Strong growth with stable wages help boost investor confidence

(Another) exciting week for equities
It was a good week in the equity market. While stock prices were lower on Monday and Tuesday, they generally posted healthy gains in the remainder of the week. The economic news was favorable and comments made by Alan Greenspan were interpreted as bullish for the markets (both stocks and bonds). As a result, the NASDAQ composite managed to hit news highs despite last week's plunge.

Dow Jones & Company announced a revision to the 30 industrial stocks. Effective with Monday's trading, Intel, Microsoft, Home Depot and SBC Communications will join the ranks of the Dow Industrials. Chevron, Goodyear, Sears and Union Carbide are out. It will be interesting to see if the composition shift gives renewed vigor to this index.

Treasury market rallies on economic data and Greenspan comments
The bond market also staged an impressive rally this week. As late as Wednesday, the yield on the long bond was hovering around 6.35 percent. Bond investors still focused on the potential rate hike in Europe. They also worried about the economic news that would be reported on Thursday. As it turns out, GDP and the employment cost index were favorable and helped push down interest rates. Bond prices were higher, and yields lower, on Friday morning after market players had a chance to digest (as much as is humanly possible) Alan Greenspan's remarks made on Thursday night. Greenspan indicated that the economy was already beginning to feel the impact of the higher rates instituted this summer. In addition, he indicated that demand forces which boosted interest rates on their own also helped to curtail economic activity. Bond investors took this to mean that the Fed might not raise rates at the next FOMC meeting. And if they did, it might be the last rate hike for this cycle.

3Q GDP growth as expected; history revised higher
The Commerce Department's first pass at adding up the goods and services produced in the United States in the third quarter revealed that real GDP expanded at a 4.8 percent rate. This was generally in line with expectations. Consumers appeared to be in a lull as spending grew at a 4.3 percent rate in the July to September period. This was significantly less than the 5 ¾ percent average rate of growth recorded in the first half of the year. Durable goods, which tend to fluctuate more dramatically than nondurables and services, moderated more sharply.

Household investment in housing also slowed. Indeed, residential investment expenditures declined at a 6.3 percent rate in the third quarter after growing at an average 9.2 percent rate in the first half of the year. The drop in housing activity may be related to the moderation in durable goods spending. Housing demand creates greater interest in spending on furniture and appliances. As the demand for housing lessens, so does the demand for household furnishings.

Expenditures on business fixed investment expanded at a 14.9 percent rate - curtailed by a drop in nonresidential structures. That means that producers' durable equipment grew at a whopping 21.7 percent rate. Incidentally, the government redefined this category to include expenditures on computer software. The inclusion of software to the GDP accounts as investment rather than secondary inputs caused the history of the series (investment and total GDP) to be revised higher - particularly in the 1990s.

Inventory building also contributed to third quarter GDP growth after acting as a significant drag in the previous quarter. The inventory build-up is not unexpected in light of potential disruptions that may be caused by the ubiquitous Y2K bug. Most analysts expect that real GDP growth will be curtailed dramatically in the first half of 2000 as inventories are run down.

Net exports widened in the third quarter, but to a lesser extent than the previous quarter. Although real imports surged 17 percent for the period, export demand jumped 12.4 percent. This was the largest quarterly increase in exports since the second quarter of 1997, and reflects recoveries in Asia and accelerating expansions in Europe.

Government expenditures also helped to propel growth this past quarter. It isn't unusual to see a surge in national defense expenditures in the third quarter as appropriations run off at the end of the government's fiscal year. It happened last year too. This should be seasonally adjusted, but can't always be captured by the seasonal factor.

The bottom-line on growth? Real GDP came in line with expectations. Some of the growth is related to the problems surrounding the turn of the millenium. More interesting perhaps than the most recent quarterly figures are the upward revisions to the history of the series. Trend growth is now estimated at 3 percent rather than 2.8 percent. The 0.2 percentage points appears inconsequential but actually represents 0.2 percentage points PER YEAR which adds up with respect to the economic pie. The greater funds spent on investment also means that productivity grew more rapidly over the past several years than was previously estimated. (We won't see actual data until the Labor Department reports the revised figures.)

Nobel prize-winning economist Robert Solow estimates that average productivity growth of 1 percent a year allows an economy to double its standard of living in 72 years. When productivity gains average 2 percent a year, the standard of living doubles in 36 years!

Stable employment cost index reassures investors
The employment cost index rose 0.8 percent in the third quarter, which translated into a year-over-year gain of 3.1 percent for the index. Notice how this keeps the ECI in a relatively stable path - and down from the peak rise of 3.4 percent in the fourth quarter of 1998. While wages were running at a slower pace than the previous quarter, some killjoys focused on the rise in benefits costs. It has shown a steady upward trend in the past year. Analysts are beginning to worry again about potentially rising health care costs - one of the major benefits components.

Ever since Fed chairman Alan Greenspan noted his interest in this index a few years ago, it has become a major market mover. Even yesterday, the combination of this stable report coupled with the moderation in the GDP price deflator (from 1.3 percent in the second quarter to 1 percent in the third quarter) helped stage major rallies in the bond and equity markets.

