Economic Highlights for the week ended February 8, 2008

Economic Week In Review: Recession Fears Linger

Vanguard 2/8 - Contrary economic trends were reported last week as analysts looked for signals that a recession was, or was not, brewing. On the one hand, a gauge of service-sector business conditions dropped so severely that it astounded analysts (since consumer spending on services is the largest component of gross domestic product) and was blamed for a stock market plunge when the report was released on Tuesday (the S&P 500 Index fell 3.2%). On the other hand, productivity growth was stronger than expected, unit labor costs were lower than projected, and factory orders continued to accelerate. For the week, the S&P 500 Index fell 4.6% to 1,331 (for a year-to-date total return of –9.2%), and the yield of the 10-year U.S. Treasury note rose by 5 basis points to 3.65%.

Factory Orders Rise 2.3% In December,

Vanguard 2/8 - New orders for manufactured goods rose by 2.3% in December, continuing an acceleration that began four months earlier. Factory orders have increased in six of the past seven months. (They declined by 3.5% in August.) Looking at the mix of December orders, durable goods rose strongly while orders for nondurable goods declined.

Non-Manufacturing ISM For January: Service Sector Slumping Sharply

Vanguard 2/8 - A survey by the Institute for Supply Management (ISM) found that a severe contraction in service-sector business conditions took place in January. The unexpected severity of the decline in the ISM's index of nonmanufacturing business activity startled analysts and stoked recessionary fears. An index reading below 50.0 indicates contraction, and, while analysts expected the index to decline from 54.4 in December to 52.5 in January, the index actually fell to 41.9. ISM said this was the first contraction in nonmanufacturing business activity since March 2003 and the lowest index reading since October 2001.

Bear Stearns 2/5 - The new ISM non-manufacturing composite index (which equally weights the business activity, employment, new orders, and supplier delivery indexes) plunged to 44.6 in January from 53.2 in December.

The new orders index fell sharply, to 43.5 in January from 53.9 in December, while employment dropped to 43.9 from 51.8.

This is a dire reading on non-manufacturing activity that portrays the emergence of recession-like conditions in the economy.  Also pointing to a potential recession is the decline in non-farm payrolls in January.  In addition, the Fed's Senior Loan Officer Survey yesterday reported a massive tightening in credit conditions for residential mortgages, commercial mortgages, and C&I loans.  In contrast, manufacturing ISM, which has historically been a good gauge of economic conditions suggests slow growth in January rather than recession.  However, it appears that recession risks continue to grow and, in the event of recession, the FOMC is likely to cut the fed funds rate to 2% by the middle of the year (on our baseline forecast of slow growth, we are projecting that the Fed will cut the funds rate to 2.5% at the March FOMC meeting).  Note that this report was released early today because of a possible leak of the information.

Productivity Gains Stronger Than Expected In The Fourth Quarter

Vanguard 2/8 - Better-than-expected changes in nonfarm business productivity and unit labor costs, both considered indicators of future inflationary trends, were reported for the fourth quarter of 2007. Following a weak increase in gross domestic product reported last week, analysts expected productivity growth to also slow. It did, but by a far lesser amount than expected (to an annualized 1.8% compared with 6.0% in the previous quarter). Unit labor costs also rose more slowly than expected, by 2.1%, after two consecutive quarterly declines. Rising productivity dampens inflationary pressures, including rising labor costs.
Bear Stearns 2/6 - Nonfarm productivity held steady at 2.6% on a year-over-year basis. Productivity growth was better than expected in the fourth quarter but only because of a decline in hours worked (likely a product of falling self employment).  The fall in hours worked paints a significantly weaker picture of the labor market in the fourth quarter than painted by the payroll data.

Jobless Claims Higher Than Expected – week ended January 26

Bear Stearns 2/7 - Initial jobless claims were higher than expected, declining by 22,000, to 356,000, in the week ending February 2.  The four-week average of claims rose 8,500 to 335,000 from 326,500 in the prior week.

Continuing claims continue to move higher, rising 75,000, to 2.785 million, in the week ending January 26 (this is the highest level for continuing claims since October 2005).  The insured unemployment rate ticked up to 2.1% from 2.0% in the prior week.

On balance, initial jobless claims have drifted higher, although at this point they remain below levels typically associated with outright recession. 

Wholesale Inventories Rise 1.1% In December

Bear Stearns 2/8 - Wholesale inventories in December were higher than the Commerce Department assumed in the advance release of fourth-quarter GDP, rising 1.1% in the month.  November wholesale inventories were upwardly revised to 0.8% from an originally reported 0.6% increase.

Wholesale sales declined 0.7% in December, but the wholesale inventory-to-sales ratio increased to 1.09 in December from 1.07 in November.

OFHEO Testimony On Housing GSEs (Excerpts, www.OFHEO.Gov)

James B. Lockhart, Feb. 7, Senate Banking, Housing and Urban Affairs Committee – “Public disclosures indicate that Freddie Mac will report annual losses for the first time in its history and Fannie Mae for the first time in 22 years. Their missions, as well as Congressional and many other pressures, are demanding that they do more and take on more risks in areas new to them – subprime and jumbo mortgages.”

