<font color=green>Econ</font>--John Lonski & John Puchalla, Moody's, 8/14/00...
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>>>Credit Market Overview -- New York, August 14, 2000
Lower Borrowing Costs Lift Economic Prospects
John Lonski, Moody's senior economist in New York
The FHLMC's 30-year mortgage yield fell to 8.04% for the week of August 11th, which was its lowest weekly reading since December 1999. US corporate bond yields have also retreated as signs of a softer economy have mounted.
Our long-term Baa industrial company bond yield has sagged from it May 18, 2000 high of 9.12% to a recent 8.23%. Speculative-grade bond yields have also dropped by about half of a percentage point from their highs of late-May 2000.
The latest retreat by fixed-rate borrowing costs should help to limit the severity of the current economic slowdown. Mortgage applications have already moved higher in response to lower borrowing costs, while consumer sentiment has improved. A rebound by home sales may not be that far behind.
Previously, the 10-year Treasury yield had generally remained under 6% during March 1993-February 1994, November 1995-February 1996, and November 1997-September 1999. For each of these three episodes, the US economy's credit worth was sufficient for the purpose of allowing lower fixed-rate borrowing costs to spur domestic expenditures. Ultimately, the rejuvenation of domestic spending would boost both inflation risks and credit demands by enough to push the 10-year Treasury yield back above 6%.
For the quarter-ended July, the prospective yearly increases of 8.6% for business sales and of 8.2% for retail sales are steep enough relative to the 10-year Treasury yield to underscore the vulnerability of a sub-6% 10-year Treasury yield. A quick quarter of a percentage point rise by Treasury yields could materialize if developments no longer favor a less-than-7% annual growth rate for business sales.
Earned Income May Determine Consumer Spending's Fate
Although consumer confidence shows signs of firming, a recent loss of momentum for wages and salaries casts doubt on the nearness of an extended re-acceleration by retail sales. May-July 2000 revealed only 69,000 new private-sector jobs -- the fewest for any three-month span since the 61,000 of 1992's third quarter. In turn, wages and salaries may have risen by merely 0.3% per month, on average, during the quarter-ended July, for the worst such performance since the 0.2% average monthly gain of the quarter-ended January 1996.
A rebound by private-sector hiring activity coupled with a quickening of wage and salary income would probably trigger a substantive revitalization of consumer spending that sends interest rates higher. The outlook for profits has yet to worsen by enough to rule out the faster expansion of both employment and personal income.
Nevertheless, the ongoing deceleration by wages and salaries does not bode well for consumer spending. July's surprisingly steep monthly jump by retail sales did not arrest the downward trend of retail sales' year-to-year increase from the 10.5% of 2000's first quarter to the 8.2% of the quarter-ended July. Similarly, the annual increase of wages and salaries has dipped from its most recent peak of 7% for the quarter ended May 2000 to the 6.6% of the quarter-ended July.
Unless the annual growth rate of same store sales soon begins a lasting upturn, the now much faster expansion of comparable retail sales versus same store sales offers yet another reason to look for a slowing of household expenditures. The roughly 43% of the US government's version of retail sales that conforms to our same store sales index was up by 8.2% yearly in July, which exceeded the concurrent 4.5% annual increase of same store sales by an above-average 3.8 percentage points. During 1995-1999, same-store sales' average yearly increase of 4.9% was accompanied by a 6.7% average yearly gain for comparable retail sales.
The gap between the annual growth rates of comparable retail sales and of same store sales has widened from the 1.8 percentage points of 1995-1999 to the 3.3 points of January-July 2000. Compared to 1999's scintillating average annual increase of 6.8%, the average yearly gain of same store sales has ebbed to the 4.5% of the quarter-ended July 2000.
Autodealership Sales Decelerate Sharply
The year-to-year growth rate of retail sales slowed from the first-quarter's 16-year high of 10.5% to the 8.2% of the quarter-ended July. The most pronounced deceleration fell upon autodealership sales, whose annual growth rate plunged from the first-quarter's 13.4% to the 6.5% of the quarter-ended July. After surging higher by 9.1% yearly in 2000's first quarter, unit sales of US-built light motor vehicles fell by 2.7% yearly during the quarter ended July. This was the first such decline since unit sales of US-built light motor vehicles sank by 6% yearly in 1998's tumultuous third quarter.
