The Fed's Not Finished
John Lonski, Moody's senior economist in New York
moodys.com
US corporate earnings should benefit from an acceleration of overseas
expenditures well into 2000. Rising industrial commodity prices reflect
an upturn by global economic activity that could boost US consumer price
inflation in the absence of a preventive climb by interest rates.
The further appreciation of equity values increases the risk of demand
outrunning supply by enough to quicken consumer price growth. A
surprising August to September rise by the Mortgage Bankers Association's
(MBA) index of mortgage applications for the purchase of a home implied
that 1999's steep ascent by bond yields has yet to subtract much from US
business activity.
With interest-sensitive activity still brisk, there is little evidence
that Fed rate increases have made borrowing costs too burdensome.
Interest rates still have room to grow before they significantly hinder
the economy.
The outlook for Treasury bonds worsened given how well the US equity
market has withstood the latest ascent by bond yields. Bond yields have
moved higher in response to what could be the sharpest acceleration of
global economic activity since 1994.
Just as the global slackening of late-1998 trimmed profitability, a
quickening of global expenditures should rejuvenate US corporate earnings.
Profitability has already improved noticeably before the full arrival of
an export recovery.
The US economy might not soon run out of upside surprises much to the
chagrin of US government bond holders. The underlying economic vigor of
the US economy implies that a federal funds rate significantly above
nominal GDP's likely year-to-year pace might be required if higher
borrowing costs are to succeed at significantly curbing profitability.
The US economy now seems to be capable of hurdling a 5.5% fed funds rate.
Although a richly priced equity market has enhanced the value of US
Treasuries by increasing the demand for defensive investments, the
possibility of a steeper yearly climb by corporate earnings warns of
higher Treasury yields, especially given an already very high rate of
labor market utilization.
As profits have recovered from their battering of late-1998, Treasury
bond yields have moved higher. When corporate operating profits
accelerated in 1987 and in 1994, Treasury bond yields would soar
throughout each episode. The current unfinished upswing by the annual
growth rate of corporate profits very much preserves the possibility of
higher bond yields.
The Fed was compelled to adopt a "tightening bias" if only to dissuade
investors from bidding stock prices higher.
A deep slide by equity prices could obviate a federal funds rate hike,
especially if household expenditures and consumer confidence subside.
Fed policymakers will also keep tabs on the supply of credit market
funds. A tightening of lending standards -- most likely in response to
declining stock prices -- would give the Fed all the more reason not to
hike interest rate on November 16th.
On November 16th, the FOMC might discount the importance of faster wage
growth if the price-to-earnings multiples of equities are significantly
lower and if corporate bond yield spreads are wider. On the other hand,
if equities extend their latest climb while nonfinancial-sector debt
continues to outrun GDP, the FOMC may have sufficient reason to put a
5.5% federal funds rate target into effect.
Another Stingy Jobs Report
For a second consecutive month, the monthly employment report has
apparently grossly shortchanged the underlying pace of US economic
activity. Among a virtual sea of upbeat assessments of US economic
activity, the employment report alone boldly indicates a nearly stalled
US economy.
Even after accounting for jobs temporarily lost to Hurricane Floyd,
September's nonfarm payrolls still fell considerably short of
expectations. September's estimated loss of 8,000 nonfarm payroll jobs
was the biggest monthly decline since furious winter weather stripped
7,000 jobs from January 1996's nonfarm employment. Similarly, September
1999's 0.5% monthly reduction in the private-sector's total number of
hours worked was the deepest such decline since the 1.2% drop of January
1996.
In February 1996, the index of aggregate weekly hours more than
recovered from the previous month's setback with a 1.9% monthly advance,
while the monthly change in nonfarm payrolls came roaring back with the
addition of 454,000 new jobs.
September's retreat was not enough to prevent the index of aggregate
weekly hours from expanding by 2.2% annualized from the second- to the
third-quarter. The rise by the quarter-to-quarter annualized growth rate
of total weekly hours from the 1.0% of 1999's second quarter portends a
rise by the comparably measured rate of real GDP growth from the
second-quarter's 1.6% to at least 2.8% in the third quarter. During the
5-years ended June 1999, the 2.9% average annualized growth for the
hours-of-work index supported a 3.4% average annualized advance by real
GDP.
