Economic Commentary - Dave’s Top Ten List
Merrill Lynch - Comment - United States
14 January 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. Housing affordability for first-time buyers increasingly stretched: Don’t just
ask us, ask Economy.com, a consulting firm that found even with low mortgage
rates, prices have so far outstripped income growth. There are now 30 metropolitan
areas that have a serious bubble ... including San Diego, San Francisco, LA, NYC,
Las Vegas, Miami, Boston, and New Jersey. Areas of greatest affordability are in
places like Syracuse, Springfield and Fort Wayne ... so everyone likes to talk about
how the housing bubble is only concentrated in the Northeast and Southwest. Yes
... the bubble is only situated where people live ... no big deal. The report
concluded that roughly half of the homes sold in Q3 were at such an exorbitant
price that they were out of reach for median-income earning families. See page 2 of
Wednesday’s WSJ for more.
2. Low savings rate not supported by fundamentals: One of our key macro themes
in 2005 is that the record low savings rate will sooner or later embark on an uptrend,
which will constrain consumer spending. One of the push backs to our view is that
the low savings rate is justifiable given the wealth effect from higher home prices
and the low interest rate environment. In response to this, we attempted to model
the personal savings rate based on fundamental drivers such as the ratio of net worth
to PDI, real long-term interest rates and inflation expectations. What we found was
that ‘fair-value’ for the savings rate should be around 3.6%, not the current 0.5%
level (R2 = 72%). And getting there in the next two years would trim roughly 0.5%
off GDP growth annually from our base-case forecast.
3. Everyone’s aghast that the back end of the yield curve is hanging in as well at it is – but the reality is that we have a Fed tightening into what is still quite a tepid jobs
market from the standards of the past. Despite all the cheerleading over the
December’s payroll numbers and the back-revisions, the bottom line is that NFP has
come in below 200k in six of the past seven months. How many times in the past has
the Fed been tightening policy in such an environment? Try never. In the 1999-2000
rate-hiking cycle nonfarm was less than 200k in only 4 of those months. In 1994, just
one month was below 200k. In the 1988-89 cycle, again – just once. In the 1987
tightening, we had NFP below 200k a mere three times and the same in 1983.
4. The portion of U.S. home buyers opting for adjustable-rate
mortgages almost doubled in 2004, now representing 46% of all
loans. Surging home prices are prompting more and more homeowners
to borrow at lower interest rates with shorter fixed periods to save on
their monthly payments – problem is that the most pronounced increases
in rates are at the front end of the curve. There are two major risks to
this: 1) a larger percentage of the population has become vulnerable to
short-term rate increases, and 2) 37% of total assets of commercial banks
are in the form of real estate loans. Should real estate prices falter or
households have problems repaying their loans, commercial banks could
restrict lending activity, which would, in turn, have negative
repercussions for the economy. As things stand, the delinquency rate on
home equity loans has already risen to levels not seen since at least 1983
when the data series on this metric began.
5. Once again, we are amazed at how 54 of 56 economists as per the
WSJ consensus sees long-term yields going up an average of 60 bps
by mid-year: We can certainly see the case for interim upward spasms –
they happen in bull and bear markets and we expect to see the usual
seasonal uptick this time around (as per our new rates view). But the
reasoning you hear for why yields are to back up is unreal – they are too
low; the current account deficit; fiscal policy; the dollar; foreign central
banks will reduce their buying; Chinese revaluation; yada yada yada.
Maybe these things give you spasms but they do not influence the trend
in bond yields. If you’re bearish on bonds, please – have a view that we
are going to have a ripping economy and that core inflation will rear its
ugly head. The other stuff is noise that you trade around. But it is
interesting, isn’t it, that in the 7 months last year that saw a slide in the
dollar, bonds rallied on 4 of those months (average decline in the 10-year
note through all 7 was five basis points). The trade deficit eroded 8
times, and on 5 occasions we saw bonds once again … rally (and the
average move in the 10-year in those 8 months was -1 bp … go figure).
We even saw the 10-year rally on three of the four months in 2004 that
saw a slowing in foreign purchases of U.S. Treasury securities. No
kidding. But … when it came to the data flow, we saw a very different
story. In those months when nonfarm payrolls breached the 200k level,
10-year Treasury yields backed up each and every time that happened on
the month (four times, the average move on the month was +25 bps).
