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Stocks
lag in response to interest rate jitters It seems that the Nasdaq market is impervious to interest rates. Most analysts attribute that to the fact that the potential returns in high tech companies can stand to see rates at current levels - or even higher. Investors are apparently projecting the returns to be that good.
The Nasdaq composite index has soared over the past several years and no change in behavior is yet evident in 2000. One thing is new this year, though. The Russell 2000, the index that measures the small capitalization market, is just about keeping up with the Nasdaq since year-end. Investment strategists have called for a rebound in the small-cap sector for the past couple of years, but were always disappointed. Apparently, the resurgence that began in December 1999 is continuing into the first quarter. It is true that at least some of the market appreciation is coming from small-cap technology stocks. All markets tumbled on Friday, but the Nasdaq composite and the Russell 2000 still managed to record solid gains for the week.
The up-and-down Treasury market could very well lead equities over a rocky road in the next several weeks. Equity investors are accustomed to monitoring interest rate levels. As rates gyrate, stock investors are likely to become more confused. Are rates rising? (Yes, on the short end.) Are rates falling? (Yes, on the long end.) It's not the same easy upward path investors followed in the past couple of years. Turbulent
Treasury Market
In the old days a negatively sloped yield curve, such as we see today, would imply that economic activity was on the verge of slowdown. Rising short rates - spurred by Federal Reserve tightening - and falling long rates usually presaged either slowdown or outright economic recession. Yet today's environment is causing a sharp plunge in long bonds because the U.S. Treasury announced they would reduce the supply of these securities in the future. The Treasury said it was reducing supply because borrowing needs are smaller than in the past. This stems from not only the federal budget surpluses of the past two fiscal years, but also those projected for the next several years. While the supply of U.S. Treasury securities is set to diminish over the coming years, it doesn't mean that private sector borrowing is on the wane. Moreover, Fannie Mae and Freddie Mac both have pressed forward with their debt calendar - also announcing plans to increase the quantity of 30-year bonds they will offer in 2000. The interest rate market will likely follow the same roller coaster pattern of the past couple of weeks for several more weeks to come. It will take some time for the bond market to make sense of interest rate levels and shifts in demand and supply of both government and corporate bonds. Fasten your seat belts for the bumpy ride ahead.
(BP = basis points; stock price indices are rounded) Retail
sales mask underlying strength
Some of the weakness in the January figures is likely related to Y2K distortions. Remember last month when we noted that consumers stocked up on Campbell's soup, Velveeta and Spam? (Food store sales surged 3.2 percent in December.) It was time to swallow that stuff in January, because food store sales fell 2.2 percent. And if consumers filled up their gas tanks in December (sales at gasoline service stations jumped 3.6 percent), they didn't in January (with sales up only 0.4 percent for the month.) Three key elements in the retail sales report suggest that the consumer spending machine hasn't shut down. Auto sales jumped 2.3 percent in January on top of a 1.4 percent hike in December and a 2.7 percent spurt in November. Sales at general merchandise stores are averaging monthly gains of 0.8 percent for the past three months, an acceleration over the past several months. Sales at apparel stores declined for five of the past eight months - but increased sharply in the most recent two months. No, consumer spending is not abating these days. Will consumer spending ever moderate? Federal Reserve officials are certainly counting on the four rate hikes that began in June 1999 to curtail spending. Typically, higher interest rates will hamper spending on housing, autos and furniture because such large-ticket items need to be financed. One would never believe this old economic theory holds any water by looking at the large monthly gains in consumer credit. In fact, the three-month moving average actually picked up steam in the fourth quarter of 1999. This largely correlates with the surging pace of motor vehicle sales.
One can't get by discussing consumer spending and not mention the wealth effect. It is now firmly entrenched in the market psyche. Consumer spending is skyrocketing - and surpassing income growth - because consumers feel wealthier as stock market returns post historic highs. Shareholders don't have to realize these capital gains to spend them. They simply borrow - and dissave. The chart below shows that the debt-to-income ratio reached a new all-time high in December 1999 at 20.6. The personal savings rate plunged ever lower to a new historical low of 1.9 percent. If stock market returns provide less stellar performance in 2000 than consumers are used to, these high debt burdens coupled with little savings won't provide much of a cushion.
