"Tug of War with Inflation and the Economy" Market WrapUp by Chris Puplava

Tug of War with Inflation and the Economy
Likely to Continue to Weigh on Future Fed Decision
BY CHRIS PUPLAVA

As expected, the Federal Reserve went on pause yesterday, though throwing in the statement that “some inflation risks remain.” The decision to pause was not unanimous as Mr. Lacker of the Federal Reserve Bank of Richmond cast a dissenting vote, wanting to raise the federal funds rate to 5.50%. The markets initially responded favorably, but with the Fed not ruling out another rate hike, the sense of finality investors had hoped for never materialized. The DJIA fell from a post-Fed decision reaction high of 11276.13 to close at 11,173.59, falling more than 100 points and down just under half a percent on the day.

Going forward there are still concerns that the Federal Reserve must keep an eye on: housing and inflation. The Fed acknowledged both a slowing economy due to a housing slowdown as well as rising inflation. Evidence of a housing slowdown continues to pile in. Residential investment expenditures fell 6.3% in the second quarter, the third straight and largest quarterly decline.

The Housing Affordability Index (HAI) plunged in June, falling to 103.7 from 105.1 in May, marking the lowest level since August 1986.

The slowing seen in housing is beginning to trickle through the economy as real GDP in the 2nd quarter was only 2.5%, with GDP revisions reducing nearly 25 basis points from annual real GDP growth during the nearly five-year expansion since 2001. Here are a few further sources of a slowing housing market. Home sales are off 10% from their peak last summer, unsold inventories have soared to a new record, construction spending is decelerating after peaking in early 2004, and the national median home price has decelerated sharply from the peak seen in 2005 (see charts below).

Homebuilder optimism has been falling for nine straight months, with July’s reading of 39 marking the lowest level since December of 1991.

The lack of optimism seen in homebuilders coupled with a rising inventory supply of homes has lead homebuilders to throw in lots of add-ons to sell homes. This will put pressure on housing prices as sellers try to reduce their supply of unsold homes. Market prices are already softening in many areas with explosive home price appreciation seen in previous years. For example, prices in Las Vegas are rising at a 9% year-over-year (YOY) rate after the 50% YOY rate seen in middle of 2004.

The strongest area as seen by Figure 8 is the West with the three other regions now appreciating in single digit YOY growth. Auto-dependent metro areas in the Midwest such as Danville, IL; South Bend, IN; Toledo, OH; and Lansing, MI are showing declines of 5% or greater.

As housing prices soften and even decline in some areas, the wealth affect on consumer spending from the recent housing boom will also weaken. The wealth affect from rising housing prices has lead to U.S. consumers taking on unprecedented debt. Commentary by Northern Trust economist Paul Kasriel is provided below.

Assuming that households do, in fact, run a deficit for all of 2006, this would mark only the thirteenth time since 1929 that this has happened. Two years in which households ran a deficit were in 1932 and 1933 – the depths of the Great Depression. It is not hard to figure out why they might have run deficits then. With unemployment soaring, folks were selling assets and borrowing just to exist. Households again ran deficits in 1947, 1949 and 1950. Again, it is not too difficult to explain deficits in these years. During WWII, durable consumer goods and new houses were not available given that most production was being used for the war effort. And because there was not much to purchase for those working on the home-front during the war, they ran huge relative surpluses, to a large degree, in the form of war bonds. Soon after the end of WWII, with their balance sheets overflowing with assets relative to liabilities, households went on spending spree, buying houses, furniture, appliances and other consumer durables – hence the household deficits.

This brings us to the “modern” era. With the exception of 2000, households have racking up large deficits starting in 1999. By the way, these deficits are not just records in absolute terms, but relative to their disposable incomes as well – e.g., 6.15% of disposable income in the first half of 2006. These “modern era” household deficits also are not that difficult to explain. Generational low nominal and real interest rates, in part engineered by the Fed, have had the effect of inflating the prices of assets – equities in the second half of the 1990s and houses in the first half of 2000s. Why should households spend less than their after-tax incomes when the value of their assets is skyrocketing? And, of course, with asset prices inflating, there is all the more collateral upon which creditors can advance loans. So long as asset inflation continues, we guess households can continue to run record deficits. We can’t wait to see how the adjustment works out when the asset-price music stops.

As housing prices roll over, home-owners are in poor financial shape with record debt levels. According to CreditForecast.com, a joint venture of Equifax and Moody’s Economy.com, mortgage credit quality is eroding as seen by rising delinquency rates. The delinquency rates are likely to only increase with a further deterioration in housing prices along with resetting adjustable-rate mortgages and a weakening job market.