Questioning the economic weakness that otherwise might be inferred from
the shrinkage of nonfarm employment was September's 0.3% monthly dip in
the number of unemployed individuals. In turn, the unemployment rate
remained at a nearly 30-year low of 4.2% in September. Perhaps jobs
growth is slowing in response to a shrinking pool of qualified and
available workers.
For labor, demand may exceed supply, but not yet by enough to stoke an
inflationary escalation of wages. After slowing to August's 0.2% monthly
rise, the average hourly wage of nonsupervisory personnel grew by a
faster 0.5% in September. The yearly increase of the average wage climbed
up from August's 3.5% to September's 3.8%. After having peaked at the
4.3% of 1998's second-quarter, the yearly increase of the hourly wage
would subsequently slow to the 3.6% of 1999's second quarter. For the
third quarter, the annual increase of the hourly wage edged up to 3.7%.
The pool of available workers includes unemployed individuals plus those
who are not currently looking for work but would take a job if an
attractive opportunity arose. September's available workers were down by
8.7% from a year earlier. For the third quarter, the supply of available
workers fell by 6.7% annually, which was deeper that the second quarter's
1.8% annual setback.
Manufacturing And Retailing Thrive Despite Loss Of Jobs
Not only has the employment report apparently been understating real
economic activity, the monthly survey of labor market conditions may not
be fully capturing the growth of employee compensation. As derived from
the September employment report, an approximation of earned income edged
higher by merely 0.2% monthly for a second consecutive month. The
earned-income proxy seems to be understating the accompanying growth of
wage and salary income. Through the first 8 months of 1999, wage and
salary income's 0.6% average monthly increase outran the earned-income
proxy's 0.4% average monthly rise in a manner which differed considerably
from what held during the 5 years ended 1998, or when wage and salary
income's 0.4% average monthly gain lagged behind the 0.5% average
monthly advance of the earned-income proxy.
The correlation between the employment report and business activity
appears to have at least momentarily broken down. Consider August's big
loss of 77,000 manufacturing jobs and the loss of 21,000 slots in
retailing, as well as August's monthly reductions of 0.8% for
hours-worked in manufacturing and of 0.5% for hours-worked at retailers.
In stark contrast to what might otherwise be inferred from such wretched
results, August's monthly changes showed factory output advancing by
0.4%, new orders for manufactured goods jumping up by 1.3%, retail sales
surging by 1.2%, and real consumer spending climbing higher by 0.6%.
The even stronger showing the National Association of Purchasing
Management's manufacturing activity index for September immediately
questioned the macroeconomic relevance of September's loss of another
21,000 manufacturing jobs and of a further 0.2% dip in the number of
hours worked at manufacturing. Ordinarily, the upswing by the
year-to-year change of unfilled "impact" durable goods orders from
November 1998's bottom of -1.6% to August 1999's +7.1% would lead to
noteworthy gains for manufacturing employment. Instead, after bottoming
with fourth-quarter 1998's loss of 130,000 manufacturing jobs, factory
payrolls shrank by another 45,000 during 1999's third quarter.
The average year-to-year growth of the same store sales of retailing
chains rose from the 6.1% of 1999's second quarter to the 6.9% of the
third quarter and, yet, the addition to retailing payrolls would fall
from the second-quarter's 185,000 jobs to the 37,000 of the third
quarter. After dropping by 0.5% monthly in August, the hours-worked in
retailing would plunge by an even deeper 1.7% during September. Consumer
spending may have lost some of its zip, but it is not collapsing in a
manner as implied by the latest nosedive in hours worked at retailing
Ample Real Bond Yields Can Help To Contain Inflation
In addition to a host of constructive developments, comparatively ample
real bond yields help to explain why inflation has slowed dramatically
since the early-1980s. Debt-financed purchases of real goods and
services pose less of a threat to price stability when real Treasury
yields remain ample.
The annual rate of core CPI inflation would inexorably climb up from its
1.2% bottom of 1966's first quarter as the real 10-year Treasury yield
sank from its 1965 average of 2.8% to 1969's 0.9%. Setting the stage for
the rapid price acceleration of 1979-1980 was the 1970s' average real
10-year Treasury yield of 1.0%.
By promoting expenditures growth to a pace well above the expansion of
the US' production capacity, the very low real bond yields of the late
1970s would prove to be macroeconomically expensive. The real 10-year
Treasury yield, or the difference between the 10-year Treasury yield and
the annual rate of core CPI inflation, averaged 0.67% during 1977-1979.
