Economic Commentary - Dave’s Top Ten List
Merrill Lynch
11 February 2005
This research product summarizes the 10 major macro themes of the past week as a
prelude to our weekly publication the Market Economist.
1. The bond market is moving further and further away from the consensus of
economists – remember that 54 of 56 economists polled by the Wall Street Journal were
bearish at the start of the year. That was a tell-tale sign of what was to come. As it now
stands, the just-released Bloomberg survey of 71 pundits still shows an end-2005
forecast of 5% (and an end-of-quarter level of 4.31%) on the 10-year. And the Stone &
McCarthy duration survey still shows the average ratio at 96.7% of bogey. The 10-year
yield has sliced below 4% for the first time since last October and is now at April/03
lows but there is now nothing but ‘dead air’ down to 3.9% with the next text after that at
3.8% which was our call at the start of the year when clients were asking us what type of
medication we were on. Now the technicals and mortgage convexity dynamics begin to
take over.
2. The long bond at 4.37% yield is now just 20 bps away from taking out the June/03
deflation low as investors try and scramble for duration ahead of any possible
accounting changes regarding defined pension benefit plans. This was in the works
for a while and we had mentioned at the start of the year – but even us bond bulls have
been surprised by the sharp 50 bp rally and the big compression in the 10/30 curve to a
mere 38 bps. It could compress further yet – in the May/00 tightening, the spread hit -30
bps; in Jan/95 it got as tight at +1 bp and in May/90 the spread moved to -8 bps; in
Feb/89 it got to -20 bps ; in May/86 it got to -40 bps; in Sept/84 it got to -30 bps. Funky
things like this happen during Fed tightening cycles – especially in the latter stages.
3. The bond rally is triggering another round of stepped-up mortgage activity (little
wonder – the 30-year fixed-rate mortgage dropped to a 10-month low of 5.48% last
week from 5.62% the week before): applications are up two weeks in a row and in
three of the past four. But what is interesting is that such an overwhelming portion of
the general public has already refinanced that the refi index gets lower and lower with
each subsequent move in the 10-year note yield below 4%. Go back to Nov/02, when
the 10-year first broke to 4%, and the MBA refi index hit 6,174. The next go-around to
4% in Feb/03 saw the refi index rise, but it hit 5,470. Then in March/04, the prior period
when the 10-year broke down below 4%, the refi index was 3,568. And lo’ and behold,
yesterday we got the latest refi index number and as the 10-year approached 4% all it
could do was edge up to the 2,430 level – 30% lower than it was on March/04 and 50%
below the Feb/03 level.
4. Since the Fed began to raise rates on June 30th, it has tightened 150 basis
points to 2.5% on the funds rate. Since that time, the long bond yield has
plunged exactly 100 basis points to 4.41%. The last time – about the only time
– the long bond yield fell this much 8 months after the first Fed rate volley
was in the second half of 1997 … and we know what happened next. As
David Wilson told me yesterday, “the stock market is smarter than everyone
combined, and the bond market is smarter than the stock market”. What is it
that Mr. Bond is seeing with his Agent 007 supersonic glasses?
5. Follow the ISM – for bonds and equity sectors: we published a report on
February 3rd showing that bond yields typically fall, not rise, when the ISM is
in a down-phase, as has been the case in the past year – there is a non-trivial
70% correlation between the two series. In each of the past 5 cycles, the 10-
year note yield dropped when the ISM index was moving from a peak to a
trough, and by an average of 140 bps over a 21-month span that sees the ISM,
on average, drop 17 points . The current down-cycle is only 12 months and
the decline in ISM has been 6.4 pts to 56.4 – and the 10-year yield thus far
has been 20 basis points, so there would seem to be more to go based on past
experience. What about equities? Well, during this 12-month phase, the S&P
500 is typically up less than 5% and the defensives tend to outperform the
cyclicals. To wit: we found at the top of the list tobacco (+64%), the food and
drug retailers (+40%); brewers (+35%), insurance companies (+35%), health
care (+32%), food processors (+30%), utilities (+21%) and the banks
(+16%). Near the bottom were mining (-13%), steel (-9%), paper (-5%),
semiconductors (0%) and cyclical consumer goods (+1%).