No wonder hours worked at the manufacture of motor vehicles fell by 2.6% yearly in July. Moreover, as derived from Ward's Automotive data, the year-over-year increase by US motor vehicle output has slumped from the 5.2% of 2000's first quarter, to the 1.5% of the second quarter, and, most recently, to the 0.3% of the third-quarter-to-date.
Sales at building material and hardware stores grew by 3.6% annually for the quarter-ended July, which was well under their 7.9% average annual increase of 1995-1999. Also slowing in response to a cresting of housing activity were furniture and appliance store sales, whose annual growth rate dipped from the 10.8% peak of the quarter-ended April 2000 to the 8.2% of the quarter-ended July.
The sales of some retail categories managed to accelerate. From 2000's first quarter to the quarter-ended July, the annual growth rates rose for general merchandise store sales -- from 6.7% to 7.8%, for food store sales -- from 4.8% to 6.4%, and for drug store sales -- from 7.7% to 9.1%. Nonetheless, apparel store sales have struggled, slowing from the first-quarter's 5% annual increase to the 3.4% of the quarter-ended July.
US Spending Slows And Industrial Metals Prices Soften
July's PPI was unchanged from June and higher by 4.1% from July 1999. Excluding food and energy prices, July's PPI rose by 0.1% monthly, while growing by 1.5% yearly. The containment of PPI inflation is but one reason why the federal funds rate will not be hiked on August 22nd.
Excluding food and energy prices, the annual rate of intermediate materials price inflation slowed from April 2000's 3.3% to July's 2.8%, while the annual rate of core crude materials price inflation dropped from a January 2000 peak of 16.3% to 7.5% in July.
The industrial metals price index most recently peaked on March 20, 2000, which corresponded to a peaking of business sales' year-to-year growth rate at the 9.9% of the first quarter, including a 10.5% top for retail sales. The industrial metals price index would immediately soften as retail sales slowed sharply from the first-quarter's breakneck pace. For the second quarter, retail sales rose by 2.1% annualized from the first quarter, while growing by 8.5% year-over-year. First quarter 2000's growth rates for retail sales were 13.5% quarter-to-quarter annualized and 10.5% year-to-year.
Recently, the industrial metals price index was down by 7.4% from its March 20th high. The almost immediate softening of prices for globally-traded industrial metals following the deceleration of US domestic spending may reflect the world economy's considerable dependence on what remains an above-average pace for US domestic expenditures.
The dollar exchange rate's continued strength in the face of a record-smashing US current account deficit highlights how the US is still the principal driving force behind world economic growth. US expenditures may have slowed, but they continue to outpace those of Europe and of Japan by a wide margin.
The rest of the world may not yet be vigorous enough to tolerate an extended deceleration of US domestic spending. Remember 1998's global crisis. A number of foreign economies slumped badly not long after the year-over-year increase of US retail sales slumped from the 6% of the six-months ended March 1997 to the 3.7% of the six-months ended March 1998. The latter trailed US retail sales' average annual growth rate of 5.9% for 1995-1999, which was joined by the 6.7% average annual gain of wages and salaries.
Rather than lead retail sales growth by 8/10ths of percentage point as in 1995-1999, the annual 6.7% growth rate of wage and salaries has instead trailed retail sales' 9.6% annual advance for the 12-months ended July by one of the widest margins since the 3.1 percentage point deficiency of late 1994. Retail sales' year-to-year growth rate would subsequently drop from the 7.8% of 1994's final quarter to the 3.9% of 1995's final quarter.
To the detriment of certain foreign economies, first-half 2000's 9.5% annual increase by US retail sales seems destined to slow by at least 2.5 percentage points.
Homebuyer Mortgage Applications Imply Mild Slowdown
A rejuvenation of household expenditures looms according to the latest upturn by mortgage applications for the purchase of a home. During the four-weeks ended August 4th, the Mortgage Bankers Association's (MBA) index of applications for mortgages from potential homebuyers rose by 4.1% from the contiguous four weeks while growing by 14.7% year-over-year.
