Economic Commentary - Dave’s Top Ten List
25 February 2005
Merrill Lynch
This research product summarizes the 10 major macro themes of the past week as a
prelude to our weekly publication the Market Economist.
1. We hear and read about how stimulative financial market conditions are….but
let's see: oil is up 35% from a year ago; 30-year fixed-rate mortgages are up 20 basis
points and prime lending rates are up 250 basis points. It begs the question – if the
markets are that accommodative, why are mortgage applications down 15% from the
nearby peak last July? Shouldn't they be up 15%? Take a look at the latest weekly data
on retail sales – the ICSC-UBS number showed a 0.1% dip in the February19th week
and the y/y pace is running at only a 1.8% pace. Everyone talks about how stimulative
market conditions have become since last June 30th (begs the question why y/y GDP
growth peaked back then instead of now) – pretty simplistic to just look at long-term
rates and the bottom line is that even though they have fallen since the Fed first started
tightening last June, they are merely in the same range they have been locked in for
about three years. THIS ALL BEGS THE QUESTION IF CONDITIONS ARE SO
PRO-GROWTH WHY IT IS THAT THE YEAR-ON-YEAR TREND IN THE
LEADING ECONOMIC INDICATOR IS RUNNING AT +0.8% RIGH NOW
VERSUS +3.8% WHEN THE FED FIRST EMBARKED ON ITS TIGHTENING
COURSE LAST JUNE. MAYBE – JUST MAYBE – THE ECONOMY CAN USE
THE 'STIMULUS' THE MARKET IS SUPPOSEDLY PROVIDING AS THE FED
CONTINUES TO RAISE SHORT-TERM INTEREST RATES.
2. The January CPI inflation report was a true breath of fresh air and restored our
conviction that pricing power remains broadly elusive in the retail sector: To be
sure, we were concerned that the markets would face another inflation scare since not
one other time in the past 25 years – until this past month – did we see a +0.8% print on
core PPI coincide with anything as low as a +0.2% reading on the core CPI. Yet that is
exactly what happened. Moreover, autos and tobacco alone added 0.1% to the core
figure and any retracement here – motor vehicle pricing sure look likely – are bound to
cast a glow on February's data as well. This is not to say that there is no inflation – but
it is still relegated largely to the producer sphere and areas with binding capacity
constraints such as ex-air transportation infrastructure. It is, after all, the corporate
sector that has the organic spending power in the broad economy. The household sector
is saturated after a three-year debt-financed spending spree, with the savings rate no
matter how it's measured near historic lows. And the reality is that the retail sector is not
only facing an ever price-conscious consumer that is already tapped-out on many fronts,
but also a sector that is gripped with overcapacity and intense competitive pressures.
Just because metal container prices, shipping vessels, agricultural machinery prices are
surging at the PPI level doesn't mean that we are going to have rampant inflation at the
retail level. Wal-Mart may have a broad array of merchandise on the shelves but
railway stock doesn’t happen to be one of them.
3. The producer index does not capture the service sector – and core prices on this
score were responsible for holding the underlying CPI number to a +0.2% print.
Inflation in ex-energy services has slowed down rapidly and this segment represents
56% of the consumer price index or well over double the share of core goods. The
“lodging away from home" (BLS-speak for hotels/accommodation) index fell 0.7% in
January and is down in two of the past three months and the year-on-year trend appears
to have rolled over. Tuition rates are turning down – +0.3% m/m in the softest increase
in the past five years. Airline fares are now deflating at an accelerating pace (-3.2% y/y)
and personal service prices fell 0.1% last month in the first decline in nearly three years.
Communications (telephony) services also remain in deflation mode. So much for the
view that the service sector was immune from competitive pressures – as the chart below
illustrates, the pricing trend is heading south at a fairly rapid clip.
4. We wonder aloud why so many pundits are so nervous about the inflation outlook
when labor income growth is so tepid as is the case today: Real average weekly
earnings fell 0.2% in (see chart above) in January and are now down in three of the past
four months. The year-to-year trend remains ensconced in negative terrain – down 0.7%
in January. Fiscal stimulus is turning towards restraint and for the first time in three
years, revolving home equity lines of credit have fallen for back-to-back weeks –
households had been tapping this as a source of spending for most of the past six months
(when it was running at 30%+ annualized growth rates). But with higher oil prices –
WTI up 35% over the past year (is this included in the oft-mentioned measures of
'financial market stimulus'?) – biting into discretionary spending power, retailers in
many sectors have repeatedly been forced to mark down their prices or hold back on
price increases.
5. Be that as it may, the Fed seems determined to continue raising the funds rate in
the months ahead: Atlanta FRB President could not possibly have struck a more
hawkish chord – especially his message that the Fed still has a "ways to go in
recalibrating" rates and his preoccupation with upside inflation risks. And as the
February 2-3 FOMC minutes revealed, the Fed remains very bullish on the economic
outlook – capital spending will accelerate, driving employment growth higher and this
then triggers a pick-up in personal incomes sufficient to keep consumer spending on a
solid path and at the same time allow for a rise in the savings rate. The job pickup is
seen taking place along with renewed labor force entry and this is enough to take the
unemployment rate down further which means that the Fed must be really bullish on the
job market picture and negative on the outlook for productivity. When you really dig
through the thought-process, it becomes abundantly clear that the Fed does not really
have a 'symmetric' risk assessment at all when it comes to inflation and growth in the
quarters ahead. To be sure, the Fed retains a benign 'official' inflation view – "low and
stable" but that result is "assuming further removal of policy accommodation". Damn
the torpedoes, full steam on getting to a 4% two-year note yield ahead!