“During 2007, the housing GSEs debt and guaranteed MBS outstanding grew $870 billion or 16% to $6.3 trillion. (In comparison)…public debt of the United States is $5.1 trillion, (with) only about $4.4 trillion in public hands.”  [Whitehead: another comparison - Farm Credit had approx. $158 billion in Systemwide Debt securities outstanding on January 31, 2008.]

“The Enterprises …credit losses… are approaching double normal levels and climbing. Some of this growth in losses was because they lowered underwriting standards in late 2005, 2006, and the first half of 2007 by buying more non-traditional mortgages to retain market share and compete in the affordable market.

[The temporary increase in the Conforming Loan Limit (CLL)… from $417,000 to $730,000… as proposed in the Economic Stimulus package…] “pushes the GSEs to increase their geographic concentration in some of the riskiest real estate markets. Roughly half of all jumbos are in California.”

Senior Loan Officer Survey Shows Significant Tightening Of Credit

Bear Stearns 2/4 - The Federal Reserve's January Senior Loan Officer Survey points to a significant tightening in lending standards for a broad range of loans.  The survey also suggests that demand for loans fell during the survey period.

In the January survey, a significant proportion of domestic banks reported that they had tightened lending standards on prime, nontraditional (nontraditional mortgages include, but are not limited to, adjustable-rate mortgages with multiple payment options, interest-only mortgages, and "Alt-A" products such as mortgages with limited income verification and mortgages secured by non-owner-occupied properties—standard adjustable-rate mortgages and common hybrid adjustable-rate mortgages are excluded), and subprime mortgages over the past three months.  52.9% of domestic respondents indicated that they had tightened their lending standards on prime mortgages, up from about 40.8% in the October survey.  84.6% of banks reported a tightening of their lending standards on nontraditional mortgage loans over the past three months, compared with 60.0% in the October survey.  71.5% of banks noted that they had tightened lending standards on subprime loans, versus 55.5% in the October survey.

The net percentage of respondents tightening standards for commercial and industrial loans to large and medium-sized firms rose to 32.2% in the January survey from 19.2% in October survey.  In addition, 80.3% of domestic banks reported tightening lending standards on commercial real estate loans over the past three months, up from 50.0% in the October survey.

The January Senior Loan Officer Survey included a special set of questions on expectations for delinquencies and charge-offs on loans to businesses and households in 2008, assuming consensus forecasts on economic growth.  On balance, the responses indicate that most banks expect a deterioration in loan quality in 2008.  For example, about 15% of domestic and 20% of foreign respondents expect a substantial deterioration in the quality of their commercial real estate portfolios.  In the residential real estate loan space, between 70% and 80% of domestic respondents expect the quality of their prime, nontraditional, and subprime residential mortgage loans, as well as their revolving home equity loans, to deteriorate in 2008.  Finally, about 70% of domestic respondents expect a deterioration in the quality of both credit card and other consumer loans.

Economic Comment/Update: Recession Odds Increase But Inflation Risks Remain

Bear Stearns 2/6 - In the latest week, the economic data point to a significantly higher risk of recession than we had previously thought.  The problem is that if we are in recession, we are convinced it is not a recession that resulted from monetary policy being tight.  Indeed, our price-level indicators, such as gold, commodities, and the foreign-exchange value of the dollar, have pointed to monetary accommodation for several years.

Although the Fed finds itself with little choice but to ease aggressively in the face of financial market turmoil and weak economic data, our feeling is that the ultimate result of this policy will be a significant pick up in inflation.  Moreover, it appears from reports from various countries that rising inflation is becoming a global phenomenon.

At this point it is clear to us that we were not imaginative enough in our recession scenario for interest rates in 2008.  In the December 19, 2007 edition of Across the Curve, we projected that, in a recession, the fed funds rate target would decline to 2½% by the end of 2008.  After the Fed’s policy statement last week and the 125 basis point cut in rates over nine days, we see the funds rate at 2½% by the March 18 FOMC meeting.  However, if the U.S. economy has fallen into recession, it seems likely to us that the Fed would cut the funds rate to 2%, or conceivably 1½%, by the middle of the year. 

We only hope that when inflation pressures become more manifest in the United States that the Federal Reserve reverses course and acts in a timely and decisive manner to contain these inflation pressures. 

The Economic Week Ahead: Feb. 11 to Feb. 15

Bear Stearns 2/8 - The economic calendar this week brings retail sales and business inventories (Wednesday), weekly jobless claims and international trade (Thursday), along with the Empire State survey, import prices, the TICS report, industrial production, and Michigan sentiment (Friday).

The highlight on the calendar this week is likely to be Fed Chairman Bernanke’s testimony on the economy and financial markets before the Senate Banking Committee (Thursday).