One of the sources for rising consumer debt has come from home-owners taking out home equity lines of credit (HELOC) to extract equity from their home. The increase in home equity extraction has lead to a negative U.S. consumer saving’s rate, with lower-income homeowners seeing the largest decline in their savings rate over the past couple of years. Renters currently have a 3% savings rate, homeowners with no HELOC have a 0% savings rate, and homeowners with a HELOC have a NEGATIVE 16% savings rate.

On the inflation front, not only was GDP recently revised but also inflation. The revisions showed that inflation is higher and has accelerated more than previously thought. In the 2nd quarter, the core consumer expenditure deflator’s YOY growth rate increased to 2.7%.Year-over-year growth in the core consumer expenditure deflator accelerated to 2.7%.

Putting further pressure on inflation is falling productivity in the face of rising labor costs. Productivity increased 4.1%, 3.7%, 3.0%, and 2.3% in 2002, 2003, 2004, and 2005 respectively, with a continual deceleration seen as the first half of 2006 put in an average of 2.7%. The YOY % change in productivity for 2nd quarter 2006 came in at 2.4%, under the YOY % increase seen in unit labor costs of 3.2%.

Going forward, a continued housing slowdown weighing down on the economy and persistent inflation will continue to play a tug-of-war with future Fed decisions as they did not close the door on future rate hikes.

The markets were up in early morning trading, rallying from strong earnings from Cisco Systems (CSCO) and Walt Disney (DIS), before declining on rising energy prices and fears of a slowing economy. Disney’s third quarter profits jumped 39% on surging demand on DVD sales of The Chronicles of Narnia and higher revenues from ESPN. The company was down 0.52% on the day. CSCO was up more than 14% on the day after CEO John Chambers forecast revenue growth between 15-20% for the fiscal year ending in July 2007, compared to expectations of 15% growth. The positive forecast from CSCO helped lift other technology names, as Broadcom (BRCM) was up 6.52%, JDS Uniphase Corp (JDSU) was up 5.77%, and Ciena Corp. (CIEN) was up 5.73% on the day.

Some of the day's worst performing stocks came from housing related industries. Mortgage lender Countrywide Financial Corp. (CFC) was down 8.65%, DR Horton Inc (DHI) was down 5.57%, KB Home (KBH) was down 4.68%, and Pulte Homes Inc. (PHM) was down 3.73% on the day.

The Energy Information Agency (EIA) released their weekly petroleum report which showed crude oil stocks fell 1.1 million barrels last week to 332.6 million, while gasoline stocks fell sharply, falling 3.2 million barrels to 207.7 million. Gasoline demand rose 1.8% higher than last year's levels despite elevated prices. Refineries increased capacity slightly, rising to 91.6%. The declining oil and gasoline stocks helped lift energy prices on the day before falling near the end of trading. The EIA noted that the data released for last week will be bullish for energy prices, yet may not be as important as next week’s data release which may begin to reflect the shutdown of the Prudhoe Bay oilfield.

Advancing issues represented 40% and 36% for the NYSE and NASDAQ respectively, with up volume representing 35% and 58% of total volume on the NYSE and NASDAQ.

All of the broad market indices were down, with the DJIA posting nearly a triple digit loss, down 97.41 points to close at 11,076.18. The S&P 500 was down 5.53 points to close at 1265.95, and the NASDAQ was also down marginally, falling 0.57 points to close at 2060.28. The 10-year Treasury note yield rose to 4.937%, and the dollar index posted a loss on the day, falling 0.11 points to close at 84.72.

Overseas markets were mostly up with Latin markets down for the day. Japan's Nikkei stock average rose 1.24%. London’s FTSE 100 rose 0.73%, Germany's DAX index rose 0.90%, France's CAC-40 rose 1.15%. Mexico’s Bolsa and Brazil’s Bovespa Index were both down, falling 1.38 and 0.92% respectively.

Sector performance was mixed on the day with the only positive performance coming from telecommunications, energy, and materials, posting gains of 0.93%, 0.52%, and 0.06% respectively. The greatest losses came from industrials and consumer discretionary, posting losses of 1.32% and 1.29%.

Spot gold prices rose $7.47 an ounce to close at $650.02 an ounce, West Texas Intermediate Crude (WTIC) oil fell slightly, down $0.01 a barrel to close at $76.30 a barrel, and Henry Hub spot natural gas prices rose $0.03 per mBTU to close at $7.04 per mBTU.

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