"Fed's Decision Well Supported as Economic Slowing Continues" Market WrapUp by Chris Puplava

Fed's Decision Well Supported as Economic Slowing Continues
BY CHRIS PUPLAVA

Yesterday’s decision by the Fed to leave interest rates unchanged is well supported as the economic slowdown continues and is broad-based as is evident in falling home sales and home construction, slipping vehicle sales and industrial production, and softer chain-store sales.

The economic slowdown is also present in the job market as payroll job gains have slowed from an average of 175,000 per month in 2004, to 165,000 in 2005, to below 150,000 so far this year, with weakness concentrated in housing related industries and manufacturing.

Slowing economic and labor growth are leading to rising business inventories as sales and shipments are slowing leading to an increase in the inventory to shipments ratio (I/S) as businesses struggle to pair business investment with demand. The industries caught most off guard, not surprisingly, are the auto and housing industries.

I/S Ratios Show Widespread Inventory Build
	Jun-06	Jul-06	Aug-06	Sep-06	Oct-06
Total Durable Goods	1.33	1.36	1.34	1.40	1.40
Durable ex Transportation	1.39	1.40	1.41	1.45	1.45
Durable ex Defense	1.30	1.33	1.32	1.37	1.37
Core capital goods ex aircraft	1.50	1.49	1.49	1.53	1.56

Primary metals	1.41	1.40	1.43	1.53	1.58
Fabricated metals	1.45	1.48	1.48	1.52	1.54
Machinery	1.64	1.63	1.61	1.66	1.63
Computers and related products	0.69	0.61	0.63	0.71	0.90
Communications equipment	1.63	1.86	1.69	1.68	1.72
Electronic equipment/appliances	1.33	1.35	1.36	1.39	1.37
Motor vehicles and parts	0.59	0.64	0.61	0.66	0.65
Civilian aircraft	2.94	3.17	2.78	2.68	2.95
Defense aircraft	3.63	3.49	3.26	3.52	3.21
Other Durable	1.29	1.32	1.32	1.34	1.35
I/S ratio 1 standard deviation above May'05 to date average
I/S ratio 2 standard deviation above May'05 to date average
I/S ratio 1 standard deviation below May'05 to date average
I/S ratio 2 standard deviation below May'05 to date average
Sources: Moody's Economy.com, Census

The following commentary was provided by Daniel Jester from Moody’s Economy.com regarding the above table.

There are several key take-aways from this exercise. First, motor vehicles is the single industry most out of balance, and the correction will likely continue for at least several more months, and possibly even longer. The last time the auto industry built up big unwanted stockpiles, in early 2005, the Big Three responded by boosting incentives and slashing production. Right now, however, vehicle production has already been quite weak for several months and inventories continue to pile up (emphasis added). To make matters worse, sales to consumers are much weaker than the topline numbers indicate, since fleet sales are disguising soft consumer demand.

Second, weakness in autos may be spilling over into other parts of the industrial base. The I/S ratio for fabricated metals has increased for six consecutive months and is now at its highest level since April 2005. Moreover, businesses may be pulling back on capital goods spending. Capital goods orders and shipments were still sturdy in the third quarter, even while autos and housing-related industries struggled. However, in October orders for core capital goods, excluding aircraft, plunged 5.1%, and shipments dropped 1.5%. The especially troubling build in computer inventories over the past two months is indicative of the lackluster momentum for capital spending in the fourth quarter. Still, given how volatile orders data can be, as well as the upbeat production data for high-tech equipment, this new evidence only shifts the balance of the risks to the downside for equipment and software investment for the fourth quarter.

With the rise in the I/S ratio for computers and related products, electronic equipment and appliances, the disappointing news from Best Buy yesterday regarding an earnings miss is not surprising. Best Buy’s EPS for the third quarter came in at $0.31, below the average estimate of analysts compiled by Bloomberg of $0.35. The company said its earnings shortfall was the result of price cuts in order to keep pace with Wal-Mart Stores Inc. and Circuit City Stores Inc. The company dropped prices on flat-panel televisions and laptop computers in the previous quarter with the company planning on reducing prices this quarter more than they did a year earlier. The reduced selling prices hurt Best Buy’s margins with gross profit falling to 23.5% from 24.4% from the same period a year earlier.

One of the changes in the Fed’s statement yesterday from the previous announcement concerned housing. The Fed indicated a main concern going forward is housing when it changed its usual statement by referring to a "substantial cooling of the housing market," adding the word "substantial" this time.

Their concern for the economy due to a housing slowdown is well supported as other signs of economic weakness and strain on the housing market comes from elevated foreclosure rates. RealtyTrac® released their third quarter report on metro area foreclosure rates (click for article) which showed that nationwide there were 318,355 properties in some stage of foreclosure, up 43% from the third quarter of 2005. One of the main culprits leading to higher foreclosures is adjustable rate mortgages (ARMs) resetting at higher rates.

"In the next 15 months, more than $1 trillion in loans are due to adjust upward," said James J. Saccacio, chief executive officer of RealtyTrac. "With such a large volume of these loans set to increase, it is a trend that definitely bears watching."