Setting the foundation of low inflation's now long-lived stay was the
very steep 4.5% average annual real Treasury yield of the 1980s.
The still sizable 3.4% average of the real 10-year Treasury yield for the
10-years ended September 1999 has facilitated the long-term containment
of price inflation. The latest real 10-year Treasury yield of roughly 4%
does not favor an extended climb by price inflation. Any forthcoming rise
by core CPI inflation should neither promote unsustainable imbalances in
the real economy nor gravely threaten the future performance of financial
markets.
A great lesson of the 1990s is not to quickly view Treasury bonds as an
attractive long-term investment when real Treasury yields -- the 10-year
Treasury yield less the annual rate of core CPI inflation -- fall beneath
3%. When the real Treasury yield last averaged less-than-3%, or 2.6% to
be specific, during 1998's second half and 1999's first quarter, the
10-year Treasury yield averaged 4.95%. At last look the 10-year Treasury
yield had climbed up to 6.05%.
Prior to 1998-1999, the real Treasury yield briefly broke under 3% in
1995's final quarter-averaging 2.86%. The 10-year Treasury yield would
quickly soar up from its 5.89% average of 1995's fourth-quarter to the
6.72% average of 1996's second quarter.
The averages of year-long 1993 showed a 5.87% 10-year Treasury yield
being joined by a 2.57% real Treasury yield. Again, a sub-3% real
Treasury yield would presage a severe sell-off of Treasury bonds. In
1994, the 10-year Treasury yield's annual average would jump up to 7.08%.
Risks Abound If Commodity Price Inflation Is Downplayed
Industrial commodity prices offer early indications of possible changes
in price inflation. Fed policymakers pay close attention to industrial
commodity prices not only to better understand inflation risks, but also
to get a sense of the underlying pace of world economic activity. Our
index of industrial metals prices has been fairly trustworthy predictor
of near-term world economic growth.
One year ago, Moody's index of industrial metals prices was down by a
disturbingly deep 20% year-to-year. In response to both the global
economic distress and warnings of more widespread price deflation
implicit to October 1998's plunge by industrial commodity prices, the
federal funds rate would be lowered from 5.25% to 5%. Had the FOMC not
eventually cut fed funds to 4.75% by November 1998, the global economy
may have fared worse, in part, because of a more widespread collapse by
product prices.
It is specious to gauge the inflationary (or deflationary) content of
industrial commodity price changes by referring to the share of operating
costs accruing to industrial materials. When conveying information about
inflation risks, the influence of changes in industrial commodity prices
extends well beyond costs. Industrial commodity price movements can
supply valuable insight regarding world economic conditions, which often
affect the US' pricing environment.
The failure of interest rates to respond appropriately to changes in
commodity prices can have very unpleasant consequences. Consider how core
CPI inflation would eventually soar after the federal funds rate declined
amid 1976's steep ascent by industrial material prices. For the
year-ended March 1977, the Journal of Commerce's index of industrial
material prices had advanced by 13% annually. Nevertheless, the federal
funds rate would drop from its 5.3% average of 1976's third quarter to
the 4.7% of 1997's first quarter.
This relaxed attitude to commodity price inflation would help to usher in
runaway price inflation. As the annual rate of core CPI inflation surged
up from the 6.1% of 1977's final quarter to its 13.3% zenith of 1980's
second quarter, the 10-year Treasury yield would eventually soar from its
7.2% average of 1976's final quarter to the economically ruinous 14.85%
of 1981's third quarter.
Corporate Bonds May Benefit From Revitalized Profitability
A weaker dollar exchange rate will probably be linked to the improved
showing of foreign economies relative to the US. US profitability should
benefit the more closely a cheaper dollar coincides with faster growth
abroad.
Accordingly, given their already generous widths, a possible narrowing of
US corporate bond yield spreads stemming from healthier profitability
could sustain foreign investor demand for US corporates.
Corporate bond yield spreads just might widen significantly if fast rising
Treasury yields trigger a deep sell-off of possibly grossly overvalued
US common stocks. Before and after the stock price crash of October 19,
1987, the average yield spread over Treasuries of long-term,
investment-grade industrial company bonds would widen from the 95 basis
points of 1987's third quarter to the 130 points of November 1987.
