Dave's Top Ten
Merrill Lynch Economic Commentary
9 December 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. What If We Are Wrong On The Consumer? We have been asked to consider where we
can be wrong on our cautious assessment of the consumer in the coming year. Here are
five possibilities: Fed does not invert the curve. In fact, inflation falls so fast that the
Fed will be cutting rates next year and bonds rally hard. This helps curb the debt service
burden. Businesses, flush with cash (and a 40-year high liquid asset ratio), no longer
deploy it in stock buybacks and dividend payouts but embark on a capital spending
boom. This in turn sparks a pickup in job creation and income growth. Oil prices fall
sharply either on new supply or a slowing in Chinese demand. This acts as a de facto
tax cut for the consumer. Keep in mind that every $10 swing in oil prices adds or
subtracts roughly $40 billion from household cashflow. Households are asset-rich –
almost $50 trillion of net worth on the balance sheet. They own nearly $10 trillion in
equities, $18 trillion in real estate, $6 trillion in deposits and cash and roughly $2.5
trillion in fixed income securities. Instead of curbing their spending habits, households
may decide instead to run down their assets to fuel consumption growth. Congress, in a
blatant pre-election move, increases the minimum wage for the first time since 1997.
2. Since mid-October, the S&P 500 financials have rallied 12%, outpacing the broad
market by over 400 basis points. The financials are behaving as if the Fed will be done
as early as December 13th – not exactly something that San Fran Fed President Yellen
was hinting at in her speech on Friday. Meanwhile, the Fed funds futures contract is
saying that it expects the Fed to go at least in 3 of the next 4 meetings. Both cannot be
right. If the financials are correct, then the Fed funds futures strip is dirt cheap. On the
other hand, if Fed funds futures is telling the accurate story, you may want to buy some
downside protection just in case the Fed doesn't change its 'hawkish' language at the
coming FOMC meeting.
3. The classic misery index combines the unemployment and inflation rates as a barometer
of economic health (the higher the index, the more miserable). We modified this index,
creating a broader measure, which includes the unemployment and inflation rates, real
GDP, fiscal budget balance, current account balance and the prime lending rate. The
broad Canadian index stands at 9, flirting with levels not seen any time during the past
40 years. By way of comparison, the US measure has deteriorated to 29, the highest
level since the late 1980s.
4. A turndown in the dollar can be expected to have its benefits as far as the
stock market is concerned – almost 40% of S&P 500 revenues are derived
from overseas operations. And the sectors with the largest foreign sales
exposure are technology, industrials, consumer staples, basic materials and
energy, which is half the market cap. From a big-picture standpoint, a weaker
dollar is good for large-cap export-oriented growth companies. Tack on to the
weaker dollar the prospect that growth in overseas business and consumer
spending is likely to outpace spending here at home, and the major barbell
theme for next year is to overweight companies levered to the foreign
economy and underweight those with a high domestic sales orientation.
5. Perhaps as a measure of how the economic gains this cycle have been
concentrated at the upper echelons of the income stream, here we have an
economy coming off a 4%+ growth quarter, and the polls look dismal for
President Bush: Latest WSJ/NBC News poll found that 34% of respondents
approve of the way Mr. Bush is handling the economy (were those 215,000
net new jobs created in November illusory?), down from 47% in January. An
AP/Ipsos poll showed that the President's approval rating on the economy is
down to 37%. Fully 52% of Americans in an ABC News/Washington Post
poll last month said that they believe the economy is getting worse, while
only 18% see it getting better. In a Harris poll, 64% stated that the economy
was either "not good" or "poor".
6. Fed Governor Olson (the lone dissenter in the September 20 FOMC meeting)
made some interesting remarks during the Q&A period at the Rotary Club in
South Dakota. He notes that Q3's real GDP pace, at 4.3%, is "well above"
trend and the Fed is watching to see if higher energy costs are moving into
core prices (no big surprise there). As for overall inflation, he notes that
consumer expectations have moderated (as in the UMich and Conf Board's
gauges in November). Finally, on the FOMC decision process, he refutes the
view that Greenspan calls the rate shot, with others just following suit. In his
case, Greenspan tried to change his mind when he dissented against the
September rate hike. As for incoming Fed Chair Bernanke, Olson rates him
as an "excellent choice".
7. Service sector remains solid: The ISM non-mfg came in just about in line
with expectations at 58.5 in November (the consensus was looking for the
index to come in at 59). This was a slowing from October's 60 reading. Just
looking back over the period beginning in mid-2003, it looks that this index
may be settling into a somewhat lower range. Nonetheless, at the current
reading of 58.5, this index is certainly holding up. Looking through the
details, the supplier deliveries index (which is not seasonally adjusted) has
actually been rising since the beginning of the year. This suggests demand
remains healthy and is likely a data point the Fed would take note of as it
could suggest some price pressures. However, the fact is, the prices paid
index fell nearly four points, and while still above the pre-hurricane level, this
is the second consecutive decline and shows that input costs are easing since
the high back in September.
8. Holiday retail sales take a dip – get ready for a cold December: For the latest
week, both the ICSC-UBS and the Redbook weekly chain store sales indexes
recorded declines in the week ended December 3. ICSC-UBS sales were
down 3.1% on the week and Redbook reported sales down 0.3% compared to
November's average. Sales fell short of plan, according to both surveys. This
supports our belief that with housing price appreciation slowing, higher
energy prices, and higher short-term rates, the consumer has a harder time
maintaining a robust spending pace. More reason for retailers to ramp up
their promotions and discounts in the weeks ahead. In addition, the
SDI/Weather Trends show that half the country is covered with snow at this
time and temperatures will approach record cold levels in December and are
on pace to average in the top coldest temperatures in 111 years. This is
usually good for must-have categories ... warm weather clothes and items, but
bad for general retail activity. Colder weather is also driving up energy
prices, and this is a drain for consumer discretionary spending. The only
possible offset to this consumer negative news from this week is that sales
typically dip the week after Thanksgiving, but again, the forward looking
indicators do not suggest a robust rebound in holiday spending.
9. More pessimistic news on the housing market: On Tuesday, we saw three
signs that the US housing market is moderating: pending home sales fall in
October, bonds backed by home loans to the riskiest borrowers are falling
sharply and foreclosure and mortgage delinquencies are on the rise. And now
we see a report from the Greater Capital Area Association of Realtors
showing that the Washington D.C. area overall housing market, one of the
hottest U.S. markets, is declining at a rapid rate. The inventories of homes for
sale rose 69% and contracts fell 19% compared to November 2004. These
pessimistic views were too much to bear for the homebuilders and they saw
their stocks prices drop in yesterday's equity action. The Dow Jones U.S.
Home Construction Index fell 3.3% yesterday. The U.S. housing market is
expected to see massive layoffs in 2006. According to UCLA's Anderson
Forecast, up to 500,000 construction jobs and 300,000 financial-sector jobs
will be lost. The report also expects weakness in the housing market to
continue for years.
10. Japan is clearly enjoying its best string of economic numbers in at least 8
years. The self-sustaining domestic demand story continues unabated – in
contrast to its prior ill-fated predecessors, this expansion is not being fueled
on exports alone or on government spending on building bridges and paving
river beds nobody needs. Household spending, wages (5 of past 6 months),
bank credit, golf course membership fees and commercial/residential real
estate are all expanding at the same time. |