There is a strong correlation behind employment growth and consumer delinquency rates. Falling employment growth leads to reduced incomes and thus delinquency rates. The figure below shows employment growth inverted along with consumer loan delinquency rates. Employment growth plummeted in the 1990 and 2001 recession while delinquency rates jumped.

Presently, employment is slowing and delinquency rates have risen off their 2005 lows, an alarming trend that will have to be monitored. Another correlation resulting from employment and income levels is delinquency rates and retail sales as falling incomes lead to contracted consumer spending and rising delinquency rates. As in Figure 9, a sharp decline in retail sales was seen in the prior two recessions, while consumer loan delinquency rates spiked with both presently repeating the pattern as delinquency rates are moving upward while retail sales are contracting.

Source: Moody’s Economy.com, Data: Federal Reserve Board, Bureau of the Census

Another trend affecting delinquency rates is looking at costs instead of incomes in determining disposable income. As falling incomes lead to higher delinquency rates by decreasing disposable income, so does rising costs--such as energy and interest rates--with interest rates affecting ARMs and other financing costs. Figure 11 below shows the strong correlation between interest rates as measured by the Federal Funds Rate and consumer loan delinquency rates. I plotted the Fed Funds Rate advancing 6 quarters as it is a leading indicator for delinquency rates. The trend in rising interest rates is indicating that the spike in consumer loan delinquency rates is the beginning of a trend that does not bode well for the economy with delinquency rates potentially rising to 3.5% when looking at the Fed Funds Rate trend advanced below.

The effect of rising interest rates on housing can be seen below as Paul Kasriel from The Northern Trust Company points out with the following commentary (Article Link):

In the late 1970s, buying a house was a "no-brainer," inasmuch as the annual rate of price appreciation on single-family existing homes exceeded the mortgage rate, or cost of financing the home. Because homes, unlike most dot.com stocks of the late 1990s, actually pay a dividend - shelter services - it was a win-win situation for the home buyer back in the late 1970s. He or she could finance an asset at an annual interest rate below the rate of price appreciation of that asset and could earn an implicit dividend on it if he or she chose to live in the house or an explicit dividend if the house were rented out. And the frosting on the cake for owner-occupied housing was the tax advantages. The guaranteed profitable carry trade in housing ended in the 1980s as mortgage rates generally were above the annual rate of price appreciation of houses. But the guaranteed profitable carry trade in housing returned in the early 2000s as once again mortgage rates fell below annual rates of house-price appreciation. Former Fed Chairman Greenspan says that you can thank the fall in the Berlin Wall in November 1989 for the return of the easy-money carry trade in housing. But I think the former chairman is once again too modest. Rather, it looks to me as though his easy money policy of the early 2000s was largely responsible for the easy money to be made in housing in the same period. But the guaranteed profitable carry trade in housing is now over as can be seen in Chart 1 (Figure 12).

Mr. Kasriel further points out that the supply-demand situation suggests that housing prices will not rebound any time soon as the following chart points out the imbalance between supply and demand in terms of year-over-year (YOY) rate of change.

The supply and demand imbalance shown in Figure 13 shows the housing contraction has further to go as does the relation of residential fixed investment as a percentage of GDP. Residential fixed investment as a percentage of GDP is currently falling after peaking last year at levels not seen in over 50 years with two standard deviations above the average. Since 1950 residential fixed investment has averaged 4.8% of GDP with prior housing bottoms reducing its percentage to about 3.5%, roughly two standard deviations below the average. With the recent high of approximately 6.3% and current reading of 5.6%, we aren’t even half way to the level of previous housing bottoms.

When looking at residential fixed investment as a percentage of GDP and a trend basis, it can be seen that over the last 50 years housing has been playing a smaller role with the trend pointing down. If the trend continues, a housing bottom might not be seen until residential fixed investment falls to two standard deviations below the trend at roughly 3.0% of GDP.

Either way, whether looking at the average or trend of residential fixed investment in relation to its contribution to GDP, housing still has a ways to go. Another gauge of looking at how far housing has to go before bottoming is its YOY rate of change in residential fixed investment. The current YOY rate of change is roughly -10% with bottoms in the rate of change ranging between -10% to -30%.

Looking at Figures 14 and 15 remove the hopes that the current -10% YOY rate of change will bottom near the lower end of the historical decline range of -10% to -30%. This is alarming as Figure 16 shows that there is a high frequency of a recession (grey bands) when the YOY rate of change falls to or below -10% with only two exceptions (1950, 1966) over the past 55 years out of 10 previous occasions. This leads to an 80% occurrence of a recession from a historical context with the economy falling into a recession 8 out of 10 times when the YOY rate of change falls to or below -10%.

