched by the S&P 500 with the same size decline. The Russell 2000 follows closely with a 1 percent drop. The Dow Jones Industrial Average is only slightly better than the Nasdaq composite, with a decline of 3 percent vs. 5.8 percent.

BONDS
Weaker-than-expected economic indicators, along with Greenspan testimony this month, helped to lift bond prices and lower yields. The 3-month T-bill yield is 16 basis points higher at the end of July than it was at the end of June, but yields along the maturity spectrum are generally lower than they were a month ago. Yes, bond investors still expect the Fed to raise the fed funds rate target at least twice more this year, and possibly as many as four times. However, the consensus no longer sees the possibility of a 50 basis point rate hike at the August meeting, which is coming up in less than two weeks.

In addition to Greenspan's testimony and weaker-than-expected economic news, Treasury securities remain a safe-haven investment opportunity as terrorist attacks remain a key worry in the investment community. Furthermore, the plunge in stock prices in July assured that monies had to flow elsewhere, at least for the moment.

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

Slower growth, more inflation
Real GDP grew at a 3 percent rate in the second quarter after an upward revised gain to a 4.5 percent rate in the first quarter. At the same time, the GDP deflator accelerated to a 3.2 percent rate after increasing at a more moderate 2.8 percent rate in the first quarter. Undoubtedly, high energy prices contributed to the rise in the GDP deflator just as they did to the CPI and PPI.

Real final sales grew at a 2.8 percent rate in the second quarter, the slowest pace in more than a year. Final sales reflect final demand (measured by real GDP less the change in business inventories). If demand is slowing down, then producers have less inclination to accelerate production.

In the second quarter, a significant moderation in the rate of consumer spending (1 percent in the second quarter relative to 4.1 percent in the first quarter) hampered total GDP growth. Consumption expenditures account for more than two-thirds of total gross domestic product. Both durable goods (-2.5 percent) and nondurable goods (-0.1 percent) decreased; spending on services increased 2.3 percent.

The pace of nonresidential fixed investment spending more than doubled in the second quarter, rising at an 8.9 percent rate, up from a 4.2 percent rate in the first quarter. In contrast to the previous quarter, investment in structures grew rather than declined; investment in equipment and software accelerated moderately (10 percent vs. 8 percent). Residential investment spending accelerated as well, surging at a 15.4 percent rate in the second quarter after increasing at a modest 5 percent rate in the first.

The Commerce Department's estimate for net exports shows that the deficit widened by a mere $2 billion during the quarter with exports surging at a 13.2 percent rate and imports growing at a sturdy, but slower, 9.3 percent rate. The Commerce Department won't have June information on the trade deficit for another two weeks and this component tends to see more significant changes than most in subsequent GDP revisions. At the same time, business inventories were estimated to have accelerated by $7.5 billion during the month. This is another component for which June data won't be available for another two weeks. Like net exports, it gets revised more frequently (than other components) in the GDP reports.

All in all, the GDP report was indicative of an expanding economy with growth shifting from the consumer sector to the investment sector. This is generally considered good news. The moderation in consumer spending was unusually large, though, and total GDP growth certainly would have benefited from faster growth - more in line with disposable income (2.9 percent rate). But then again, consumer spending had outstripped income growth for several quarters and it was time to get back on track.

The slower pace of growth in GDP in the second quarter relative to the first quarter certainly corresponds to the slowdown in nonfarm payroll growth that took place between April and June. While one can make the case that rapid productivity growth along with outsourcing hurts domestic employment, there is no question that the largest impediment to employment growth is the moderate rate of GDP growth.

The personal consumption expenditure deflator for nondurable goods rose at a whopping 6.7 percent rate in the second quarter after increasing at a 5.3 percent rate in the first quarter. Undoubtedly, this represents faster energy price hikes. Most economists, including Fed policymakers, expect these outsized gains to diminish.