6. Reasons why we are dovish on inflation: first, even after the latest round of
production cuts, Big Three auto inventories at 71 DS are 7% above normal.
So here we have a chronic supply overhang in 10% of the core CPI. Then we
have apparel, which is another 5% of the core index and its deflation trend
may well accelerate – why do you think China’s exports and trade surplus
exploded to the upside last month? Export growth ballooned 42% y/y from
33% in December – with clothing and textiles leading the way as global quota
restrictions were finally relaxed. Other Asian textile exporters like
Bangladesh and Cambodia are being forced to compete more intensively with
China, which now commands a 17% share of the $500 bln global market and
the World Bank estimates that this share will soar to 50% in the next four
years.
7. The IBD/TechnoMetrica economic optimism index fell in February to
54.8 from 56.2 – the “economic outlook” index slipped to 51.2 from 53.3 in
January, and well off the nearby high of 58.2 in August. Note that the sixmonth
outlook fell 2.1 points to 51.2 – lowest in ten months. This index, as an
aside, has shown an uncanny ability to foreshadow the U of M consumer
sentiment index. We also got the ABC News/Washington Post consumer
confidence index for the week of February 6th – rang in at -10 from -11, but
is still 4 points off the -6 print of a year ago. ‘Buying climate’ is nothing to
write home about at -24 – same as last week and off 8 points from the -16
reading at this juncture in 2004.
8. The consensus is looking for real GDP growth of 3.6% SAAR in Q1, up
from the estimate of 3.5% last month: How we get there without a
productivity boomlet remains to be seen, given the weak starting point in the
hours-worked data. Plus, the momentum going into the quarter both in terms
of real retail sales (given the sharp falloff in auto sales in January) and
business spending on equipment are both barely running at over a 1% annual
rate. Inventories and trade should be a wash and housing’s contribution to
GDP is yesterday’s story. Our bean count suggests a Q1 number closer to 3%
than 3.5% – below trend, and one reason why the curve is flattening as the
Fed continues to raise rates in an environment where the economy no longer
is growing above potential.
9. U.S. consumer credit demands receded in December – only +$3.1 bln,
well below consensus: This is a 1.8% annualized increase and this followed
an almost equally meager 1.1% pace in November. The 3-month trend has
been wound down to a 3.7% SAAR pace from 6.4% in September. As the
chart below shows, credit growth and interest rates go hand-in-hand together.
It’s tough to square the circle that non-revolving consumer credit was up less
than 0.2% at a time when auto sales, for example, surged 12% in December.
But we know from the banking sector data that home-equity loans soared at a
17% annual rate during the month and are up more than 40% year-on-year,
and we can’t find any other metric, financial or economic, that is running that
strong. Are people actually tapping into their home-equity lines of credit to
finance their third SUV purchase?
10. The NFIB small business index dropped from its lofty heights for the
second month in a row – to 103.6 in January from 106.1 (and lower than the
105.8 print a year ago) and the November high of 107.7. The y/y trend is
sliding fast, and at -2.1% is now at a 21-month low. The share of small
businesses expecting the economy to improve sank from 37% to 25% – the
lowest since April/03. The labor market indicators softened, confirming the
NFP survey – those with more than 1 job opening fell 2 points to 15, and
hiring plans dropped the same amount to 21. The Fed’s big bet this year is
that companies will boost spending, but what we see from the NFIB index is a
scaling-down of capex intentions in the next 3-6 months to 34 from 38; those
saying that “now is a good time to expand” receded to a four-month low of 23
in January from 28 in December. The inflation readings remain high but are
rolling off their peaks – the % intending to raise prices dipped to 28 from 30
and remains in the broad 24-30 band established since last April. In other
words, no breakout. The % planning to boost worker compensation dropped
to 17 from 20 – second-biggest decline since mid-’03. All in, nothing here to
threaten the bond rally. |