However, by December 1987 that spread had returned to 106 basis points,
which was well under December 1986's 212 basis points. In other words,
investment-grade corporate bond yield spreads were nearly halved despite
how foreign net buying of US corporate bonds collapsed from 1986's then
record $40.2 billion to 1987's $18.8 billion.
October 1987's crash was not the beginning of the end for either the US
stock market or US corporate bonds mostly because a depreciated dollar
exchange rate and a livelier world economy would help to enliven US
profitability. As estimated by the Commerce Department, the annual rate
of change for corporate operating profits would recover from 1986's -3.4%
to the +13.4% of 1987, and not peak until reaching 1988's +14.7%. In
response to fast-rising profitability, the yield spread of long-term,
investment-grade industrials would eventually drop to a third-quarter
1988 average of just 84 basis points.
Unless management is generally inept, profitability should benefit from
the refreshing combination of a cheaper dollar exchange rate and faster
expenditures growth abroad.
Around the time of the previous record current account deficit, the
estimated pace of real economic growth outside the US would slow from
1985's 4.2% to 1986's 3.5%. By 1987, the annual rate of foreign economic
growth had rebounded to 4.4% and would ultimately reach 5% in 1988 -- a
pace that has not been surpassed since at least 1979.
Profits have much more influence over the performance of US corporate
bonds than does the investment behavior of foreign investors. Amid
concerns regarding the above-average widths of corporate bond yield
spreads, analysts have time and again overlooked the importance of a
widely anticipated acceleration of corporate earnings, as well as the
benefits flowing to debt protection from a possible firming of product
prices.
Investors Downplay September's Loss Of Jobs
On balance, holders of earnings-sensitive securities found little
evidence of disappointing profits in September's shocking dip by nonfarm
payrolls. Investors generally assigned more importance to September's
trimming of the ranks of the unemployed by 17,000 than to the
corresponding net loss of 8,000 nonfarm jobs. During the day of the
September employment report's release, the S&P 500 stock price index
posted a hefty 1.4 advance. Notwithstanding the Fed's adoption of a
tightening bias, the S&P 500 was up by an outsized 4.1% for the week.
According to the steep upturn by the annual growth rate of total business
sales from its 2.5% bottom of 1998's third quarter (which was also a
7.5-year low) to the 7.9% of the quarter-ended August 1999 (new 4-year
high), profitability ought to improve. Not only are business sales
engaged in their steepest acceleration since 1994, but a stronger world
economy and a possibly softer dollar exchange rate could lend valuable
support to business sales and profits well into 2000.
Faster Rise Of Labor Costs To Rein In Profitability
To the detriment of corporate earnings, employee compensation has been
outpacing the net sales of nonfinancial corporations, where the latter
has been approximated by the gross domestic product of nonfinancial
corporations. Nevertheless, after most recently cresting at the 7.5% of
1997's final quarter, the annual growth rate for the employee
compensation of nonfinancial corporations would eventually slow to the
6.1% of 1999's first quarter before inching up to the 6.2% of the second
quarter. Throughout this span, however, employee compensation outran
nonfinancial-corporate net sales, which would slow from their latest 7%
peak yearly increase of 1997's third-quarter to the 5.1% nadir of 1998's
third quarter. Subsequently, the annual growth of estimated net sales has
climbed up to the 5.8% of 1999's second quarter.
When debt repayment problems last intensified on the way to, first, a
credit crunch and, then a recession, the annual increase of
nonfinancial-corporate GDP would plunge from the 8.3% of year-end 1988 to
the 2.9% of year-end 1989. The latest accelerations of business sales and
of net sales can only benefit the debt repayment capabilities of
businesses.
Operating profits will grow more rapidly the faster net sales climb
relative to employee compensation, and vice versa. When the difference
between the annual growth rates of net sales less employee compensation
climbed up from 1993's 8/10ths of a percentage point to 1994's wide
2.2-points, the annual increase of operating profits would climb up from
1993's 17.2% to 1994's 26.2%. A far cry from 1994's lucrative imbalance
between annual net sales growth of 8.1% and employee compensation's 5.9%
gain was 1998's slower 5.5% increase by net sales versus employee
compensation's 6.8% advance. Reflecting the 1.3 percentage point
deficiency of net sales growth relative to labor costs growth, was 1998's
painfully small 0.8% annual rise by operating profits.
Although net sale should accelerate, the now faster underlying rate of
expansion for employee compensation should prevent a return of operating
profits growth in excess of 15% annually.