However, other GDP components also showed acceleration: the GDP deflator for investment spending on structures increased at a 5.8 percent rate after growing at a 4.8 percent rate in the first quarter; the deflator for residential investment spending grew at a 7 percent rate, showing a persistent pattern of acceleration over the past year. While the energy price gains could moderate, the acceleration in construction reflects the strong demand in this sector. Rising interest rates may cool housing demand, but thus far, we haven't seen a significant slowdown. Bottom line' While the real GDP deflator is most likely to moderate from the current pace of 3.2 percent, don't expect it to return to the 1.1 percent rate of growth seen a year ago.

Durable goods disappoint
New orders for advance durable goods rose a modest 0.7 percent in June after declining in both April and May. Luckily, new orders surged in March and this had set the quarterly path on a higher level. Consequently, quarterly new orders managed to post an increase in the second quarter, albeit at a slower rate than in the three previous quarters. Nondefense capital goods, a leading indicator for capital spending, managed to accelerate its rate of growth from the two previous quarters. While the quarterly growth rate was positive, the monthly figures were disappointing for the manufacturing sector - and certainly the growth in 2003 and early 2004 does not offset the weakness exhibited from 2000 through 2002.

The NAPM-Chicago index, which measures business activity in this region, jumped more than eight points in July to reach 64.7 after falling sharply in June. While the chart below shows the relationship between the national ISM manufacturing index and the NAPM-Chicago report to be sometimes tenuous, overall trends often move in tandem. Moreover, two key Fed surveys (Philadelphia and Empire State) also revealed that manufacturing activity accelerated in July from June. Thus, the Chicago index confirms faster growth in July for overall business activity.

Home sales jump in Q2
New single-family home sales edged down 0.8 percent in June, but existing single-family home sales increased 2.1 percent during the month to reach a new peak. As a result, total home sales surged in the second quarter even as mortgage rates rose more than 50 basis points on average from the first to second quarters. Notice that home sales had moderated in fourth quarter 2003 and first quarter 2004 even as mortgage rates were still in a declining trend. Yet when rates started to rise, procrastinators thought they may as well buy before rates rise even more rapidly! Housing starts have moderated in the past few months and it will be interesting to see whether it proves a momentary pause or not. If the downward trend in housing starts persists, home sales too will most likely begin to follow a downward trend, even if it is only a modest one.

Wages remain moderate, but not benefits costs
The employment cost index increased 0.9 percent in the three months ending June, slower than the 1.1 percent gain reported for the period ending in March. Wages and salaries increased 0.6 percent in both quarters, but benefits costs moderated in June (1.8 percent) from March (2.4 percent). The year-over-year changes in the employment cost index tend to tell a more descriptive story. On the whole, the ECI has held at less than a 4 percent rate for about two years. Wages and salaries have moderated practically each quarter since reaching a peak in 2000. However, benefits costs have escalated rapidly since early 2003 after reaching a plateau from 2000 through 2002. Benefits include a variety of variables including vacation, defined contribution plans and health insurance. Most of the time, acceleration in benefits costs are due to increased health insurance.

The Fed monitors the ECI to see whether accelerating compensation costs will lead to inflationary pressures. The ECI hasn't changed much in the past several years and that should reassure policy makers that inflationary pressures are not on the horizon. However, the composition of the ECI does not necessarily bode well for workers or businesses. From the employee perspective, wages aren't keeping up with inflation. (The CPI rose 3.2 percent in June versus a year earlier.) This means that discretionary income is not keeping up with inflation, leaving less money to spend on retail sales.

At the same time, the employer is not benefiting either, because benefits costs are accelerating rapidly. While workers indirectly benefit from health insurance and vacation and defined benefit contributions, they don't see it in their take-home pay. While benefits typically account for only one-third of total compensation costs, both workers and employers would benefit more if wages accelerated and benefits costs moderated. Thus, while the ECI appears to remain stable, its composition is worsening to the benefit of virtually no one.

The Bottom Line
Economic indicators were abundant this week. While a few (consumer confidence surveys, housing) helped the equity market by showing higher than expected gains, others led to mini-rallies in the Treasury market (durable goods, GDP) by growing less than expected. On the whole, weaker data were in the second quarter, while stronger data were for July (the beginning of the third quarter). Perhaps Greenspan was correct in believing that the June moderation was a temporary soft patch - but it is still too early to tell for sure.