The bottom-line on compensation costs? The stability of compensation costs is astounding given the high degree of tightness in the labor markets. Some analysts might suggest that the employment cost index doesn't reflect true compensation costs as more employers are offering stock options to a wider number of employees (not just executives). Yet, neither these figures nor the GDP deflator suggest that inflation is a near term problem.

Durable goods falter after four month run
New orders for manufacturers' durable goods fell 1.3 percent in September after gaining a cumulative 6.6 percent in the previous four months. A drop in aircraft orders hampered new orders, although orders still fell 0.5 percent for the month after excluding transportation. Yet, there is undoubtedly an upward drift in manufacturing activity. Unfilled orders, which are more stable than new orders, rose 0.6 percent, and their third straight monthly gain. The are recovering on a year-over-year basis as well.

The bottom-line on manufacturing activity? Although new orders for durable goods declined in September, the sector is showing more strength these past several months versus late 1998 and early this year. Strength may have carried over into the fourth quarter. The Chicago purchasing managers' index gained five points to 58.8 in October. The index fluctuates more wildly than the NAPM, but often moves in the same direction.

Home sales take a dive
Sales of single family homes took a dive in September - and Hurricane Floyd didn't cause it all. New home sales plunged 12.8 percent during the month with equally sharp declines in all regions of the country. Sales declines for existing homes were concentrated in regions that were in the hurricane's path. New homes tend to be more expensive than existing homes. It is possible that the rise in mortgage rates that began earlier this year is finally taking a toll on the housing market.

Since the beginning of this year, mortgage rates have risen nearly 150 basis points. Even though healthy income gains and a booming stock market helped to boost housing activity earlier this year, the rising rate environment was bound to curtail housing activity eventually. Indeed, addressing the Business Council Thursday evening, Fed chairman Alan Greenspan noted that the summer's rate hikes were beginning to have an impact on economic activity. Furthermore, he noted that rising interest rates induced by supply and demand forces would also hamper growth.

The bottom line on housing? Housing starts and home sales probably peaked in this past summer. As we go forward, higher mortgage rates will reduce the rate of growth. Moreover, this slowdown will also extend to consumer spending on furniture and appliances.

THE BOTTOM LINE
Market players have come to the conclusion that the economy can withstand more economic growth without generating accelerating inflationary pressures. The Commerce Department revised real GDP with new and improved definitions and found faster growth throughout the 1990s. To a large part, this reflects the inclusion of computer software in the investment component. So technology has improved productivity and our living standards in recent years.

Despite the stability in the employment cost index and the slower rate of inflation measured by the GDP deflator, not all economists and policy-makers (including Fed chairman Alan Greenspan) are willing to concede that inflation has been completely eradicated. While Greenspan did suggest that "faster productivity growth keeps a lid on unit costs and prices," he also is worried that the current pace won't be sustained or reign in consumer demand.

Wall Street economists continue to debate whether the Fed will raise rates, or not, at the November 16 FOMC meeting. No one is debating whether the employment situation, reported next Friday, will make a difference. Investors' eyes will be glued to their screens.

Looking Ahead: Week of November 1 to 5
We use the Market News Service survey of forecasts to describe the market consensus.

Monday
Market players expect the NAPM index to edge down to 56.5 in October from 57.8 in September. This represents a healthy level of manufacturing activity. The prices paid and the supplier delivery components will also get close scrutiny.

Construction expenditures are expected to decrease 0.3 percent in September in line with the past several months. As housing activity simmers down in coming months, so will construction expenditures.

Tuesday
Market participants are looking for personal income to post a modest 0.2 percent gain in September. The slower pace comes from weak employment and hours worked for the month. At the same time, personal consumption expenditures should rise 0.4 percent, half the rate posted in August. This could hold the savings rate level for the month.

Wednesday
The consensus forecast is showing a 0.6 percent drop in factory orders for September. This reflects the 1.3 percent decline recorded for durable goods partly coming from a decrease in aircraft orders. This would offset only a small portion of the gains posted in the past few months.

The index of leading indicators is expected to remain unchanged in September. This index is going nowhere and doesn't reflect any real changes in the economy.

All eyes will turn to the Beige Book proceeding the November 16 FOMC meeting. Market players would like the Beige Book to reveal that consumer demand is waning; housing activity is moderating; labor market is less constrained and prices and wages are stable. The question is: will they?

Thursday
Market participants are expecting new jobless claims to increase 7,000 in the week ended October 30 from last week's 278,000. Claims remain range-bound.

Friday
Economists are predicting that nonfarm payrolls will increase 300,000 in October after an 8,000 drop in the previous month. At the same time, the civilian unemployment rate is expected to remain unchanged at 4.2 percent. Hourly earnings should rise 0.2 percent in October after a 0.5 percent hike last month. The average workweek is predicted to rise to 34.5 from 34.4 in September.

Consumer installment credit is expected to rise $7 billion in September after a whopping $10.8 billion gain in August. This should come from softer retail spending - particularly on cars and trucks.