The yearly growth rate of real consumer spending last broke well under its 15-year average of 3.4% in 1995. In response to sharply higher borrowing costs, the annual increase of real consumer spending would drop from the 4.4% of the quarter-ended April 1994 to the 2.4% of the quarter-ended April 1995, where the latter now serves as an eight-year low.
On the way to 1995's slump in household spending, mortgage applications for the purchase of a home would plummet by as much as 18.1% year-over-year for the quarter-ended November 1994. As of the quarter-ended April 1995, the MBA's index of
homebuyer mortgage applications was still down by 8.1% yearly.
The latest climb by mortgage yields has trimmed mortgage applications from potential homebuyers by no more than the 5% yearly dip of the quarter ended November 1999. The three-month moving average of homebuyer mortgage applications would then recover to the 12.1% annual increase of the span-ended April 2000 before slowing to a still solid prospective gain of 8% for the span-ended August.
Consensus Calls For A Major Consumer Spending Slowdown
The year-to-year increase of real consumer spending has already slipped from first-quarter 2000's 16.5-year high of 6% to the second-quarter's 5.4%. The Blue Chip consensus estimates that the annual increase of real consumer spending will drop to 4.3% by 2000's final quarter and then eventually slide to the 3% of 2001's fourth quarter.
The latter would be the flattest yearly increase by real consumer spending since 1996's third quarter, or when unit sales of US-built light motor vehicles grew by 2.5% annually and same store sales gained 3.1% annually. For the quarter ended July 2000, unit sales of US-built light motor vehicles were down by 2.7% yearly, while same store sales rose by 4.5%.
If the annual change of real consumer spending does sag from the 6% of 2000's first quarter to the 3% of 2001's fourth quarter, the yearly change of consumer spending will have incurred its deepest drop over a seven quarter span since 1991.
The annual increase of real consumer spending may not descend to its bottom of 1995, but the profitability of companies having substantial exposure to household expenditures will be at risk if the projected consumer spending slowdown materializes. Nevertheless, investors might take comfort from how the consensus has consistently underestimated real consumer spending.
Back in January 1999, the consensus looked for a 2.6% annual rise by 2000's real consumer spending. By December 1999, that projection had been ratcheted up to 3.4%. As of early August 2000, the consensus was anticipating a 5.1% annual advance for 2000's real consumer spending. The latest upturn by homebuyer mortgage applications preserves the possibility of forecasts again having shortchanged the vigor of consumer spending.
Consumer Spending Index Sees Flatter Rise By Retail Sales
One consumer spending index consists of the weighted average for the year-to-year percentage changes of unit sales of US-built light motor vehicles and of same store sales. For the quarter ended July, the consumer spending index was up by 1.9% yearly.
Not only was the latest rise by this statistic its smallest annual increase since the 1.4% of 1998's third quarter, it also retail sales' 8.2% yearly advance by the widest margin on record. Consider how third-quarter 1998's meager annual uptick by the consumer-spending index was accompanied by merely a 4.2% annual increase for retail sales.
Third quarter 1998's gap between the yearly growth rates of retail sales and of the consumer spending index was not that far removed from the long-term average 2.2 percentage point premium of retails sales growth over the consumer spending index's growth rate. In sharp contrast, the 8.2% annual increase by retail sales for the quarter-ended July 2000 topped the consumer spending index's 1.9% annual rise by a very wide 6.3 percentage points. Plan for a further deceleration by retail sales even if the consumer spending index recovers.
Overseas Net Buying Of US Equities Soars
Foreign investment in US equities soared in 2000's first quarter. Net foreign investment in US stocks proceeded at an unheard of $250.7 billion annualized pace during 2000's first three months, which was well above 1999's record year-long net investment of $94.3 billion.
According to the Federal Reserve's preliminary first-quarter estimate, an unprecedented 34% of the first-quarter's net foreign purchase of US assets consisted of equities, which was a tad above fourth-quarter 1999's old record of 33%. For all of 1999, 13% of foreign net investment in the US was allocated to stocks, compared to a 7% share for 1996-1998.
For the year-ended March 2000, foreign net purchases of US stocks approached 19% of total net foreign investment in US assets. By comparison, the US' net buying of foreign stocks over the same 12 months ended March 2000 approximated 34% of total net US investment in foreign assets.
