Matthew Greene : Northwestern Mutual - Economic Commentary - August 2008 : Article: Economic Commentary

Economic Commentary - August 2008

Clare Zempel

Economic and Investment Strategies Consultant

Overview

Stocks fell in early July and the total decline from last October’s peak reached 22.4% for the S&P 500 Common Stock Index. Various concerns were behind this latest setback. One was that commodity prices could cause a rapid rise in inflation worldwide. There is no question that increases in oil and food prices have intensified pressures on consumers who are also burdened with debt and fearful about job prospects. Consumer sentiment has fallen to its lowest level since 1980 amidst renewed worries about recession.

Another concern is that the potential for policy mistakes seems to have risen. If the Federal Reserve does not raise interest rates, then the dollar’s value in foreign exchange could fall further and drive commodity prices even higher. But if the Fed and other central banks do raise rates to contain inflation, that could slow the world’s economic expansion and reduce the demand for our exports. A third issue is that home prices have continued to fall. This reduces household net worth and inhibits consumer spending. It also puts additional pressure on financial institutions to write down real estate loans. That in turn reduces their capacity to extend new loans. A fourth problem is that tax increases seem likely after the election. And so on.

What should an investor do when faced with such widespread pessimism? The first step is to review what the more reliable indicators tell us to expect. Real interest rates have fallen to levels that spurred economic recoveries and reaccelerations in the past, and the stock market’s valuation relative to interest rates has been nowhere near troublesome levels since 1999. A second step is to note that spikes in oil prices did not result in recessions in the past unless the real fed funds rate was above 450 basis points – and the real fed funds rate is below zero now. Moreover, the sharp rise in oil’s price has in part reflected a decline in the dollar’s value, which in turn reflected expectations that the Fed would lower interest rates further. The new view that the Fed will soon raise rates should help stabilize the dollar and contain or lower oil prices. And oil-price spikes like the recent one have tended to occur in the past just before prices mounted extended declines.

The third step is to recall that bearish sentiment and bad news tend to peak near stock market lows. The unpleasant news that the unemployment rate rose from 5% in April to 5.5% in May renewed fears about a bear market, but the stock market was always sharply higher a year after such outsized increases occurred in the past. The fourth and most important step is to remember that well-diversified portfolios have delivered positive long-run results in the past despite frequent short-run setbacks. July’s setback seems to have been based much more on fear than on fundamental factors. Investors should continue to tilt their portfolios toward bullishness.

Economic and Market Update: The Continuing Discussion

The Consumer Sentiment Index has measured how optimistic consumers are since 1952. Except for three months in 1980, that index has never been lower than it is now. This is remarkable because current economic conditions have remained much more favorable than was true in most past recessions. For example, when the sentiment index bottomed at 62.0 in March 1982, the unemployment rate stood at 9%. In contrast, the unemployment rate this past June was 5.5% but the sentiment index was just 56.4. And “core” inflation was 7% then versus 2.1% now. (Figure 1.)

There is no doubt that consumers have reasons for concern. Based on the Establishment Payroll Survey, non-farm employment fell by 438,000 jobs from December 2007 to June 2008 – a 0.3% decline. Such weakness in the employment trend is much worse than seen in mere “mid-cycle slowdowns” that occurred in the past (1962-1963, 1966-1967, 1976, 1984-1986, and 1994-1995). At the same time, it is far less severe than what happened during the first six months in the six most recent recessions, when non-farm employment fell 0.9% on average. In other words, if we were six months into an average recession now, then non-farm employment should have fallen three times more than it has so far. (Figure 2.)

Other data support the idea that economic conditions

remain better overall than was true in past recessions. The Claims-Based Unemployment Rate (Initial Unemployment Insurance Claims/Labor Force) has risen much less than it did leading into past recessions. Real GDP (Real Gross Domestic Product) has continued to expand despite severe weakness in the housing and motor vehicle sectors. Indeed, Real GDP seems to have risen faster last quarter than it did in the previous two periods. (Figure 3.)

The perspective here is that real interest rates provide the most reliable clues about recession risk. Real or inflation-adjusted interest rate levels measure the extent to which the Federal Reserve’s policies are restrictive or not. The federal funds interest rate is the most important rate to watch for this purpose. This is

the rate that applies to funds that banks with excess reserves sell to other banks that need them to support their loans and investments. This is also the interest rate that the Federal Reserve raises and lowers to implement its policies. The fed funds rate was lowered to 2% on April 30.

