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Today's Market WrapUp 05.16.2007 Mon Tue Wed Thu Fri Puplava Archive
Evidence is piling in weekly that the economy is clearly slowing as the effects of the housing recession are being felt by the consumer through diminished spending growth with businesses responding accordingly.Chain Store Sales One of the big news stories last week was a large drop in chain store sales by 2.4% in April compared to last year’s levels, the largest drop on record dating all the way back to 1970. Although some of the weakness was attributed to a shift in Easter sales, the trend speaks for itself with no declines of more than 1% occurring since 1986. Figure 1
Proof that housing is contributing to the slowdown in the economy can be seen in furniture chain store sales that tumbled 18.1% compared to last year’s levels, continuing its negative trend of eleven consecutive year-over-year (YOY) monthly declines.A new development that is not encouraging and may provide support for consumer retrenchment argument was the 10.1% YOY decline seen in apparel chain store sales, the largest decline since April of 2002 (-11.6%).Weak consumer spending led to only 3.2% growth in total sales, the second weakest growth rate on record dating back to 1987, with the weakest growth rate coming in September of 2002 (2.6%).The developments in consumer spending mentioned above clearly spell a retrenchment in consumer spending as the housing recession and resetting mortgage payments cut into consumer wallets, with businesses taking their cue from the consumer. Businesses Seeing the Writing on the Wall? Not only are banks tightening lending standards for real estate loans, but the same trend is also seen in commercial and industrial loans (C&I). The net percentage of banks reporting stronger demand for C&I loans has contracted sharply after peaking in 2005 (coincident with the housing top), and is contracting at a negative 22.6% YOY rate. A contraction in loan demand of greater than 20% was last seen leading into the 1990 and 2001 recessions. Figure 2
One difference currently is that the present contraction in demand for C&I loans is coming despite lending standards that are not as tight as they were leading up to the previous recessions that saw roughly 60% of banks reporting tightening lending standards. This indicates that the drop in C&I loan demand is resulting less from tightening lending standards by banks and more by other circumstances, which is likely businesses preparing for a consumer retrenchment. There is a strong correlation between demand for C&I loans and retail sales as seen in the figure below, which seems to suggest that businesses are in fact taking their cue from the consumer as C&I loan demand is falling in lock-step with decelerating retail sales. Figure 3
The trend in decelerating retail sales is likely to only weaken in the near future as consumer loan delinquency rates continue to rise sharply, indicating increasing financial strain felt by the consumer. Retail sales move inversely to delinquency rates and fall as consumer delinquency rates rise. The figure below shows this relationship with retail sales inverted for directional similarity. Figure 4
Providing a cue for how much further retail sales could decelerate is seen by the figure below which provides the relationship between interest rates and consumer spending. There is roughly a two year lag between interest rates (as measured by the yield curve) and consumer spending. Even if the Fed starts slashing rates here and now there will be a lag witnessed in retail sales before the Fed relief is felt, with the figure below indicating further deceleration in retail sales into next year. No wonder businesses are cutting back on C&I loans as consumers are likely to retrench spending even further despite any near-term Fed relief. Figure 5
Inflation Moderating: Stage Set for Fed to Lower Interest Rates Presented above was clear evidence of a slowing economy that gives more support for Fed relief via lower interest rates. What is keeping the Fed on pause is inflation, which the FOMC comments remains stubbornly high. This may soon reverse course as change is in the wind. One of the driving factors of broad based inflation is wage inflation, as rising incomes leads to greater spending with businesses raising prices with rising demand. Wage inflation typically peaks ahead of a peak seen in the core CPI, with sharp decelerations in wage inflation in the early 80s, 1990, and 2000, proceeding eventual sharp deceleration in the core CPI. An important development is the likely peaking of wage inflation as measured by the YOY change in average hourly earnings, which has reached a cyclical peak near 4%. A peak in wage inflation will work its way through the economy as consumer income gains moderately and contributes to decelerating inflation as the core CPI falls. Figure 6
Another important inflation development is housing inflation. One major component of the CPI index is housing (42.6%), with owner’s equivalent rent (OER) a subcomponent of housing and comprising 23.8% of the overall CPI index. OER helped keep the CPI index low during the housing boom as renters bought houses, creating a greater supply of rental units and depressing rental rates. This can be seen as OER inflation rates remained relatively flat between the middle of 2004 to the middle of 2006 at 2.5%. Imagine if housing prices, which were rising at double digit inflation rates, were substituted for OER as the housing component. This would have lead to the core CPI rising rapidly between 2004 and 2006. Instead, OER was used and kept the CPI artificially low, and now the fall out is that it is keeping the core CPI high as the housing market has reversed as there are now marginally more renters than buyers. Figure 7