As of March 2000, foreign investors owned $1.37 trillion of US corporate equities, or about 8% of the market value of all US equity shares. The foreign ownership share of US stocks peaked at the 9.2% of 1990's third quarter.
Foreigners also were attracted by the relatively ample interest rates offered by US corporate bonds. Facilitating foreign investor purchases of US corporate bonds has been the rapid growth of large-sized global bonds.
Foreigners were net buyers of $181.4 billion annualized of US corporate bonds in 2000's first quarter. In terms of a 12-month moving average, the foreign net buying of US corporate bonds was a record $169.9 billion for the span ended March 2000.
For 1996-1998, the $96.7 billion average annual net purchase of US corporate bonds by foreigners trailed their $197.6 billion average annual net investment in US government securities. Subsequently, the $163.4 billion average annual net purchase of US corporate bonds by foreigners has topped their $101.2 billion average annual net outlay on US governments.
As of March 2000, foreigners owned $863.9 billion, of 20.5%, of all US corporate bonds outstanding. The foreign ownership share previously peaked at the 16.2% of year-end 1986 and would eventually temporarily bottom at March 1993's 12.6%. Over the five-years ended March 2000, the 21.5% average annual advance by foreign holdings of US corporate bonds sped past the 12.7% average annual growth rate of US corporate bonds outstanding.
The net purchase of US government bonds approached 12% of 1999's total foreign net investment in US assets, which was substantially under its 36% share of 1996-1998.
Foreign net buying of US governments attained a $168.8 billion annualized pace during 2000's first quarter. After averaging $233.1 billion per year during 1995-1997, foreign net buying of US government securities slumped to 1998's $90.9 billion and then sagged to $84.3 billion in 1999.
Foreign net purchases of US governments fell to 0.9% of US GDP in 1999, which was the smallest such share for any calendar year since 1991's 0.7%. For 1995-1997, foreign net investment in US governments approximated 3% of GDP -- the steepest share for a three-year span on record.
Business Sales Pushes Aside GDP In Terms Of Relevance
Lately, the Commerce Department's estimate of business sales has outperformed GDP as far as explaining changes in financial market sentiment. Offering a much better indication of reduced worry over Fed rate hikes and rising concern over profitability was the drop by the annual increase of business sales from the 9.9% of 2000's first quarter to the 8.8% of the second quarter, as opposed to the concurrent rise by nominal GDP's growth rate, from 7.1% to 8.1%.
Leading up to the latest series of Fed rate hikes that began at the end of June 1999, the annual growth of business sales improved considerably from its 2.6% rise of 1998's third-quarter to the 6.2% of 1999's second-quarter. At the same time, the yearly increase of nominal GDP barely inched up from 5.2% to 5.4%.
By our own measure, the annual growth rate of nonbank corporate revenues has slowed from first-quarter 2000's better-than-10 year high of 12.2% to 9.7% for the second-quarter's unfinished sample. In turn, the annual increase of nonfinancial-corporate recurring profits has retreated from the first-quarter's 21.6% to the 15.6% of the available second quarter sample. In addition to slower sales growth, profitability has been curbed by the faster rise of raw material costs, by steeper employment costs, and by dollar exchange rate depreciation.
The second quarter slowdown still left recurring profits growing at an above-trend pace. Possibly because of higher operating costs and dollar exchange rate appreciation, sales growth appears to be supplying less of a boost to corporate earnings growth than during the mid-1990s.
One of the primary driving forces behind the profits slump of 1998 was a drop by our annual growth rate of nonbank corporate revenues from the 7.4% of 1997's final quarter to the 2.2% of 1998's final quarter. Another severe deceleration by revenues should be avoided. Accordingly, the annual increase by recurring profits ought to fare much better compared to what transpired during 1998, or when the yearly increase of nonbank recurring profits plunged from 1997's 12.5% to 1998's 2.3%.
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John Lonski
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More Downgrades Fatten High-Yield Spreads
A growing number of high-yield downgrades relative to upgrades might continue to push yield spreads wider and the default rate higher. Downgrades tend to increase the
riskiness of the high-yield market, which is a key driver of forecasted default rates.