Next week will bring a variety of key information for the month of July - from the ISM surveys to motor vehicle sales (granted boosted by incentives once again) to the employment situation, the mother of all indicators. An acceleration in nonfarm payroll growth from the June pace will go a long way in spurring retail sales.

Looking Ahead: Week of Aug 2 to Aug 6

Monday
The ISM manufacturing survey moderated slightly in June as the diffusion index fell back to 61.1 percent from a level of 62.8 in May. New orders, production and supplier deliveries all decreased from May but remained at high levels.

ISM manufacturing index Consensus Forecast for July 04: 62
Range: 59 to 63.5

Construction expenditures edged up 0.3 percent in May after posting stronger gains in March and April. Residential construction spending moderated in May but remained relatively healthy. Declines in housing starts in recent months point to slower construction spending gains in months ahead.

Construction spending Consensus Forecast for June 04: 0.1 percent
Range: -1 to +0.5 percent

Tuesday
Personal income increased 0.6 percent in May for the second straight month after posting 0.5 percent hikes in the two previous months; income growth has accelerated in the first half of 2004 relative to the second half of 2003. Personal consumption expenditures jumped 1 percent in May, boosted by gains in durable and nondurable goods. Retail sales weakened in June, however, and this will put a damper on total consumer spending for the month.

Personal income Consensus Forecast for June 04: 0.3 percent
Range: -0.2 to 0.4 percent

Personal consumption expenditures Consensus Forecast for June 04: 0.0 percent
Range: -0.8 to 0.4 percent

Domestic motor vehicle sales plunged 15.4 percent in June to a 12.1 million-unit rate after rising 9.2 percent in May to a 14.3 million-unit rate. Domestic cars were sold at a 4.97 million-unit rate in June while light trucks were sold at a 7.17 million-unit rate for the month.

Light truck sales Consensus Forecast for July 04: 7.7 million-unit rate
Range: 7.5 to 7.8 million-unit rate

Domestic auto sales Consensus Forecast for July 04: 5.3 million-unit rate
Range: 5.2 to 5.6 million-unit rate

Wednesday
Factory orders edged down 0.3 percent in May after decreasing 1.1 percent in April. Durable goods orders had decreased in both months; nondurable goods had posted gains but these were not large enough to offset the declines in durables. In June, durable goods orders rose 0.7 percent, less than expected. The rise could help boost total factory orders for the month.

Factory orders Consensus Forecast for June 04: 0.6 percent
Range: 0.0 to 1.0 percent

The ISM non-manufacturing survey moderated in the past two months after the business activity index surged to 68.4 in April. While this headline number fell back to 59.9 in June, other components of the ISM survey remained healthy during the month.

Business activity index Consensus Forecast for July 04: 61
Range: 59.5 to 63.8

Thursday
New jobless claims edged up 4,000 in the week ended July 24 to 345,000, bringing the 4-week moving average down to 336,250. A variety of special factors have caused more weekly volatility than normal around this time of year. Perhaps claims will soon be back on track and once again reflect current conditions.

Jobless Claims Consensus Forecast for 7/31/04: 340,000 (-5,000)
Range: 335,000 to 360,000

Friday
Nonfarm payroll employment rose 112,000 in June, about half the pace recorded in May. After growing for four straight months, factory payrolls decreased 11,000 in June. The civilian unemployment rate remained unchanged at 5.6 percent for a third straight month in June. Average hourly earnings rose 0.1 percent after rising 0.3 percent in May. The average private workweek decreased 12 minutes to 33.6 hours.

Nonfarm payrolls Consensus Forecast for July 04: 233,000
Range: 190,000 to 325,000

Unemployment rate Consensus Forecast for July 04: 5.6 percent
Range: 5.5 to 5.6 percent

Average workweek Consensus Forecast for July 04: 33.8 hours
Range: 33.6 to 33.9 hours

Average hourly earnings Consensus Forecast for July 04: 0.3 percent
Range: 0.2 to 0.4 percent

Consumer installment credit expanded by $8.2 billion in May after increasing a more moderate $5.3 billion in April. While retail sales play a role in consumer credit usage, so do auto sales and mobile home shipments.