Mr. Kasriel provides further evidence that the housing contraction has more to go when looking at real residential fixed investment with the following figure and commentary:

Former Fed Chairman Greenspan has recently commented to the effect that the worst of the housing recession is behind us. History is not on the side of this view. Chart 3 shows the peak-to-trough percentage declines in the GDP line item, real residential investment. In the prior nine housing cycles, the average peak-to-trough decline is 24.6%; the median is 22.6%. The peak-to-trough decline to date in the current housing recession is 7.9%. Unless this turns out to be a more moderate than usual housing recession, unlikely given the amount of speculation and leverage involved in the boom, then we have "miles to go" before we can put this housing recession "to sleep." Thus, don't look for the carry trade in housing to turn profitable any time soon.

Mortgage demand increased 11.4% last week with a spike in both the refinance index and purchase index, rising 15.8% and 8.7% respectively. The purchase index is still 3% below its year-ago level while the refinance index is 60% higher than it’s year-ago level due to an increase in ARM resets and lower interest rates. ARMs represented 25% of the number of mortgage applications and 40% of the dollar volume, with refinancing representing 53% of the total number of applications and 57% of the total dollar volume.

OPEC ministers meet tomorrow in Nigeria to discuss another cut in production even while oil inventories continue to plunge. Both the U.S. Secretary of Energy and the Executive Director of the International Energy Agency (IEA) called on OPEC to refrain from further cuts in production quotas.

The affect of their previous cut is still being felt as seen by a decrease in imports, which, when coupled with lower refiner utilization and sturdy demand, are contributing to significant decrease in oil inventories.

Last week saw crude inventories fall 4.3 million barrels, a huge drawdown compared to the 0.6 million expected decrease. Gasoline inventories fell by 0.1 million barrels in stark contrast to an expected 1.2 million barrel build with gasoline inventories 3.1% below last year's levels with demand 1.9% above last year's levels. Distillate inventories fell 0.5 million barrels, slightly above expectations, and refinery utilization fell 1.4% to 89.1% against expectations for a 0.5% increase in the utilization rate.

Rising demand for crude oil and gasoline along with a drop in imports is causing a decline in inventories with crude oil stocks still above the average range, but gasoline inventories are now below the average range while distillate stocks continue to fall, approaching the lower end of their average range.

Total retail sales surprise on the upside by rising 1.0% in November, higher than the 0.2% consensus forecast (Thomson Financial Consensus). Large gains were seen in electronic and appliance stores (4.6%), gasoline stations (2.3%), and building material dealers (1.8%). The only declining segment was furniture and home furnishing stores which saw a 0.1% decline. On a year-over-year basis, total retail sales are up 5.6% with the strongest gains in non-store retailers (10.1%), electronic & appliance stores (8.6%), and food services and drinking places (7.9%). The weakest segments were gasoline stations (-2.3%) and general merchandise stores (3.8%).

Total business inventories increased 0.4% for October as did manufacturing inventories, while wholesalers experienced the greatest build, up 0.8% in October while retailer inventories remained unchanged. Sales were unable to keep pace with rising inventories as the total inventory-to-sales ratio (I/S) moved to 1.31, up from the recent bottom of 1.25 seen in May.

The stock market rose in early morning trading by the positive surprise in November retail sales, but then gave back their early gains on the larger than expected drawdown in crude oil and gasoline inventories. The markets then entered into a trading range as investors weighed the positive news from retail sales and the increase in mortgage demand against the negative petroleum report.

The markets finished mainly flat with the DJIA posting a small gain of 1.92 points to close at 12,317.50. The S&P 500 was up 1.65 points to close at 1413.21, and the NASDAQ was also up marginally, rising 0.81 points to close at 2432.41. A strong sell-off was seen in Treasuries today as stronger mortgage data and larger retails sales diminished hopes of an early 2007 interest rate cut with the 10-year note yield rising to 4.577%, up nearly 2% by rising 8.6 basis points. The dollar index posted a decent gain on the day with the positive economic news, rising 0.38 points to close at 83.32. Reflective of the flat markets were advancing and declining issues, with advancing issues representing 50% and 51% for the NYSE and NASDAQ respectively, with up volume representing 50% and 51% of total volume on the NYSE and NASDAQ.

Energy commodities were up on the day after the release of the EIA petroleum report with the strongest gains seen in Henry Hub spot natural gas (+4.05%). Precious metals were down with gold falling $1.80/oz to $628.25/oz and silver falling $0.0775/oz to close at $13.8075/oz. Base metals were also mostly down on the day, with spot lead prices showing the largest decline (-5.79%) with a 5.42% increase in LME inventories, while spot aluminum put in a positive result (+0.79%), which showed the smallest build in LME inventories. Agriculture and softs were mixed with spot ethanol putting in the largest advance (+2.14%), and spot sugar price showing the largest decline (-1.32%).

Overseas markets were mostly up with the largest advances coming from France’s CAC-40 and Germany’s DAX index, up 0.90% and 0.69% respectively. Mexico’s Bolsa index posted the largest decline, falling 0.53%.

The ten S&P 500 sector performances were mixed on the day with energy leading the pack on the EIA petroleum release, up 1.05% on the day followed by the utility sector and consumer discretionary, up 0.40% and 0.33% respectively. Industrials and consumer staples led the decliners, down 0.43% and 0.15%.