An increasing risk of default for some issuers weakens access to capital for more financially secure companies as investors seek to reduce exposure to risk. Alternatively, investors have demanded higher potential returns to finance high-yield issuers, which has helped to widen yield spreads.
Speculative-grade yield spreads have been highly correlated with the ratio of high-yield downgrades to upgrades. A continued increase in the number of downgrades implies high-yield spreads have yet to peak.
Each high-yield upgrade was accompanied by 3.3 downgrades in the first half of this year for the highest ratio since an identical 3.3 downgrades-per-upgrade in 1991. Warning of higher spreads, the 674 basis point average high-yield spread in 1991 was well above the current 603 basis point premium.
Also, the 32 speculative-grade downgrades thus far in the third quarter outweighed the six upgrades by an even wider 5.3-to-1 margin, which would be the third highest quarterly ratio on record. When the high-yield downgrade-to-upgrade ratio peaked at 7.4-to-1 in the first quarter of 1990 and 5.7-to-1 in the first quarter of 1991, spreads averaged 644 and 890 points, respectively.
Because the U.S. economy does not appear to be headed for a recession, the default rate and high-yield spreads should peak at levels below their highs of the early 1990s. Nevertheless, another 25-50 basis point widening of high-yield spreads appears likely while a 100-150 basis point increase cannot be ruled out.
Credit risks in the high-yield market are much higher than during the last peak in the credit cycle. Downgrades of speculative-grade bonds bottomed relative to upgrades in the three years ended 1997. Accompanying the 0.8-to-1 ratio of downgrades-per-upgrade over this span, yield spreads also bottomed at an average of 325 basis points while the three-year average default rate reach a low of 2.3%.
Fewer Equity Buybacks Still Present Risk to Credit Worth
The number of companies announcing equity buybacks has begun to decline but several large announcements have thus far prevented a similar slide in the dollar amount of share repurchase announcements. Stronger earnings have allowed larger companies to limit the decline in financial flexibility from an equity buyback but a likely slowdown in consumer spending has prompted a growing number of companies to preserve cash. A still brisk pace of share repurchase announcements and a gradual increase in managerial aggressiveness nevertheless continue to present a greater risk to corporate credit worth than in the mid-1990s.
Buyback announcements tend to be concentrated around the quarterly release of corporate earnings. The 115 U.S. companies announcing equity buybacks in July was down 18% from 140 in April notwithstanding a concurrent 14% increase in the dollar amount of announcements to $25.1 billion. After averaging 158 per month in the quarter ended May, domestic buyback announcements fell to 117 per month in June and July.
Financial companies have been the primary contributors to the recent increase in the dollar amount of buyback announcements. Six financial firms - including three banks - have announced buybacks of at least $1 billion in the last two months totaling an estimated $14.7 billion. There were just four $1 billion buyback announcements by financial companies with a total value of $7.6 billion in the quarter ended May.
Over the same span, average monthly buyback announcements by industrial companies dipped from six to three while the average monthly dollar amount concurrently plummeted from $9.9 billion to $4.2 billion. Diminishing buyback volume suggests that industrial corporations do not expect to repeat the spectacular earnings performance of late 1999 and early 2000.
A tight labor market diminishes the likelihood of a significant reduction in inflation risks. Without the support of sharply lower interest rates that might accompany lower inflation, fewer buybacks and a deceleration of corporate earnings growth would pressure stock prices.
Corporate credit worth can improve despite a rising number of equity buybacks if share issuance also increases. A sizable portion of recent offerings of common stock, however, have been concentrated in Internet start-ups and other technology companies, which tend to have less publicly traded debt outstanding. As a result, in terms of the universe of corporate bond issuers, the increase in equity buybacks has outstripped the boost to credit worth from new share offerings.
The drag on credit worth is evident in corporate rating revisions. The number of equity-buyback linked credit rating downgrades - including leveraged buy-outs - increased from nine per annum in the five years ended 1999 to a total of 20 in the first half of 2000. Over the same span, the number of upgrades related to an offering of common equity slipped from an annual average of 32 to a total of just 11 in the first half of this year. Similarly, the five equity buyback linked U.S. corporate credit rating downgrades thus far in the third quarter topped the lone upgrade related to a share issuance.
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John Puchalla <<< |