The bottom-line on the consumer? Y2K distortions masked underlying strength in retail sales. Consumer spending was robust throughout 1999 and into the beginning of 2000. Consumer spending continues to outpace income growth and consumer installment credit gains are running as strong as ever. Indeed, it appears that debt growth has accelerated in the past few months. As long as consumer confidence is set at a "euphoric high," retail sales could continue to record healthy gains in the first part of 2000. Yet, one would think that old economic theories have withstood the test of time because they hold true in the long run. That means that increases in interest rates already put in place by the Fed will eventually dampen spending. And the Fed is on standby to raise rates again … soon. Robust
productivity doesn't disappoint Unit labor costs declined at a 1 percent rate in the fourth quarter, after dipping in the third quarter as well. Despite the worries over tight labor markets and accelerating wage pressures, labor costs remain subdued. The chart below depicts annual gains in productivity and unit labor costs during the 1990s. We like to compare yearly changes by fourth-quarter/fourth-quarter growth rates. Note that productivity grew at its fastest pace in seven years in 1999! At the same time, unit labor costs posted their smallest rise since 1996. While the same pace of productivity and unit labor cost growth can't be guaranteed for the upcoming year or so, there is no question that these figures are favorable for the economy.
The bottom-line on productivity? The reliability of productivity data has long been controversial. It is easy to measure productivity in the goods-producing sector because one can count the number of employees on the payroll and then look at the monthly industrial production figures that measure physical output. But productivity in the service sector is another matter. Service sector output is generally measured by employment in the service sector. However, there is no corresponding physical output to which one can point. By definition, service sector productivity will always remain unchanged and static. In reality, service sector productivity can also grow. Workers tend to gain experience with years on the job. Computers and information technology have eased the burdens of employees in the service sector. Federal Reserve chairman Alan Greenspan has questioned the degree to which productivity gains will be forthcoming in 2000 and beyond. Because we don't have accurate measures of relevant data, no one can really know how fast productivity will grow in the future. Historically, productivity growth waned over the mature phase of the business expansion. Based on these historical rules of thumb, Greenspan is surmising that productivity growth will soften in coming months, and a slowdown in productivity growth would narrow the margin for non-inflationary wage gains. As a result, Fed officials are more vigilant against upward price creep these days. THE
BOTTOM LINE
Financial market participants will focus on inflation news in the upcoming week. Two key inflation measures will be reported - the consumer price index and the producer price index. It will also be interesting to see if higher mortgage rates are dampening housing activity. Housing starts will be watched closely for signs of moderation. Probably the most important focus for the market will be Greenspan's testimony for Humphrey-Hawkins. Financial market players are counting on at least one rate hike at the March FOMC meeting and will be looking for clues in the testimony. Many economists are calling for rate hikes at the March and May meetings. In the meantime, it will be difficult to make sense of sentiment in the bond market, since it will be overshadowed by the turmoil caused by the reduction in supply of Treasury securities. Looking
Ahead: Week of February 14 to February 18 Monday
Tuesday
Wednesday
Thursday
The consensus shows that the producer price index will increase 0.2 percent in January. Higher energy prices are still hurting this series. Excluding food and energy prices, the PPI is expected to rise only 0.1 percent for the month. The Philadelphia Fed's business outlook survey is projected to rise modestly in February to 12.0 from a level of 9.1 in January. This would indicate continued gains in production. Friday
The international trade deficit for goods and services is expected to widen slightly in December to $26.7 billion from a shortfall of $26.5 billion in November. The trend of import growth outpacing export growth is not expected to change in the near term. The market consensus shows that the Treasury will announce a federal budget surplus of $58.5 billion in January. Estimated tax payments tend to swell Treasury coffers this time of year. |
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