Soft Landing or Recession?
07/31/06
The government's first estimate of second-quarter GDP came in at an annualized 2.5%, well below economists' consensus forecast of 3.2% growth. The markets reacted to this number on Friday as most would have predicted. Stocks and Bonds rose (yields declined) on the notion that 2 years worth of tightening finally did the job by slowing the economy sufficiently to relieve pressure on "resource utilization" (as the Fed put it) or contain inflation (as you and I would put it). At midday on Friday, the futures market put the likelihood of another fed funds rate hike at the next FOMC meeting on Aug. 8 at 26%, down from 45% Thursday. Tony Crescenzi notes that the futures markets price in greater odds of a fed funds rate cut than they do a hike over the next year. "The market is priced for greater odds that the funds rate will be 5% next year, than 5.5%," he writes. The yield on the 10-year Treasury note, meanwhile, sank below 5%, to 4.99%. The Standard & Poor's 500 gained 3.1% on the week, to 1278, its best week since November 2004, while the recently laggard Nasdaq Composite jumped 3.7%, to 2094. That was its largest weekly gain since the first week of this year. Sentiment had reached excessive levels of negativism and stocks relieved the pent-up pressure by rallying this week.
The left chart above shows the quarterly annualized growth rate of the economy (red line). We went from 1.7% in the 4th quarter 2005 to 5.6% in the 1st quarter 2006 to 2.5% in the 2nd quarter 2006. It seems clear that Hurricane Katrina stole growth from the 4th quarter 2005 and pushed it into the 1st quarter of 2006. The average of the last 4 quarters currently seems to hover right around 3.5%. The most important aspect of the GDP data is the weakness in spending on equipment and software, the main gauge on capital spending. It fell at an annual rate of 1.0% during the quarter, much weaker than the 10% gain that was expected and the weakest for any quarter since the first quarter of 2003. No wonder the Semiconductor Index ($SOX) lost 20% in the past three months. The data challenge the notion that strength in business spending will offset any weakening of consumer spending.
The good news was, that the inflation components of the report, such as the Personal Consumption Expenditures Index (PCE Index, right chart above) was not worse than expected. Still, at 2.9%, this inflation indicator experienced its largest quarterly gain since the third quarter of 1994. The figures would be worrisome if not for the slowing in the economy, which should mitigate the inflation pressures eventually. That is also the reason why bonds did not decline on worsening inflation news but rallied sharply instead. The yield difference between the Fed Funds rate at 5.25% and the 10 year notes at below 5% increased markedly. The yield curve (T-bills vs. 10s) is at its most inverted in five-and-a-half years, an obvious indication of concern about the economy. The word "Stagflation" has been used more and more recently when describing our current economic environment. Stagflation is the combination of a slowing/stagnant economy and rising inflation (=stagflation). These days, many investors are wrestling with relief over an end to the rate hikes on one hand versus concern over an economy that is clearly losing steam on the other. Federal Reserve officials explicitly acknowledged that lead times between tightening and economic slowdown vary between 9 and 18 months, depending on the circumstances. The Fed started raising interest rates exactly 2 years ago. The economy has probably started to slow at the beginning of this year. The Katrina effect distorted the numbers somewhat but the fact is that the Fed's tightening measures today will affect the economy at about this time next year. No wonder that many people think that the Fed might be overdoing it - again. This concern is understandable if one looks at the housing sector.
The left chart above shows the sales of newly constructed single family homes. As you can see, the annual growth rate reached its peak in July 2005 and turned negative in January this year. The housing sector is clearly in trouble and the effect on the economy today is as great as it was in former times. The housing sector provided one out of three new jobs in the labor market in recent years. That is a scary number. A decline in the housing sector might make the difference between a soft landing and an outright recession. So far, I am holding out hope, that the Fed is able to engineer a soft landing, partly because of the chart on the right hand side above. The so called GDP Deflator is one measure of inflation that can not be "manipulated" as some conspiracy theorists would have it. The GDP deflator is not based on a fixed basket of goods (like the CPI) and does not contain the so called owner's equivalent rent. Therefore, the GDP deflator has an advantage, because it automatically captures changes in consumption patterns and the introduction of new goods or services. It is based on actual purchases and consumption preferences and not on theoretical constructs of indexation. You can see that the GDP deflator still hovers below the peak reached in the 4th quarter of 2004. Given the fact that resource utilization is tapering off, creating slack and less price pressure in the economy, I believe, as does Bill Gross at PIMCO , that inflation will reach a cyclical peak sometime this year.
The bond market already seems to discount a recession by the end of this year. I hope the fixed income types are wrong but honestly I would not bet money on it. The bond market is the bigger and smarter brother of the stock market and when the most inflation sensitive bunch on Wall Street is betting on a recession, it behooves us to pay attention. Perhaps that is the reason why for most of last week, earnings misses were pummeled more than earnings successes were rewarded. Earnings (just as inflation data) are backward looking. What counts is the future and it just might be, that in the coming quarters it does not pay to be overly optimistic on stocks. At least that seems to be the message of recent strength in pharmaceutical and consumer non-discretionary stocks. Merck not surprisingly then, reached a 52 week high last week as did Colgate-Palmolive the week before.
Not many people are currently betting on a cyclical recovery. It makes me think that it is high time to put the defensive team on the field.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
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