OER inflation jumped in late 2005 into 2006 once housing peaked, with less people leaving rental units in search of homes, and there was an increasing amount of home owners locking in gains by selling their homes and becoming renters. This increased demand for rental units sharply droving OER inflation higher, which also contributed to a sharp jump in the CPI index. However, OER inflation appears to have peaked as seen in Figure 6, acting to pull down the CPI instead of keeping it higher on a relative change basis. Likely contributing factors to the OER rolling over are condo conversions that have been reversed amidst a housing recession, putting units back on the market for rent. Those who bought a second home as an investment are likely putting them up for rent at depressed rental rates to bring in renters to help offset their mortgage payments. Both events create a greater supply of rental units. Notice in the figure above that the core CPI did not fall materially at the beginning of the decade until OER fell significantly, with a rising OER from early 2000 to early 2002 keeping the CPI index elevated. The core CPI index fell from 2.9% in September of last year to 2.4% presently, despite OER remaining elevated. With OER rolling over currently the core CPI is likely to pick up steam on the downside and approach the Fed’s comfort zone of 2%. Too Little Too Late? What is not likely lost by the Fed is that inflation is a lagging indicator as the core CPI did not peak until the END of the last recession (Figure 6), an argument they are likely to cite once they do reduce interest rates. The question remains whether or not lowering of future interest rates by the Fed is too little too late. Core retail sales (ex auto and gas sales) have plummeted sharply after peaking in the middle of last year as they did prior to the last recession. What also followed the trend in core retail sales were unemployment insurance claims (inverted in figure below for directional similarity). Figure 8
Though unemployment insurance claims have not picked up meaningfully, the contraction in retail sales may be painting a dark picture of what may lie ahead if the correlation between the two holds up. Don’t expect a bottom in housing any time soon if the National Association of Home Builders (NAHB) data is any indicator. The NAHB housing market index (HMI) data came out yesterday, falling three points to 30, as every component of the index fell in May, the supposedly strong housing shopping season. Figure 9
Commentary provided by Patrick McPherron from DismalScientist is provided below: The record low numbers for the May survey beg the question, "can the housing market get any worse without a recession?" The numbers from last month’s survey were the worst on record for April, but the numbers this month are by far the worst on record for May in the subcategories of current sales and traffic of future buyers. The optimism for sales in the next six months is also the lowest for May in the 22 years of the survey, but only slightly below conditions in 1990. Additionally, the NAR records a 1.7% year-to-year drop in the median existing house price in the first quarter of 2007, with about 40% of the U.S. declining. Also, over 30 states reported that existing home sales were down in March. Another question is whether inflation fears have waned enough to prompt FOMC action? Figure 10
The fed funds rate may be too high for this sector to recover in the current economy. One concern is the rising number of bankruptcies and other insolvency issues for subprime lenders. Large banks and Wall Street firms are forcing smaller mortgage originators to buy back defaulting loans. There is little evidence that the expected return on these “junk” mortgages justified the risk, so much tighter lending practices will be evident this year. Tighter lending standards will lower the demand for single-family housing, making it difficult to work off the already high levels of inventory. Figure 11
The economy continues to slow with the revised Q1 2007 GDP possibly coming in below 1%, and inflation is moderating. These two developments give the Fed room to lower interest rates in the near term, a development seriously needed by the housing market as more and more adjustable rate mortgages reset amidst tighter lending standards. Will the lowering of interest rates by the Fed be enough to stave off a recession, or is it too little too late? As Mr. McPherrron put it, “can the housing market get any worse without a recession?" Figure 12
The risks of a recession are rising as consumers retrench and corporations pull back on leveraging up as C&I loan demand is drying up. The Moody’s Economy.com probability of a recession index rose sharply in March to 28%, up from February’s 21% level. Contributing factors to the rise were a sharp moderation in consumer confidence, March’s equity correction, further inversion of the yield curve, and unemployment insurance claims picking up in March. The equity markets move in April will be a positive development, though Moody’s comments that “the chance of the economy being in recession in six months is elevated and rising.” TODAY'S MARKET The Dow Jones Industrial Average finished up on the day, posting a triple-digit gain of 103.69 to close at yet another new record of 13487.53. The Dow rose on news of billionaires accumulating Citigroup and Johnson & Johnson, with Warren Buffett raising his stake in JNJ to 48.7 million shares in the first quarter from 24.6 million, nearly doubling his position, with the news sending JNJ up nearly 2%. Billionaire hedge fund manager Edward Lampert increased his position in Citigroup by more than 15 million shares sending Citigroup up over 4% on the day. Other markets faired well on news of a jump in industrial production, falling energy prices, and a positive surprise seen in housing starts. The NASDAQ was up 22.13 points to close at 2547.42 (+0.88%) and the S&P 500 was up as well, rising 12.95 points to close at 1514.14 (+0.86%). Investors purchased Treasuries today with the 10-year note yield at 4.708%, falling 0.4 basis points. The dollar index was up on the day, rising 0.44 points to close at 82.20. Advancing issues represented 60% and 56% for the NYSE and NASDAQ respectively, with up volume representing 71% and 67% of total volume on the NYSE and NASDAQ respectively.
Energy prices were down on the day after release of petroleum inventories. Gasoline inventories rose for the second straight week with inventory builds seen in crude oil and distillates. West Texas Intermediate Crude (WTIC) fell $0.62 a barrel to $62.55 a barrel, and spot Henry Hub natural gas fell 2.17% to $7.68. Precious metals fell on the day aided by a rising dollar with gold falling $9.90/oz to $662.15/oz (-1.47%) and silver fell $0.29/oz to close at $12.91/oz (-2.20%). Base metals were mixed with nickel putting in the strongest performance (+0.37%), while copper displayed the weakest performance (-1.08%).
Overseas markets were mostly up with Latin markets leading the charge, with Mexico’s Bolsa index putting in the strongest showing, up 2.44%, followed closely by Brazil’s Bovespa index, up 2.41%. The greatest weakness on the day was seen in France’s CAC-40 index, down 0.53%. The move in the markets was broad based as all ten of the S&P 500 sectors were up on the day, with telecommunication services (+1.28%) and the the financial sector (+1.08%) putting in the strongest advances. The greatest weakness was seen in materials (+0.23%) and industrials (+0.52%) sectors.
Chris Puplava Copyright © 2007 All rights reserved.
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