And in those months when we found out that core CPI was above 0.2%
sequentially – out of those three occasions, bonds sold off twice and the
overall average move was +30 bps. So if you’re outright bond bearish,
have a view that employment surges and core inflation moves above
0.2% per month in 2005 and at least you will have a consistent story.
6. Look at the history books: Since 1982, we count 10 times when real GDP
growth slowed on an average annual basis – like everyone has on this
year’s forecast to varying degrees. Out of those, bond yields fell 8 times
(Dec. to Dec.) on the year … and the two times that did not happen was in
1987 and 1990 when core inflation rose. Again, have an inflation story.
Don’t have a fiscal story. Don’t have a dollar story. If these really
mattered, then 10-year yields would not have surge 165 bps in 1999, which
was the last year the dollar rallied and the last year the government was in
budgetary surplus (it just so happens that real GDP growth at that time
accelerated to a cycle-high of 4.5% – is anyone calling for that for 2005?).
7. That said, we just made our biggest changes to our rate outlook since
last September: Based on the December minutes, the Fed has hung onto
its 3.5%-4% GDP growth view for 2005 and at the same time took down
its estimate of potential GDP growth and the output gap. So while our
numbers suggested that the Fed could pause at 2.25% on the funds rate,
the Fed’s numbers suggest that neutral is closer to 3.25% and that would
mean a tightening at each of the next 4 meetings, which takes us to June.
Actually at that point, the tightening cycle will be one-year old, which
traditionally is how long these rate-hiking cycles last.
8. We haven’t made any big changes to our macro view – we see GDP
growth for this year, on average, coming in at 3.2%, down from
4.4% in 2004. We still see core inflation finishing the year at 1.7% from
2.2% today. What has changed in our bond model is the Fed and a flatter
curve lies ahead with some potentially important sector implication. But
in terms of the quarterly pattern to bond yields, For 2-year yields we see
Q1 at 3.75%, for Q2 at 3.65%, for Q3 3.5% and for Q4 3.45% – peak this
quarter but at a higher level (before, we were at 2.65% for Q1, 2.55% for
Q2, 2.65% for Q3 and 2.75% for Q4). For 10-year yields, we now are at
4.65% for Q1, 4.5% for Q2, 4.3% for Q3 and 4.25% for Q4 – and we
want to stress that before, we were at 4.1% by year-end on the 10-year
and 2.75% on the 2-year note, so almost all of the change in the rates
view is at the front end of the yield curve. Message is near-tem upside
risk to yields, but not sustained. But what that means is a much flatter
curve since this is part and parcel of the Fed’s strategy to cool off
demand and speculative pressure in financial assets – by June, the spread
between 2s and 10s goes from 105 bps today to 85 bps; and by year end it
goes to 80 bps. In our prior forecast, the curve was seen at 125 bps at
June and 135 bps year-end.
9. Now we mentioned that there was little change in our GDP growth
view for the year as an average but the recent data flow and the fact
that the Fed is now seen raising rates farther than we thought, there is
a shift in the quarterly pattern. There’s more momentum on the
consumer spending side as we move into the new year. So we’ve taken up
GDP growth for this quarter to 3.2% a.r. from 2½%, which would be the
same as our estimate for Q4, and all that upward revision basically reflects
an upward adjustment to the consumer from 2.4% to 3.0%. We’ve left Q2
untouched at 3.0%. But we have taken a knife to the second half of the
year as the lagged effects of the Fed tightening kicks in – Q3 is now at
2.7% from 3.3%; and Q4 is 2.5% from 2.8%. Our annual number for S&P
500 operating EPS is unchanged at $69.30 or 3.9% growth, down from
22% growth in 2004. We piggybacked on some work that Rich B. has
done and found that in the past 30 years, the Fed tightened with profit
growth slowing in just 5 of those years, the average change in the S&P
500 during that interval was -1.5%. The best performing sectors were
health care, utilities and staples; the worst were basic materials, tech and
consumer discretionary.
10. Debt-heavy consumers already feeling the strain: the percentage of
individuals with overdue loan payments rose to 1.9% in September from
1.8% in July and that doesn’t include the impact of the last two Fed
tightenings either. The share of home equity loans that are 30 or more
days past due jumped from 2.5% to 2.82% (it was 2.37% in Q1) – the
highest since record-keeping began on this metric in 1983. Delinquency
rates on auto loans also rose during this interval to 2.29% from 2.2%. |