6. Confidence crunch: ABC News/Washington Post consumer comfort poll fell 1 point to
-11 in the February 20th week – the 'buying climate' subindex sagged 2 points for the
second week in a row to -28, the weakest print since Jan 15, 2005. This followed the
news that the Conference Board confidence index dipped from 105.1 in January to 104
in February. There was a big split in the components as the 'present situation' index'
jumped again to 116.4 (from 112.1 in January, 105.7 in December, 96.3 in November
and 94.0 in October). In other words, 'present situation' has soared 22.4 points since
October – second strongest string in the past seven years – and nonfarm payrolls could
only average less than 140k? This spells bounceback in nonfarm next Friday. But the
'expectations' component fell to a three-month low of 95.7 from 100.4. Good news for
employment did come from the 'jobs hard to get' series – falling from 24.3 to 22.6 which
is the lowest read since May 2002. But that is the here and now. Expectations for the
next six months saw only 15.2% expecting job conditions to improve – down from
16.6% in January and the nearby high of 17.8% last September. The % seeing poorer
job prospects jumped to 16.8% from 15.1%. As for income expectations, only 18.5%
see an increase in the next two quarters – down from 19% in January and 21% in
December. Homebuying plans fell to 3.3 from 3.5 (3.8 a year ago); major appliances
dropped to 27.1 from 28.3 (27.5 a year ago); car buying plans stayed at 7.2; intentions to
Economic Commentary – 25 February 2005
Refer to important disclosures on page 4. 3
take a vacation slid to 42.2 from 48.5 in December.
7. The key to consumer spending in the year ahead will hinge critically on the outlook
for home prices since borrowing against the rising notional value of the home has
been the single largest source of spending stimulus in the past year and the key
reason why the savings rate is flirting with historically low levels. What we have
detected is a recent increase in the backlog of unsold homes on the market – 3.9%
months' in October, then to 4.7 months' in November and then to 4.8 months' in
December – a five-year high and a breakout from the recent range of 3.5-4.5 months'
supply. If this metric breaks towards 6 months' supply, we would not be surprised to
see the price correction that so many believe can never occur. A new paradigm is one
thing – breaking the laws of supply and demand are quite another (as an aside, in nonseasonally
adjusted terms, the backlog of unsold homes is already at 6.2 months' supply,
an 8-year high).
8. Look at what's starting to lose some steam – home-equity lines of credit: They fell
last week (at a 3.8% annual rate) and have dropped now for two weeks in a row which is
something that hasn’t happened since April/01. This once hot-credit-item is now up at
only a 4.3% annualized pace over the past month. This is a far cry from the 25% trend
back in mid-January. Interestingly, with real estate credit growth ebbing, the banks have
been adding to their cache of U.S. government bonds – $48 bln just over the past four
weeks.
9. IPO Mania: so far in 2005, we have witnessed $8.4 bln stemming from IPO activity, a
record for the first 1-1/2 months of the year (Thomson Financial data). This tops the
$7.6 bln at this same juncture of the prior peak in early 2000. And it's not a dot.com
boom here – in fact, only about 20% of the companies in the IPO pipeline are now in the
tech space (versus an average of 35% and the 60% share at the height of the 1999-200
bubble). And there is no 'bubble' here as the average IPO is now trading just +7% above
the offering price and actually FLAT relative to the first-day close. Not only that, but a
growing share of IPOs are being withdrawn in favor of acquisition offers – see page C6
of the Wednesday WSJ ("IPO’s Increasingly Turn Into M&A") – so far in 2005, 33% of
the 18 IPOs that were iced were due to acquisition discussions (versus 18% in 2004 and
16% in 2003).
10. Dollar gets a big reprieve – the Bank of Korea, just days after issuing a report to the
legislature where in just one sentence it hinted at possibly diversifying out of dollars
(which the media leapt on), now says that it has no such plan to begin selling greenbacks
from its $200 bln reserve fund. That, however, does not mean that the BOK will refrain
from slowing down its purchases of Treasuries and dollars – which is why bringing the
current account down to more manageable levels is so crucial (keep in mind, though,
that it is really the BOJ with over $800 bln in FX reserves and the PBOC with $600 bln+
that are the ones with the greatest influence). We also see on our screens, perhaps in a
bid to stabilize the situation, that Taiwan also announced that it has no intention of
selling its Treasury holdings (rejecting "foreign media reports" of such). As well,
Japanese export growth throttled back unexpectedly in January to sharp slowdown in
outbound electronic shipments – total exports moderated to +3.2% y/y (slowest in over a
year and a big deceleration from the +8.8% pace in Dec) while the stronger +11.6% pace
of imports cut into the trade surplus (which shrank almost 10% from December). And
we see that business confidence in both Germany and France throttled back this month
so if the global economy is really chugging along at that rapid a clip, it must be due to
China (though we received news there that the y/y inflation rate cooled to 1.9% last
month – well off the peak of 5.3% seen last August. Consumer goods are deflating and
producer prices are also slowing). All this news is not exactly dollar-negative |