Europe May Outpace US Economy For The First Time Since 1991
Faster growth in Europe could go far at compensating for an expected
slowing of US expenditures in 2000. Next year, or for the first time
since 1991, the economic growth of the EU-15 may top that of the US.
May-July 1999's 0.3% annual dip by US merchandise exports to Western
Europe underscores the considerable upside potential for US exports to
Europe.
Nevertheless, Germany's count of seasonally-adjusted unemployed
individuals rose from the prior month for a sixth consecutive month in
September. Still, September's number of jobless Germans was off by 5.1%
annually, while September's 10.1% unemployment rate dipped under the
10.3% of both August 1999 and September 1998.
In addition to the upward creep of seasonally-adjusted joblessness,
1999's third-quarter revealed a 25% yearly increase in the number of
Germans working shortened hours that exceeded a 3.1% yearly rise in the
number of unfilled job vacancies.
Far different was third-quarter 1998's 32.6% annual drop in the number
assigned to shorter workweeks compared to the similarly upbeat 30.2%
advance in the number of unfilled job vacancies. The latest trends
regarding shortened workweeks and unfilled job vacancies suggest that the
decline by Germany's still steep unemployment rate might stall. However,
an improvement in German corporate earnings prospects could spur hiring
activity.
Regardless of Germany's somewhat disappointing report on September
unemployment, expectations of faster European economic growth remain in
effect. After rising by 1% monthly in July, German industrial output
advanced by another 1.1% in August. For the 3-months ended August,
German industrial production grew by an estimated 6.4% annualized from
the 3-months ended May 1999.
Moreover, German industrial orders now grow more rapidly. German
industrial orders jumped higher by 5.1% monthly in August. For the
2-months ended August, German industrial orders grew by 5%, compared to
both the contiguous bimonthly observation and to July-August 1998. For
the 2-months ended August 1999, the year-to-year comparisons showed the
12.2% increase by bookings from foreign customers far outdistancing the
0.6% rise by domestic orders.
Manufacturing improves in the UK. In August, British industrial
production grew by 3.4% quarter-to-quarter annualized. This is the
highest such growth rate since August of last year. The growth in the
UK's industrial production hit a low in January of this year, when it
contracted by an annualized 3.4% quarter-to-quarter. Since then,
production has steadily recovered.
Another jolly sign from the Brits is the latest diffusion report on retail
sales volume. In September, the percentage of retailers reporting
year-to-year growth for sales volume led those reporting a year-to-year
drop by 41 percentage points. This huge margin favoring retail sales
volume growth is the widest such difference since April of 1997, and well
ahead of the 10 percentage-point-average of the previous 12 months.
This piece of good news hints at increased British retail sales growth
for September. When the retail diffusion index last hovered around 40
percentage points in April 1997, year-to-year retail sales volume growth
averaged 5.0%. In August of this year real retail sales were up by 3.6%
year-to-year which leaves room for an acceleration of retail sales.
Across the Channel, French household spending might quicken. French
consumer confidence rose in September for a third consecutive month to a
record high for a survey that was initiated in 1987.
The unemployment rate for all 15 member countries of the European Union
(EU) stayed at July's slack 9.3% in August. Although the EU-15's August
jobless rate left much to be desired at least it was under the 10% of
August 1998 as well as being the lowest since December 1992.
Credit Rating Revisions: US Corporates Now Trail Rest Of The World
Outside the US, credit rating revisions have improved substantially.
Preliminary results show third-quarter 1999's 68 credit rating upgrades
of entities domiciled outside the US exceeding the 55 such downgrades.
For non-US issuers, the number of credit rating upgrades last edged out
the number of downgrades in 1996 by a 1.01:1 margin. By 1998, the
upgrade-per-downgrade ratio of non-US entities had slumped to 0.15:1,
but had recovered to 0.61:1 during the first-half of 1999.
Early indications are that the 89 US corporate credit rating downgrades
of 1999's third quarter topped the accompanying 56 such upgrades,
implying an upgrade per downgrade ratio of 0.63:1. The latter was up
from the ratio's latest bottom of 0.40:1 for both 1998's final quarter
and 1999's first quarter, but was a tad under the 0.67:1 of 1999's second
quarter. As US profitability improves in response to a enlivened world
economy, the upgrade per downgrade ratio of US corporate credit rating
revisions should rise.
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John Lonski, chief economist
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