The real fed funds rate is the difference between the nominal interest rate and inflation. The inflation rate used here is based on the Personal Consumption Expenditure Deflator (PCED) – a price index that is similar to but broader and more sensitive to shifts in spending habits than the Consumer Price Index (CPI). The “core” inflation rate – the 12-month change in the PCED excluding food and energy – is about 2.1%. Hence, the real fed funds rate is about -0.1% or -10

basis points – the 2% nominal fed funds rate minus the 2.1% inflation rate. (Figure 4.)

The reason it is important to know that the real fed funds rate is minus 10 basis points or so is that there has never been a recession until sometime after the real fed funds rate rose above 450 basis points. The 450 basis point level has been the “tipping point” where the Fed’s policies restricted or reduced borrowing and spending, resulting in a broad and sustained economic decline. Recession risk has been and remains low now because the real fed funds rate has been nowhere near 450 basis points since before the 2001 recession (the highest level since then was 334 basis points in June 2007).

There should be no recession now because the real fed funds rate never approached the level seen before all recessions since 1960. But it also seems important to note that the real fed funds rate has fallen to levels that ended past recessions and spurred recoveries. A similar observation applies to the Yield Spread (10-year T-Note Yield – Fed Funds Rate) which has now rebounded to about 210 basis points – in line with its levels when past recoveries started. Both rate-based measures promise that whatever economic weakness exists or develops should prove limited in depth and duration. Other factors aside, both rate-based measures indicate that Real GDP should continue to expand and that non-farm employment should rebound soon. (Figure 5.)

Could rising oil prices turn the economic slowdown into a recession and the stock market correction into a bear market? This is possible but improbable. Sharp increases in oil prices did not result in recessions in the past unless the real fed funds rate was above 450 basis points – and the real fed funds rate has been nowhere near this “tipping point” level. Moreover, the sharp rise in oil prices has in part reflected a steep decline in the dollar’s value in international exchange, which in turn reflected expectations that the Federal Reserve would lower interest rates even further. The Fed’s apparent new inclination to raise rates sometime soon should help to stabilize the dollar and contain or lower oil prices in the not-too-distant future.

The rise in oil prices over the year that ended in June was the third sharpest 12-month rise since 1980. The record shows that outsized advances in oil prices – 12-month increases that surpassed 77.5% – have tended to occur around the time that oil’s price level peaked. Subsequent declines in oil’s price surpassed 30% in depth and 14 months in duration. There can be no assurances but the sharp drop in oil prices in recent weeks could mean that the end to the upward spiral is at hand. (Figure 6.)

A recession would pose a serious threat to the stock market but real interest rates seem much too low to cause such a traditional economic downturn. The undeniable weakness in employment trends owes more to the post-bubble correction in home prices and the spike in oil prices since last summer. The former has not run its course but could do so within 6-12 months. The latter could be near its end and further declines would do much to alleviate pocket-book pressures and fears.

Absent a recession, stocks tend to rise unless real interest rates soar – which is not an issue now – or unless the market soars and becomes overvalued in the extreme – which is also not relevant now. Stocks also tend to rise when pessimism becomes extreme – and the Consumer Sentiment Index has now dropped to a near-record low. The AAII (American Association of Individual Investors) Investor Sentiment Index has also plummeted, in its case to a bearish extreme seen just twice in the past (1990 and last winter). Extreme investor bearishness tends to occur near stock market lows. (Figure 7.)

Economists and investors are inclined to extrapolate economic trends but “bad” news often has “good” implications. News that the unemployment rate had

risen from 5% in April to 5.5% in May renewed fears about a recession and a bear market, but the fact is that since 1948 the stock market has always been sharply higher – and the economy has always been in expansion – a year after such an outsized increase in joblessness occurred in the past. (Figure 8.)

Real interest rates do not threaten a recession or a bear market, employment trends are consistent with a slowdown but not a recession, and the stock market is not so overvalued that it threatens to fall under its own weight. The correction in housing has moved ever closer to its completion and the punishing rise in oil prices may be near its end.

Add to this mix the well-founded contrarian concept that extreme bearishness and bad news are bullish, and it seems probable that the stock market has all but discounted the worst. Risks and uncertainties remain but the fundamental forces that matter most still point in positive directions for the economy and the stock market.

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